ACP Test vs. ADP Test: What to Know About 401(k) Nondiscrimination Testing

The actual deferral percentage (ADP) test and actual contribution percentage (ACP) test are both required to be administered every year to ensure traditional 401(k) plans are in compliance. While ADP considers only employee deferrals, ACP also includes employer contributions. However, plan sponsors must conduct both tests regardless of whether or not they match.

If you’re interested in setting up a 401(k) or changing 401(k) companies, Human Interest offers low-cost plans that are very competitive in the small business market. They can also help structure a Safe Harbor 401(k) that’s exempt from ADP and ACP testing or streamline compliance testing to let you know before your plan becomes noncompliant.

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How the ADP Test & ACP Test Work

Each year, 401(k) plans must undergo 401(k) nondiscrimination tests including the ADP and ACP tests. These tests are typically conducted by plan administrators and compare contributions or deferrals of highly compensated employees (HCEs) with those of other plan-eligible employees. To learn about retirement plans exempt from ADP and ACP testing, check out the “Retirement Plans Exempt from ADP & ACP Testing” section below for details.

The purpose of 401(k) nondiscrimination tests is to ensure that all employees are benefiting from the 401(k) plan — not just company owners and high earners. ADP and ACP testing require that owners and high earners deferrals and contributions don’t greatly exceed those of other employees. A noncompliant plan would have company owners and high earners making more than two-thirds of the total contributions or owning more than 60 percent of plan assets.

In any 401(k) plan, there are two types of employees: HCEs and nonhighly compensated employees (NHCEs). HCEs are any plan-eligible employees who earn $125,000 or more in total cash or stock compensation or who own 5 percent or more of the business during the past year. NHCEs are any employees who are eligible for the 401(k) plan but don’t qualify as HCEs.

401(k) Nondiscrimination Testing: ADP & ACP Limits

Under ACP and ADP testing, the deferral and contribution of HCEs and owners who own at least 5 percent of a business with a traditional 401(k) can be limited. Based on the deferral and contribution rates of NHCEs, HCEs may not be able to contribute as much as they’d like based on these limits.

If the average deferral rate of NHCEs who are eligible for a company’s 401(k) is less than 2 percent, then company owners and HCEs are not allowed to have an average deferral rate more than double that of NHCEs. If NHCEs contribute between 2 percent and 8 percent, then HCEs can’t contribute more than 2 percent more than NHCEs. Finally, if NHCEs contribute more than 8 percent on average, the HCEs can’t contribute more than 25 percent more than NHCEs.

The biggest difference is that the ADP test compares relative deferrals among HCEs and NHCEs whereas the ACP test compares the contributions of both groups that include employer matching.

Here’s how the ADP test and ACP test work.

The ADP Test

The ADP test requires employers to compare the average annual deferral rates of HCEs and NHCEs. However, ADP testing specifically excludes any employer matching — it only measures employee deferrals. The ADP test is also based only on employee cash- and stock-based compensation. Health insurance and other perks are excluded.

To conduct the ADP test, start by calculating each employee’s actual deferral rate. This requires dividing each employee’s total deferrals — both pretax and Roth — by the employee’s total annual compensation in cash and stock. You then find the average deferral rates for HCEs (including any 5 percent-plus owners) and NHCEs separately. The average annual deferrals for HCEs can’t exceed the limits outlined above.

ADP Test Example

Imagine you have a business with 10 employees, all of whom are eligible for a 401(k) and participate in the plan. Let’s say that you own 100 percent of the business, but you have two all-star employees who make more than $125,000 per year. You and your high earners always maximize contributions but contributions are lower or nonexistent for some other employees.

Each year, you will need to find the deferral rates (employee contributions only) for all of your employees based on total compensation in cash or stock. Then, you find the average rate for you and your high-earning employees and the average for everyone else. If the average deferral rate for you and your high earns is 3 percent, for example, then in order to pass the ADP test your other employees need to have an average deferral rate of at least 1.5 percent (1.5 percent x 2 = 3.0 percent).

If, on the other hand, the average deferral rate for your NHCEs was 1 percent, then the average deferral rate for you and your HCEs couldn’t exceed 2 percent (1 percent x 2 = 2 percent). If your average deferral rate was 3 percent for a given year, you would either need to return some deferrals to you and your high earners to make contributions on behalf of your NHCEs to give them another 0.5 percent.

