Quick Summary
The ADP test compares the average deferral rates of highly compensated employees with those of everyone else, and the ACP test does the same for matching and after-tax contributions. If highly compensated employees save too much relative to others, the plan fails and must correct, usually by refunding excess contributions or making additional employer contributions. Refunds made within two and a half months after the plan year ends avoid an employer excise tax. Safe harbor designs, automatic enrollment, and stronger participation among rank-and-file employees reduce the risk of failure.
A 401(k) plan receives significant tax advantages. In exchange, the tax code requires that the plan not unfairly favor highly compensated employees. For most traditional 401(k) plans, that requirement is checked every year through two tests: the ADP test and the ACP test.
For small businesses, these tests are a frequent source of unwelcome surprises, often in the form of refund checks to owners after the year is over.
Who counts as highly compensated
A highly compensated employee (HCE) is generally anyone who:
- Owned more than 5% of the business at any time during the current or prior year, or
- Earned more than an IRS-indexed compensation threshold in the prior year
Ownership is attributed among family members, so the spouse, children, parents, and grandparents of a more-than-5% owner are also treated as owners. Plans may also elect to limit the compensation-based group to the top 20% of earners.
Everyone else is a non-highly compensated employee (NHCE).
The ADP test
ADP stands for actual deferral percentage. For each eligible employee, the plan calculates deferrals as a percentage of compensation. Eligible employees who do not contribute count as 0%. The plan then averages the rates for HCEs and for NHCEs and compares them.
The HCE average cannot exceed the following limits:
| NHCE average | Maximum HCE average |
|---|---|
| 2% or less | 2 times the NHCE average |
| More than 2%, up to 8% | NHCE average plus 2 percentage points |
| More than 8% | 1.25 times the NHCE average |
For example, if NHCEs defer an average of 3% of pay, HCEs can defer an average of no more than 5%.
Catch-up contributions made by participants age 50 and older are not counted in the ADP test.
The ACP test
ACP stands for actual contribution percentage. It works the same way, but measures employer matching contributions and any employee after-tax contributions instead of deferrals.
Prior year versus current year testing
Plans can compare HCEs' current-year rates against NHCEs' current-year rates, or against NHCEs' rates from the prior year. The prior year method gives HCEs a known target at the start of the year, which can make planning easier.
What happens when a plan fails
A failed test must be corrected. The common methods are:
- Refunding excess contributions to HCEs, along with earnings. Refunds are taxable to the HCE in the year they are distributed.
- Recharacterizing excess deferrals as catch-up contributions for HCEs age 50 and older who have not used their full catch-up amount.
- Making additional employer contributions to NHCEs, known as qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs), to raise their averages.
Timing matters. Corrective refunds made within two and a half months after the plan year ends, or six months for plans with an eligible automatic contribution arrangement, avoid a 10% excise tax on the employer. Corrections must be completed by the end of the following plan year to avoid putting the plan's qualified status at risk.
Why small plans fail
Small plans fail more often for predictable reasons:
- A small number of NHCEs, so a few non-participants pull the average down
- Low participation among rank-and-file employees
- Owners and family members contributing the maximum
Reducing the risk
Several design and operational choices make failure less likely:
- A safe harbor design, which generally exempts the plan from ADP testing, and from ACP testing for qualifying matches
- Automatic enrollment, which raises NHCE participation
- A matching formula that encourages employees to contribute
- Participant education aimed at rank-and-file employees
- Mid-year testing, which gives HCEs a chance to adjust their deferrals before year end
Accurate data matters
Testing is only as accurate as the census data behind it. Compensation, hire dates, ownership, family relationships, and hours all affect the results. Errors in the data produce wrong test results, which can mean missed corrections.
Other annual tests
ADP and ACP are not the only tests. Your third-party administrator also checks top-heavy status, coverage, the annual deferral limit, and the annual additions limit.
Want a second look at your plan's testing results and design? Brian Williams, CPFA®, of Northshire Consulting LLC | Registered Investment Advisory Firm meets with business owners to review plan design and compliance. Call 203-401-6062, email bwilliams@northshireconsulting.com, or visit northshireconsulting.com to schedule a plan review.
Frequently asked questions
Does a safe harbor plan need ADP testing?
Generally no. A properly operated safe harbor plan is treated as passing the ADP test, and the ACP test for qualifying matching contributions.
Are refunds from a failed test taxable?
Yes. Refunded excess contributions are taxable to the HCE in the year they are distributed.
When will we find out if our plan failed?
Testing is usually completed after the plan year ends. Many TPAs offer mid-year preliminary testing so adjustments can be made before year end.
This material is for educational purposes only and is not individualized investment, tax, or legal advice. Advisory services are offered through Northshire Consulting LLC | Registered Investment Advisory Firm.