ADP and ACP tests provide a crucial verification step for 401(k) retirement plans, ensuring that these plans maintain fairness and compliance with the Internal Revenue Service (IRS) regulations. With so many retirement plan options available, it’s essential to understand the ins and outs of each, including the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests for 401k. In this comprehensive guide, I’ll walk you through the complexities of these tests, popular retirement plans in the market, Sample working calculation for ADP and ACP tests and how to stay compliant with the regulations. Let’s dive in!
Table of Contents
Introduction
While there are various types of retirement plans available, some of the most common and popular plans are 401(k) plans. These plans allow employees to make pre-tax contributions, and employers can also choose to match a portion of those contributions.
However, offering a 401(k) plan comes with certain responsibilities and regulations to ensure fairness for all participants. This is where the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests come into play. These tests are mandated by the Internal Revenue Service (IRS) to prevent Highly Compensated Employees (HCEs) from disproportionately benefiting from the plan compared to Non-Highly Compensated Employees (NHCEs).
Nondiscrimination Tests
Nondiscrimination tests are an essential aspect of employer-sponsored retirement plans, ensuring that these plans are designed and operated in a manner that does not disproportionately benefit Highly Compensated Employees (HCEs) at the expense of Non-Highly Compensated Employees (NHCEs). The Internal Revenue Service (IRS) has established various nondiscrimination tests to maintain the tax-qualified status of retirement plans and uphold the principle of equitable treatment for all plan participants.
There are several key nondiscrimination tests that retirement plans must comply with:
- Actual Deferral Percentage (ADP) Test
- Actual Contribution Percentage (ACP) Test
- Top-Heavy Test
- Minimum Coverage Test
Understanding the ADP Test
The ADP test is a nondiscrimination test mandated by the IRS to ensure that Highly Compensated Employees (HCEs) do not disproportionately benefit from a 401(k) plan compared to Non-Highly Compensated Employees (NHCEs). In essence, the ADP test ensures that everyone gets a fair share of the retirement plan benefits.
The test calculates the average deferral percentage for both HCEs and NHCEs, and then compares the two groups. If the difference exceeds the permissible limit, the plan fails the ADP test.
To pass the ADP test, the average deferral percentage for HCEs must not exceed the following limits:
- If the average deferral percentage for NHCEs is 2% or less, the average deferral percentage for HCEs must not exceed twice the NHCE average.
- If the average deferral percentage for NHCEs is between 2% and 8%, the average deferral percentage for HCEs must not exceed the NHCE average plus 2%.
- If the average deferral percentage for NHCEs is over 8%, the average deferral percentage for HCEs must not exceed 1.25 times the NHCE average.
If a plan fails the ADP test, the plan sponsor must take corrective actions such as refunding excess contributions to HCEs or making additional contributions to NHCEs to balance the deferral percentages.
Understanding the ACP Test
Similar to the ADP test, the ACP test ensures that employer matching contributions and employee after-tax contributions do not disproportionately benefit HCEs. Just like the ADP test, the ACP test calculates the average contribution percentage for HCEs and NHCEs and compares the two groups.
The ACP test is similar to the ADP test, but it focuses on employer matching contributions and employee after-tax contributions instead of employee deferrals. Like the ADP test, the ACP test compares the average contribution percentages of HCEs to those of NHCEs to ensure that the plan does not disproportionately benefit HCEs in terms of employer contributions.
The ACP test uses the same limits as the ADP test to determine whether the plan passes or fails. If a plan fails the ACP test, the plan sponsor must take corrective actions such as refunding excess contributions to HCEs, making additional contributions to NHCEs, or recharacterizing certain contributions to balance the contribution percentages.
ADP and ACP tests for Popular Retirement Plans
While the ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) tests are most commonly associated with 401(k) plans, they also apply to other types of employer-sponsored retirement plans that allow for employee deferrals or employer matching contributions. Some of these plans include:
- 403(b) plans: These plans are similar to 401(k) plans but are designed for employees of tax-exempt organizations, such as educational institutions, non-profit organizations, and religious institutions. Like 401(k) plans, 403(b) plans can include employee deferrals and employer matching contributions, which make them subject to the ADP and ACP tests.