The ACP Test

The ACP test includes not only employee salary deferrals and after-tax contributions but also employer matching contributions. In addition to the ADP test, employers are also required to conduct the ACP test. However, the results will be the same except if employers don’t provide matching contributions.

The ACP test requires employers to follow a process similar to the ADP test. First, each employee’s annual contribution rate is determined by adding employee deferrals, after-tax contributions, and employer matching, then dividing the total by each employee’s total annual compensation. Rates are then averaged for HCEs and NHCEs with HCE contributions limited based on the average annual NHCE contribution rate.

ACP Test Example

Continuing with the above example of a 10-person company with three HCEs, let’s say that in your 401(k) plan you match all employee contributions up to 3 percent. Using this example, each year you would need to find each employee’s annual contribution rate.

To do this you would add the total contributions to each employee’s account (salary deferrals plus employer matching contributions) and divide by their total cash and stock compensation. As with the ADP test, you then find the average contribution rate for you and your HCEs and the average rate for everyone else.

If in this example, the average contribution rate for your NHCEs was 1.75 percent, then the average contribution rate for you and your high earns could not exceed 3.5 percent and still be compliant (1.75 percent x 2 = 3.5 percent). If your average rate was 5.5 percent, for example, then you would either need to return money to HCEs to bring their average deferral back below 3.5 percent. Alternatively, you could make contributions to all NHCEs to bring their average contribution rate up to at least 3.5 percent (3.5 percent + 2 percent = 5.5 percent).

Both the ADP test and ACP tests must be conducted each year for 401(k) plan sponsors. Each test has ranges that employee deferrals or contributions must fall in for a plan to be compliant. If employee contributions fall outside these ranges, a plan sponsor must take corrective action to bring the plan back in compliance. These corrective actions are discussed further in the “ADP Test and ACP Test Rules” section below.

Avoiding ADP & ACP Testing

ADP and ACP testing is typically conducted by plan administrators but can still cause headaches for plan sponsors. If you have a small business with just a few high-earning employees or struggle with participation among NHCEs, ACP and ADP testing can restrict HCE contributions or increase expenses to make contributions for NHCEs.

Safe Harbor 401(k)

To alleviate yourself of this testing, one thing that you can do is to utilize a safe harbor 401(k) plan. Qualifying a 401(k) for safe harbor requires that you match employee contributions up to 4 percent using one of two different matching schemes. You are also required to vest all employer contributions immediately with employees, rather than using a 401(k) vesting schedule.

If setting up a safe harbor 401(k) sounds like it may be a good fit for your small business, we recommend looking at Human Interest. Human Interest is a great low-cost provider of 401(k) administration and has particular expertise around safe harbor 401(k) plans. To learn more about Human Interest and its offerings, visit its website.

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ADP Test & ACP Test Rules

To keep a 401(k) plan in compliance, plan sponsors are required to conduct ACP testing and ADP testing annually. To avoid corrective contributions or distributions, the contributions of HCEs and NHCEs need to be kept within strict guidelines. Failure to make corrective distributions or contributions when necessary can result in fines or penalties.

ADP Test Rules

The ADP test is typically conducted by a plan administrator and requires that the average deferral rate for HCEs stay within certain limits relative to the average deferral rate of NHCEs. When conducting the ADP test, administrators are required to include all company employees who are eligible for 401(k) benefits. While the tests include all compensation in the form of cash or stock, other benefits like health insurance are not included.

ADP testing compensation includes:

• Salaries: Regularly weekly paychecks
• Commissions: Any performance-based income
• Bonuses: Additional cash compensation paid to employees
• Stock awards: Stock options or awards during the plan year

ACP Test Rules

Like the ADP test, ACP tests are typically conducted by 401(k) provider and requires that the average annual contribution rate, which includes pre- and post-tax employer contributions plus employer matching for HCEs not to exceed limits outlined in the “401(k) Nondiscrimination Testing: ADP & ACP Limits” section above.

As with the ADP test, ACP testing includes all cash- and stock-based employee compensation throughout the year. However, unlike the ADP test, the ACP test measures not only employee salary deferrals but also matching employer contributions. This means that, if you fail the ADP test, you are almost guaranteed to fail ACP testing as well.

What Happens When You Fail the ADP Test or ACP Test

When a 401(k) plan fails the ACP test or ADP test, plan sponsors must choose one of two ways to bring the plan back into compliance. Plan sponsors can either make tax-deductible corrective contributions on behalf of NHCEs to make up the difference or make corrective distributions to HCEs that are taxable as income.

