Actual Deferral and Actual Contribution Percentage Tests (ADP/ACP)
What Are the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Tests?
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are two tests that companies must conduct to guarantee that their 401(k) plans don't unjustifiably benefit generously compensated employees to the detriment of others.
Companies that offer 401(k) plans must conduct the tests to hold the qualified status of their plans under IRS rules and the Employee Retirement Income Security Act (ERISA).
In the event that the plan fails either test, the employer must make a corrective move in the year period following the close of the plan year in which the oversight happened. Failure to do so can bring about the IRS forcing financial punishment charges, plan preclusion, and fiduciary liability with respect to the employer.
How ADP and ACP Tests Work
The ADP test compares the average salary deferral percentages of [highly compensated employees](/exceptionally compensated-employee) (HCE) to that of non-profoundly compensated employees (NHCE). A HCE is any employee who claims over 5% interest in the company whenever during the current or past plan year or acquired more than $130,000 during the 2020 tax year.
The ADP test considers both pre-tax deferrals and after-tax Roth deferrals, however no catch-up contributions, which might be made exclusively by employees age 50 and over. To breeze through the assessment, the ADP of the HCE may not surpass the ADP of the NHCE by multiple percentage points. Furthermore, the combined contributions of all HCEs may not be multiple times the percentage of NHCE contributions.
The ACP test involves a comparative method as the ADP test with the exception of that it utilizes matching contributions or employee after-tax contributions.
Amending an ADP/ACP Test Failure
At the point when employers fail the ADP/ACP tests, they can cure the failure by refunding excess contributions back to HCEs in the amount important to breeze through the assessment. Notwithstanding, these refunds will be at risk for income tax for the HCE people.
A few companies set buffer zones inside their plan reports to control plans from possibly failing the ADP/ACP test in the first place. One option is setting a cap on contributions by HCEs. Another option is to place a contribution limit on HCEs at the point where the plan would fail an ADP/ACP test. Setting plan buffer zones might expect employers to conduct ADP/ACP test projections, commonly in the center of the plan year, to decide whether any limitations should be applied.
In any case, a few companies utilize a Safe Harbor 401(k) plan to keep away from the ADP/ACP test completely.
What Is a Safe Harbor Plan?
Safe Harbor 401(k) plans permit backers to sidestep ADP/ACP and other non-segregation testing in exchange for giving eligible matching or nonelective contributions for their employees.
To meet all requirements for Safe Harbor, a company must give an essential match, for example, a 100% match on the first 3% of deferred compensation and a half match on deferrals of 3% to 5%. They may likewise give every employee a nonelective contribution of no less than 3% of compensation, paying little heed to how much the employee contributes or on the other hand on the off chance that they contribute by any stretch of the imagination.