- SIMPLE 401(k) plans: These are simplified versions of traditional 401(k) plans, designed for small businesses with 100 or fewer employees. SIMPLE 401(k) plans require employers to make either matching contributions or non-elective contributions to employees’ accounts. Although SIMPLE 401(k) plans are not subject to the ADP test, they are still subject to the ACP test for matching contributions.
- SIMPLE IRA plans: Similar to SIMPLE 401(k) plans, SIMPLE IRAs are designed for small businesses with 100 or fewer employees. These plans require employers to make either matching contributions or non-elective contributions to employees’ individual retirement accounts. SIMPLE IRA plans are not subject to the ADP test, but they are subject to the ACP test for matching contributions.
- SARSEP plans: A Salary Reduction Simplified Employee Pension (SARSEP) plan is a type of SEP plan that includes a salary reduction arrangement, allowing employees to make elective deferral contributions. These plans were only available to small businesses with 25 or fewer employees and could not be established after 1996. Existing SARSEP plans are subject to both ADP and ACP tests.
10 Essential steps to Pass the ADP and ACP Tests for 401k
To pass the ADP and ACP tests, you can implement various strategies, such as:
- Know the Rules and stay informed.
- Monitor plan participation.
- Utilize the EACA and QACA Options.
- Educate employees on the benefits of contributing to the retirement plan.
- Offer an attractive matching contribution formula.
- Implement automatic enrollment and escalation features.
- Adopt a plan design that encourages broad participation.
- Consider a Safe Harbor 401(k) plan to avoid ADP and ACP testing.
- Conduct Annual Nondiscrimination Testing.
- Consult with Professionals.
The Safe Harbor 401(k) Plan
Safe Harbor 401(k) plans are a popular choice for businesses looking to bypass the ADP and ACP tests. By providing specific employer contributions, these plans are exempt from the tests, making compliance much easier. There are two main types of Safe Harbor contributions:
- Non-elective contribution: The employer contributes 3% of each eligible employee’s compensation, regardless of whether the employee contributes to the plan.
- Matching contribution: The employer matches employee contributions, typically up to 4% of the employee’s compensation.
Top-Heavy Plans and Their Impact on ADP and ACP Tests
A retirement plan is considered top-heavy if more than 60% of the plan’s assets are held by Key Employees at the end of the plan year. Top-heavy plans are subject to additional requirements to ensure fairness for all employees.
To prevent a plan from becoming top-heavy, employers can:
- Encourage broad employee participation in the plan.
- Monitor plan demographics and adjust plan design as needed.
- Implement a Safe Harbor 401(k) plan, which is not subject to top-heavy rules.
The Importance of Recordkeeping and Compliance
Maintaining accurate records and staying compliant with the ADP and ACP tests is crucial to avoid IRS penalties and ensure the long-term success of your retirement plan. Employers should:
- Keep track of employee deferrals, matching contributions, and after-tax contributions.
- Conduct annual ADP and ACP tests, if applicable.
- Correct any failures promptly to avoid penalties and maintain the plan’s tax-qualified status.
- Partner with experienced plan administrators and advisors to ensure smooth plan operation.
ADP and ACP tests for 401k – Sample Calculation
Let’s explore an example of the ADP and ACP tests using the Highly Compensated Employee (HCE) compensation criteria of $215,000 for 2023. Suppose we have a small business with 10 employees, with two employees classified as HCEs and eight employees as NHCEs.
Employee Breakdown:
| Employee | Status | Compensation | Deferral % | Employer Match % |
|---|---|---|---|---|
| A | HCE | $220,000 | 6% | 4% |
| B | HCE | $240,000 | 8% | 4% |
| C | NHCE | $60,000 | 3% | 3% |
| D | NHCE | $50,000 | 4% | 4% |
| E | NHCE | $40,000 | 2% | 2% |
| F | NHCE | $55,000 | 3% | 3% |
| G | NHCE | $45,000 | 4% | 4% |
| H | NHCE | $70,000 | 3% | 3% |
| I | NHCE | $75,000 | 4% | 4% |
| J | NHCE | $65,000 | 3% | 3% |
ADP Test:
To calculate the ADP for each group, we first compute the deferral percentages for each employee and then find the average for each group.
