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Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are two different nondiscrimination tests that 401(k) plans must pass in order to be in compliance with ERISA and IRS regulations.
These assessments make sure that the contributions produced by and for highly compensated workers (HCEs) are equal to those made by and for less highly compensated employees (NHCEs).
The average salary deferral to 401(k) accounts between HCEs and NHCEs is compared using the ADP test. Pre-tax and Roth's deferrals are subject to the test, but catch-up contributions for employees above the age of 50 are not included. The average percentage of pay that HCEs and NHCEs receive as matching or after-tax contributions from their employers is compared using the ACP test.
The contribution percentages of the HCEs must fall within a range set by the NHCEs' contribution percentages in order to pass the tests. Both the 125% approach and the 200% method can be used to determine these limits. For the strategy to pass the tests, it must adhere to any of these strategies.
According to the 125% technique, the HCEs' share of the total contribution cannot be greater than the NHCEs' share of the total contribution. For instance, if the average contribution percentage of the NHCEs is 4%, the average contribution percentage of the HCEs cannot be higher than 5% (125% of 4%).
According to the 200% method, the HCEs' contribution percentage cannot be greater than the lesser of 200% of the NHCEs' contribution percentage or the NHCEs' contribution percentage plus 2%. The HCEs cannot, for instance, have an average contribution percentage of more than 6% (the lesser of 8% (200% of 4%) or 6% (4% plus 2%) if the NHCEs have an average contribution percentage of 4%.
The tests can be run using either the most recent year's data for the NHCEs or data from a previous year. The method utilized must be specified in the plan document, and it can only be modified in certain situations.
If the plan doesn't pass either test, it must make corrections within a year of the plan year's conclusion. Refunding excessive payments to HCEs, making additional contributions to NHCEs, or reclassifying excessive contributions as after-tax contributions are some examples of corrective measures. Both employers and employees may be affected by these acts in terms of taxes.
A safe harbor plan design may be used in some plans to evade the ADP and ACP tests. For all qualified employees, a safe harbor plan mandates that the employer make a minimum amount of matching or nonselective contributions, as appropriate. The rules and restrictions that apply to these donations must be clearly defined and completely vest them. In addition to passing the top-heavy and coverage standards for nondiscrimination, a safe harbor strategy may also need to pass other nondiscrimination tests.
