The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are critical components of maintaining equitable 401(k) plans in the United States. These tests ensure fair treatment of employees regardless of their income levels, particularly in relation to highly compensated employees (HCEs). In this article, we will delve into the details of these tests, how they function, the implications of their outcomes, and alternative strategies companies can utilize to remain compliant.
The Importance of ADP and ACP Tests
Why Conduct ADP and ACP Tests?
As businesses offer 401(k) retirement plans to their employees, they must adhere to regulations set forth by the Internal Revenue Service (IRS) and the Employee Retirement Income Security Act (ERISA). These tests help ensure that retirement savings plans do not disproportionately benefit HCEs at the expense of non-highly compensated employees (NHCEs).
Failing to conduct these tests can result in serious consequences, including: - Penalties: Employers may incur significant fines for non-compliance. - Plan Disqualification: Failure to meet the requirements can lead to the loss of tax advantages associated with 401(k) plans. - Fiduciary Liability: Companies may face legal repercussions for not meeting their fiduciary duties to employees.
Key Takeaways on ADP and ACP Tests
- The ADP test evaluates pre-tax and Roth deferrals, ensuring that the percentage of contributions from HCEs does not exceed that of NHCEs by more than two percentage points.
- The ACP test assesses employer matching contributions and after-tax contributions, following a similar formula.
- Companies must take corrective action within 12 months of discovering a test failure.
How ADP and ACP Tests Function
The ADP Test
The ADP test compares the average salary deferral percentages between HCEs and NHCEs to discern whether the retirement plan is discriminatory. According to IRS guidelines for 2024: - An HCE is defined as an employee who owns more than 5% of the company or earns more than $155,000 annually. - The test considers only regular contributions (e.g., pre-tax and Roth contributions) and does not include catch-up contributions, which are permitted for employees aged 50 or older.
To pass, the ADP of HCEs must not exceed that of NHCEs by more than two percentage points. Additionally, the overall contributions of HCEs should not surpass double that of NHCEs.
The ACP Test
Similar to the ADP test, the ACP test focuses on employer contributions: - It measures the actual contributions made to the 401(k) plan by both HCEs and NHCEs, including employer matching and employee after-tax contributions. - Employers need to ensure that HCEs are not disproportionately benefiting from matching contributions compared to their lower-earning colleagues.
Correcting ADP and ACP Test Failures
When companies fail either the ADP or ACP tests, several corrective measures are available: 1. Refunds: Employers can refund excess contributions made by HCEs back to them, which will be subject to income tax. 2. Modification: Adjusting contribution limits or implementing plan design changes during the year can preclude future failures.
Employers may consider setting buffer zones within their plan documents to minimize the risk of failing the tests. Some companies even conduct mid-year projections of ADP and ACP tests to gauge the need for adjustments.
Safe Harbor 401(k) Plans
One viable alternative to avoid ADP/ACP testing altogether is to adopt a safe harbor 401(k) plan. Qualifying plans must offer: - A matching contribution structure (e.g., a 100% match on the first 3% and a 50% match between 3% and 6%). - A nonelective contribution option, regardless of employee contributions, typically around 3%.
These structures allow companies to bypass the intricate testing process while still offering robust retirement benefits to employees.
Conclusion
The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests play a crucial role in promoting fairness and compliance within 401(k) retirement plans. By understanding these tests, their implications, and the corrective actions required when they are failed, employers can ensure that their retirement plans remain equitable and compliant with IRS regulations.
Additionally, companies seeking a streamlined approach may opt for a safe harbor 401(k), providing peace of mind and simplifying administrative complexities. Thus, keeping informed is essential not only for the integrity of the retirement plan but also for maintaining employee trust and fostering a positive workplace environment.