Back to: ACCOUNTING, TAX, & REPORTING
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.
A Little More on What is an Actual Deferral Percentage & Actual Contribution Percentage Test
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 participant’s deferral rate. To calculate this, you will have to divide the participant’s 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 group’s average deferral rate.
Generally, for a group to pass the ADP test, the HCE group’s 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 HCE’s average deferral rate to stay within a given limit. This should be relative to the NHCE’s 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 year’s 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 employer’s contribution together with the employer matching for HCE’s 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 won’t 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 employer’s 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 employee’s 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.
Academics research on “Actual Deferral Percentage / Actual Contribution Percentage – ADP/ACP Test”
A behavioral model for predicting employee contributions to 401 (k) plans: preliminary results, VanDerhei, J., & Copeland, C. (2001). A behavioral model for predicting employee contributions to 401 (k) plans: preliminary results. North American Actuarial Journal, 5(1), 80-94. Previous research on employee contribution behavior to 401(k) plans has often been limited by lack of adequate data. This is primarily because of the types of matching formulas utilized by sponsors. While these formulas are often complicated because of the desire of sponsors to provide sufficient incentives to non-highly compensated employees to contribute in order to comply with technical nondiscrimination testing, this complexity makes it virtually impossible to appropriately analyze the employee’s behavior if we are forced either to observe aggregate plan data or to use information on the plan contribution formulas provided by the participant. The purpose of this paper is to provide preliminary findings introducing new methodology to expand the usefulness of modeling these data as well as a better understanding of contribution behavior by 401(k) plan participants. We utilize a sequential response regression model to allow for the differing incentives faced by the employees at various levels of contributions. Based on findings from 137 distinct matching formulas, we have estimated a behavioral model that is able to control for the tendency of employers to substitute between the amount they match per dollar of employee contribution and the maximum percentage of compensation they are willing to match.
Pension nondiscrimination rules and the incentive to cross subsidize employees, Brady, P. J. (2007). Pension nondiscrimination rules and the incentive to cross subsidize employees. Journal of Pension Economics & Finance, 6(2), 127-145. Among the requirements a pension plan must meet to qualify for tax benefits are the nondiscrimination rules. Nondiscrimination rules are designed to ensure that pension benefits do not disproportionately accrue to highly compensated employees. But the rules are also complex and increase administrative and compliance costs associated with offering a pension plan. Recent pension reform proposals would simplify nondiscrimination rules, reducing administrative and compliance costs and potentially leading to more employers offering pension benefits. However, there are concerns that any loosening of the rules could lead to a drop in participation by low-wage workers. This paper examines the economic incentive that nondiscrimination rules provide to employers to cross subsidize employees; that is, the incentive to increase pension benefits (and total compensation) paid to low-paid workers for the express purpose of enabling high-paid workers to receive a higher proportion of compensation in the form of pension benefits. The study calculates the incentives faced by a hypothetical firm, and then illustrates how those incentives change when assumptions about employee contribution behavior, employee compensation, and employer-matching formulas are allowed to vary. Results show that only firms with a relatively low ratio of low-paid workers to high-paid workers would have an economic incentive under a standard 401(k) plan to cross subsidize employees. Although this incentive may exist in a large number of firms, these firms likely employ only a small portion of the workforce. This is ultimately an empirical question, however, and examining data on the distribution of earnings within pension plans, as well as determining if firms find nondiscrimination rules binding, would be a useful extension of this research.
What determines 401 (k) participation and contributions, Munnell, A. H., Sunden, A., & Taylor, C. (2001). What determines 401 (k) participation and contributions. Soc. Sec. Bull., 64, 64.
Factors affecting participation rates and contribution levels in 401 (k) plans, Clark, R. L., & Schieber, S. J. (1998). Factors affecting participation rates and contribution levels in 401 (k) plans. Living with defined contribution pensions: Remaking responsibility for retirement, 69-97.
Contribution Behavior of 401 (k) Plan Participants During Bull and Bear Markets, Holden, S., & VanDerhei, J. (2003, January). Contribution Behavior of 401 (k) Plan Participants During Bull and Bear Markets. In Proceedings. Annual Conference on Taxation and Minutes of the Annual Meeting of the National Tax Association(Vol. 96, pp. 44-53). National Tax Association.