Most companies who fail the ADP or ACP tests elect to make corrective distributions and return 401(k) contributions to company owners or high earners. These corrective distributions create unexpected income tax liability for HCEs but are generally lower cost to plan sponsors as opposed to corrective contributions.

When you fail ACP testing or ADP testing, you can either:

• Corrective distributions: Returning money to high earners and owners to bring the plan back into compliance
• Corrective contributions: Making nonelective contributions to NHCEs to make the plan compliant

“If a plan fails ADP or ACP testing, the failed test must be corrected within 2 1/2 months after the close of the plan year to avoid a 10 percent excise penalty tax. If the test still isn’t corrected by the end of the following plan year (within 12 months of the plan year end), the plan sponsor must make special contributions to their NHCEs (qualified nonelective contributions or 1-to-1 contributions) while still making corrective distributions to HCEs. If the plan still isn’t brought back into compliance, the plan potentially may be disqualified.” — Cindy Bloch, Chief Compliance Officer, ForUsAll

If you want to avoid 401(k) nondiscrimination testing entirely, including the ADP test and ACP test, you may want to consider setting up a safe harbor 401(k) with a firm like Human Interest. For more information on this these types of plans and how they can exempt you from 401(k) nondiscrimination testing, be sure to visit the Human Interest website.

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Retirement Plans Exempt from ADP & ACP Testing

For traditional 401(k) plans, both the ACP and ADP tests need to be conducted annually. Both tests are usually conducted by 401(k) providers — typically administrators. Some firms even advise plan sponsors when their plans are headed toward noncompliance so that contribution levels can be adjusted as necessary.

For more information on the best 401(k) companies, the investment options they offer, and how they benefit employees be sure to check out our guide to the best 401(k) companies.

There are some types of retirement plans that are not required to conduct ACP testing or ADP testing each year, including:

• Safe Harbor 401(k): 401(k) plans that institute matching programs that qualify for safe harbor are not required to conduct ACP or ADP tests
• SIMPLE IRA: A savings incentive match plan for employees (SIMPLE) is often called the “poor man’s 401(k),” and these are not required to undergo nondiscrimination testing
• SEP IRA: A simplified employee pension (SEP) IRA requires employers to fund contributions to all employee accounts proportion to contributions to their own account and do not require ADP or ACP testing
• Traditional IRA: Traditional IRAs are set up for individuals rather than as employer-sponsored retirement plans and are not required to undergo nondiscrimination testing

These retirement plans exempt sponsors from requirements to conduct ADP and ACP testing for employee deferrals and employer matching. However, nondiscrimination testing is still required for profit-sharing contributions for plans including safe harbor 401(k) plans.

Human Interest is a relatively new provider of plans, including safe harbor 401(k)s, which mostly exempt employers from 401(k) nondiscrimination testing. If you decide not to institute a safe harbor plan, Human Interest is also one of the few administrators that will alert 401(k) plan administrators before their plan becomes noncompliant so that adjustments can be made.

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Frequently Asked Questions (FAQs)

Are Catch-up Contributions Included in the ADP Test?

While plan participants age 50 and older are permitted to make additional “catch-up contributions” to their 401(k) each year, these contributions aren’t included in calculations for ADP testing. However, Roth and other after-tax contributions are included.

What Is the HCE Limit?

The contribution limit for HCEs (those that earn more than $125,000 or own more than 5 percent of the business) varies depending on the average annual deferral and contribution rate for NHCEs. HCE contribution limits for a 401(k) are typically between 2 percent higher than and double the average contribution/deferral rates for NHCEs.

What Is Top-heavy Testing?

In addition to the ADP test and ACP testing, plan sponsors are also required to conduct annual top-heavy testing. This additional type of 401(k) nondiscrimination testing prohibits company owners and high earners from owning more than 60 percent of the total plan assets.

The Bottom Line

The ADP and ACP tests are two kinds of 401(k) nondiscrimination testing that 401(k) plan sponsors are required to run each year. These tests ensure that 401(k) contributions of company owners and high earners don’t outpace those of NHCEs drastically.

Thankfully, you can avoid many of the headaches caused by failing ADP or ACP testing by using the right providers. Human Interest is one 401(k) company that alerts plan sponsors when a plan is headed towards noncompliance and also offers 401(k) safe harbor plans that are exempt from nondiscrimination testing. Visit Human Interest’s website for more information.

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