Actual Deferral Percentage / Contribution Percentage Tests - Explained
What are the Actual Deferral Percentage and the Contribution Percentage Tests?
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Table of ContentsWhat are the Actual Deferral Percentage & Actual Contribution Percentage TestsHow are the Actual Deferral Percentage & Actual Contribution Percentage Tests Used?How ADP/ACP Test WorksADP/ACP Test RuleACP Test RulesHow to Solve ADP/ACP Test FailureADP/ACP Test ExemptionWhat is a Safe Harbor Plan?Important of ADP/ACP TestComplications Associated with the ADP/ACP Test Academics research on Actual Deferral Percentage / Actual Contribution Percentage - ADP/ACP Test
What are the Actual Deferral Percentage & Actual Contribution Percentage Tests
The Actual Deferral Percentage/Actual Contribution Percentage simply refers to two separate 401 (k) nondiscrimination plan tests. ERISA and the IRS require that a 401K pass these tests to maintain its qualified status. The purpose of these two tests is to determine whether or not the 401 (k) salary deferral plans surpasses the set guidelines for discrimination in the tax code.
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How are the Actual Deferral Percentage & Actual Contribution Percentage Tests Used?
Generally, the ADP test is used to compare the average percentage of the deferral salary of the highly compensated employee (HCE). The compensation is done to that of non-highly compensated employees (NHCE). HCE refers to any of the employees who have more than 5 percent interest at any time of the current or previous year. Note that the ADP test covers both pre-tax and after-tax Roth deferrals. However, the contributions do not relate to the catch-up.
How ADP/ACP Test Works
When implementing ADP and ACP tests there are a number of steps involved. They include the following:
Step one: This step involves identification of the testing group. The groups are usually comprised of those employees who meet all the requirements that apply to the plan (eligible employees).
Step two: This involves the grouping of participants. Here, the participants are separated into two groups. The groups are the HCEs and the non-HCEs respectively.
Step three: Step three is about computing each participants deferral rate. To calculate this, you will have to divide the participants total salary deferrals by his or her compensation. The calculation should include both pre-tax and Roth.
Step four: This is the last stage where you are supposed to determine the HCE and NHCE groups average deferral rate. Generally, for a group to pass the ADP test, the HCE groups average has to be within the NHCE average given spread. According to the existing rule, the spread is supposed to be at a two percentage point.
ADP/ACP Test Rule
Both ADP and ACP test is implemented under certain rules as explained below:
ADP Test Rule
- It is carried out by an administrator from 401 (k) plan.
- The HCEs average deferral rate to stay within a given limit. This should be relative to the NHCEs average deferral rate.
- Administrator to ensure that all the company employees eligible for 401 (k) benefits are included.
- The tests to include all compensations. This should be in the form of stock or cash. However, this does not include health insurance
ADP Testing Compensations are as follows:
- Regular weekly paychecks (salaries)
- Any income that is based on any work performance (Commissions)
- Any extra cash paid to employees and compensation (Bonuses)
- Any awards or stock options are given during the years plan (Stock awards)
ACP Test Rules
- ACP is also conducted by an administrator from the 401 (k).
- It requires that the average annual contribution rate which is the employers contribution together with the employer matching for HCEs should not surpass the set limit in the 401 (k) Nondiscrimination Testing.
Note that the ACP test measures both employees salary deferral as well as matching for the employer. Also, the ACP testing includes both stock-based employees and well as cash compensation across the year.
How to Solve ADP/ACP Test Failure
When implementing the ADP/ACP test, there is a possibility that it will backfire or it wont succeed. There is, however, a number of things you can do to rectify the problem. They are as follows:
- Refunding high earners so that the owners can ensure that the plan is taken back into compliance.
- Making the plan compliant by giving out non-elective contributions (tax-deductible contributions) to NHCEs. This refers to the necessary amount required to pass the ADP/ACP test.
- To place a restriction limit on HCEs contributions. This is best done during mid-year plans. This is for the purpose of determining whether or not the application restriction is actually needed.
ADP/ACP Test Exemption
There are various retirement plans that are exempted from ADP/ACP testing. They are as follows:
SIMPLE IRA: This refers to the savings incentive match plan for employees. Those under this retirement plan are not required to go through nondiscrimination testing.
Safe Harbor 401 (k): The 401 (k) plans are also not required to under ACP/ACP tests. The 401 (k) plans refer to those plans that institute matching programs that qualify for safe harbor.
SEP IRA: This refers to a retirement plan called a simple employee pension (SEP) IRA. An employer is required to contribute funds to all employees accounts. This should be proportion to contributions to their own account. This retirement plan does not require ADP/ACP testing.
Traditional IRA: This is a retirement plan created for participants who do individual contribution. This means that they are not under the employers sponsorship. This retirement plan is not required to undergo the ADP/ACP test. Note that despite the above exemptions, a plan such as a harbor 401(k) is still subject to nondiscrimination testing. This is because they are contributions related to profit-sharing plans that exist within the plan.
What is a Safe Harbor Plan?
Safe Harbor 401(k) is a plan that allows sponsors to skip ADP/ACP nondiscrimination testing. This is done in exchange for providing nonelective contributions that are eligible. Note that in order to qualify for Safe Harbor, it is a must for the company to: Provide a basic match. The match may include 100 percent match on the first 3 percent of deferred compensation and a 50 percent match on deferrals of 3 to 5 percent. Provide every employee with at least 3 percent compensation of non-elective contribution. Note that this is regardless of the amount the employee contributes. It also applies to those employees who are not contributing.
Important of ADP/ACP Test
The ADP and ACP tests are created to specifically ensure that the employees average contribution rate and that of the employer match are actually balanced between the HCEs and the nonHCEs.
Complications Associated with the ADP/ACP Test
The ADP/ACP testing is generally complex. This is because it involves many considerations which make the process complicated. Some of these considerations are:
- Employees changing family relationships through the process of divorce or adoption as well as the top-paid 20 percent of the correct application. This complicates the ADP/ACP process because of regular changes.
- Restrictions that apply to the process of switching between the present year testing method, and the previous year testing method. The restrictions may make the process complex.
- The flexibility involved in the compensation for the testing purpose definition.
- Where some employees have to be left out from the ACP test on the basis of hours and their status of employment.