HCEs:
- Average: (6% + 8%) / 2 = 7%
NHCEs:
- Average: (3% + 4% + 2% + 3% + 4% + 3% + 4% + 3%) / 8 = 3.25%
Since the HCEs’ ADP is 7% and the NHCEs’ ADP is 3.25%, the difference is 3.75%. Based on the ADP test rules, the maximum allowable difference for this example is 2%. Therefore, the plan fails the ADP test.
ACP Test:
To calculate the ACP for each group, we first compute the contribution percentages (employee deferrals + employer match) for each employee and then find the average for each group.
HCEs:
- A: (6% + 4%) = 10%
- B: (8% + 4%) = 12%
- Average: (10% + 12%) / 2 = 11%
NHCEs:
- Average: [(3% + 3%) + (4% + 4%) + (2% + 2%) + (3% + 3%) + (4% + 4%) + (3% + 3%) + (4% + 4%) + (3% + 3%)] / 8 = 6.5%
Since the HCEs’ ACP is 11% and the NHCEs’ ACP is 6.5%, the difference is 4.5%. Based on the ACP test rules, the maximum allowable difference for this example is 2%. Therefore, the plan fails the ACP test as well.
What Happens When a Plan Fails the ADP or ACP Test?
Failing the ADP or ACP test can have significant consequences for both the employer and the Highly Compensated Employees (HCEs) involved. It’s crucial to understand the implications of a failed test and the necessary corrective actions to maintain the tax-qualified status of the retirement plan.
Consequences of Failing the ADP or ACP Test
When a retirement plan fails the ADP or ACP test, it jeopardizes the plan’s tax-qualified status. If left uncorrected, the plan could face penalties from the IRS and even possible disqualification. Some consequences of a failed test include:
- Taxable income for HCEs: If excess contributions are refunded to HCEs, those amounts are treated as taxable income for the affected employees.
- Potential penalties: Failure to correct a failed test within the required timeframe may result in IRS penalties for the employer.
- Loss of tax benefits: If the plan is disqualified by the IRS, the tax benefits associated with the retirement plan could be lost for both the employer and employees.
Correcting a Failed ADP or ACP Test
To avoid these consequences and maintain the plan’s tax-qualified status, the employer must take corrective action within the specified timeframe. The IRS allows a 2.5-month period following the end of the plan year (known as the “correction period”) to fix a failed test. Employers have two primary options for correcting a failed test:
- Refund excess contributions to HCEs: The employer can return a portion of the HCEs’ deferrals or contributions to bring the HCEs’ average percentage in line with the permissible limits. Refunded amounts will be treated as taxable income for the affected HCEs. This correction must be made within the 2.5-month correction period to avoid penalties.
- Make additional contributions for NHCEs: The employer can make Qualified Non-Elective Contributions (QNECs) or Qualified Matching Contributions (QMACs) to NHCEs’ accounts to increase their average percentage, thereby bringing the plan into compliance. These additional contributions must be made within the 2.5-month correction period and are tax-deductible for the employer.
If corrections are not made within the 2.5-month correction period, the employer may still correct the failure within a 12-month period following the plan year-end, but a 10% excise tax will apply to the excess contributions.
By promptly addressing a failed ADP or ACP test and taking the appropriate corrective measures, employers can maintain their retirement plan’s tax-qualified status, protect valuable tax benefits, and ensure fairness for all participants.
Conclusion
Understanding the ADP and ACP tests is essential for any business offering a retirement plan to its employees. By carefully selecting the right plan, educating employees, and staying compliant with regulations, you can create a successful retirement plan that benefits both you and your employees.
One cannot plan for everything, but making sound financial investment decisions early in life can help with situations when you need the money most. Here are additional articles that deal with smart investments:
- Average 401(k) Balance by Age: Unlocking the Secrets to a Successful Retirement
- Automatic Investment Plan (AIP): Comparison of Investment Strategies SIP vs AIP
- What is the Difference Between Pension And 401(k): Breaking Down the Mystery and Similarity.