Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Tests: A Complete Guide 📊💡

Introduction to ADP and ACP Tests 🏦

When it comes to 401(k) plans, employers must ensure that the benefits are fairly distributed among employees. This is where the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test come into play. These IRS-mandated tests prevent highly compensated employees (HCEs) from receiving disproportionate benefits compared to non-highly compensated employees (NHCEs).

In this guide, we’ll break down everything you need to know about ADP and ACP tests, how they work, and what employers can do to maintain compliance.

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What Is the Actual Deferral Percentage (ADP) Test? 🔍

The Actual Deferral Percentage (ADP) test measures the average percentage of salary that employees defer into their 401(k) plan. The IRS uses this test to ensure that highly compensated employees don’t contribute significantly more than other employees.

How Is the ADP Test Calculated? 🧮

The ADP is determined by calculating the average pre-tax and Roth 401(k) deferrals (excluding employer contributions) for two groups:

1️⃣ Highly Compensated Employees (HCEs) – Employees who earn above a certain IRS-defined limit (e.g., $155,000 in 2024) or own more than 5% of the company.
2️⃣ Non-Highly Compensated Employees (NHCEs) – All other employees who don’t meet the HCE criteria.

ADP Test Limits ⚖️

To pass the ADP test, the HCEs’ average deferral rate must not exceed a specific limit based on the NHCEs’ average deferral rate:

• If NHCEs’ average deferral rate is 0% - 2% → HCEs can defer up to 2x the NHCE rate.
• If NHCEs’ average deferral rate is 2% - 8% → HCEs can defer up to NHCE rate + 2%.
• If NHCEs’ average deferral rate is above 8% → HCEs can defer up to 1.25x the NHCE rate.

🔹 Example Calculation:
If NHCEs contribute an average of 4% of their salary, the HCEs' limit would be 6% (4% + 2%).

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What Is the Actual Contribution Percentage (ACP) Test? 🔎

While the ADP test focuses on employee elective deferrals, the Actual Contribution Percentage (ACP) test measures the contributions made by employers, including:

✔️ Employer matching contributions
✔️ After-tax employee contributions

How Is the ACP Test Calculated? 📊

Similar to the ADP test, the ACP test calculates the average contribution percentages for HCEs and NHCEs, then applies the same limits:

• If NHCEs’ contribution percentage is 0% - 2%, HCEs can contribute up to 2x that amount.
• If NHCEs’ contribution percentage is 2% - 8%, HCEs can contribute up to NHCE rate + 2%.
• If NHCEs’ contribution percentage is above 8%, HCEs can contribute up to 1.25x the NHCE rate.

🔹 Example Calculation:
If NHCEs receive an average employer match of 3%, then HCEs can receive a maximum match of 5% (3% + 2%).

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What Happens If a Plan Fails the ADP or ACP Test? ⚠️

If a 401(k) plan fails the ADP or ACP test, the employer must take corrective action to rebalance contributions. Some solutions include:

🔄 Refunding Excess Contributions – HCEs may receive refunds for excess deferrals to bring the plan into compliance.
💰 Making Employer Contributions – The company can make additional contributions to NHCEs to boost their average contribution rate.
📝 Using a Safe Harbor Plan – A Safe Harbor 401(k) plan automatically passes the ADP and ACP tests by meeting specific employer contribution requirements.

🚨 Important: If corrective actions aren’t taken within 2.5 months after the end of the plan year, the employer may face IRS penalties.

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How to Ensure ADP and ACP Compliance? ✅

Employers can take proactive steps to prevent compliance issues:

✔️ Educate Employees – Encourage NHCEs to participate by providing financial education and incentives.
✔️ Auto-Enrollment – Automatically enroll employees in the 401(k) plan with a reasonable default contribution rate.
✔️ Offer a Safe Harbor 401(k) Plan – This eliminates the need for ADP and ACP testing by following IRS Safe Harbor guidelines.
✔️ Monitor Contributions Regularly – Track contributions throughout the year to catch potential compliance issues early.

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Safe Harbor 401(k) Plans: The Best Solution? 🛡️

One of the easiest ways to bypass ADP and ACP testing is to adopt a Safe Harbor 401(k) plan. This plan requires employers to provide one of the following contributions:

1️⃣ Basic Matching – 100% match on the first 3% of employee contributions + 50% match on the next 2%.
2️⃣ Enhanced Matching – 100% match on the first 4% of employee contributions.
3️⃣ Non-Elective Contribution – Employer contributes at least 3% of salary to all eligible employees, regardless of participation.

📢 Bonus: Safe Harbor plans also allow HCEs to maximize their contributions without restrictions!

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Final Thoughts: Stay Compliant and Avoid Penalties 🚀

ADP and ACP tests are essential for ensuring fairness in 401(k) plans. While compliance can be complex, strategies like auto-enrollment, employer contributions, and Safe Harbor plans can help simplify the process.

By taking proactive measures, businesses can avoid IRS penalties and create a more inclusive and financially secure workplace.

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