ADP/ACP Testing — Comprehensive Bullet-Point Notes

Overview of ADP/ACP Testing

• 401(k) plans are fundamentally designed to encourage retirement savings, but they must operate under strict nondiscrimination rules, primarily mandated by the IRS under IRC sections 401(a)(4) and 410(b), to prevent them from disproportionately benefiting Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs). The ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) tests are core components of these rules, specifically mandated annually for 401(k) arrangements to ensure that the ratio of benefits provided to HCEs is proportionate to that provided to NHCEs. Compliance with these tests is critical to maintain the tax-advantaged status of the plans for all participants and avoid severe penalties.

• The ADP test specifically scrutinizes elective deferrals made by employees, including both pre-tax and Roth contributions, to determine if HCE deferral rates are excessively higher than NHCE rates. Conversely, the ACP test evaluates employer matching contributions and any after-tax employee contributions. Both tests are critical for annual plan compliance. Should a plan fail either test, immediate corrective actions are required to rectify the imbalance. Common correction methods include:

  • Distributing excess contributions: This involves returning excess deferrals (for ADP) or contributions (for ACP) back to HCEs, which may result in those distributions becoming taxable income for the HCEs in the year distributed. This is often the simplest and most direct correction.

  • Forfeiting excess aggregate contributions: In the case of ACP test failure, matching contributions related to excess after-tax contributions may be forfeited.

  • Making Qualified Non-Elective Contributions (QNECs): These are employer contributions made on behalf of eligible NHCEs, immediately 100% vested and subject to distribution restrictions, designed to increase their average deferral percentage for the ADP test.

  • Making Qualified Matching Contributions (QMACs): These are employer matching contributions also made on behalf of eligible NHCEs, immediately 100% vested and subject to distribution restrictions, designed to increase their average contribution percentage for the ACP test.
    Corrections must typically be completed within 12 months after the close of the plan year. Failure to correct within this period can lead to excise taxes ($10\%$ of the excess contributions) and potential plan disqualification, resulting in loss of tax-advantaged status for all participants.

• Certain types of plans are statutorily exempt from ADP/ACP testing, provided they adhere to specific design requirements that inherently ensure nondiscrimination. This exemption simplifies administration for employers who commit to these mandatory contributions. These include:

  • Safe Harbor 401(k) plans: These plans mandate specific employer contributions (e.g., a specific matching formula or a non-elective contribution to all eligible employees) which are immediately 100% vested. Because these contributions ensure a minimum level of benefit for all eligible employees, especially NHCEs, they automatically satisfy the nondiscrimination requirements.

  • Starter 401(k) plans: Introduced under Secure 2.0, these plans are designed for small employers (generally those that have not sponsored a retirement plan in the past three years) and are exempt from ADP/ACP testing if they meet certain contribution and participation requirements, such as a matching or non-elective contribution for all eligible employees.

  • SIMPLE IRA and SIMPLE 401(k) plans: These plans are typically adopted by small employers (100 or fewer employees) and have simplified administrative requirements, including an exemption from ADP/ACP testing, due to their mandatory employer contribution requirements (e.g., a $2\%$ non-elective contribution or a dollar-for-dollar match up to $3\%$ of compensation).

Key Concepts and Definitions

• HCE (Highly Compensated Employee): Defined by the IRS annually under IRC §414(q). For a given plan year, an employee is an HCE if they fall into one of two categories based on the look-back year (the prior plan year):

  • They owned more than $5\%$ of the employer (directly or indirectly, including attribution rules) at any point during the current or prior plan year.

  • They earned over a specified compensation threshold (e.g., $155,000$ for 2024 for the 2023 look-back year) in the prior plan year and, if the employer elects, were among the top $20\%$ most highly compensated employees by compensation for that prior year. This definition helps identify those who benefit most from the plan, ensuring their contributions are appropriately measured against NHCEs to prevent discrimination.

• NHCE (Non-Highly Compensated Employee): Any employee who does not meet the criteria to be classified as an HCE. These employees form the benchmark group whose average contribution rates are used to determine the permissible limits for HCEs, thereby ensuring fairness in plan design and operation.

• ADR (Actual Deferral Percentage): This is an individual ratio calculated for each eligible employee (both HCEs and NHCEs) and represents their total eligible elective deferrals (both pre-tax and Roth, excluding catch-up contributions for those age 50 or older, since these are not subject to ADP testing) divided by their IRC §414(s) compensation for the plan year. The formula is: $ADR = \frac{\text{elective deferrals}}{\text{IRC } \S414(s) \text{ compensation}}$. The average of these individual ADRs is used in the ADP test for each group (NHCEADP and HCEADP).

• ACR (Actual Contribution Ratio): Similar to the ADR, the ACR is calculated for each individual employee and includes their employer matching contributions and any after-tax employee contributions. QNECs (Qualified Non-Elective Contributions) and QMACs (Qualified Matching Contributions) made by the employer may also be strategically included in the NHCEs' ACRs to help satisfy the ACP test. The formula is: $ACR = \frac{\text{contribution amount}}{\text{IRC } \S414(s) \text{ compensation}}$.

• IRC §414(s) Compensation: This refers to the specific definition of compensation used for calculating ADRs and ACRs, which must be consistently applied to all participants and typically includes W-2 wages or a similar broad definition of compensation that is nondiscriminatory. This compensation amount is subject to an annual limit (e.g., $345,000$ for 2024), meaning any compensation above this limit is not considered for testing purposes, ensuring that highly paid employees do not skew the averages excessively based on very high salaries and that the tests focus on the proportionate nature of contributions relative to a reasonable compensation base.

• QNECs (Qualified Non-Elective Contributions) and QMACs (Qualified Matching Contributions): These are special, irrevocable types of employer contributions that are immediately 100% vested for employees and are subject to the same withdrawal restrictions as elective deferrals (e.g., generally not available before age 59\frac{1}{2}, termination, death, or disability). Their primary purpose in ADP/ACP testing is to be allocated to NHCEs, usually those who contribute little or nothing, to increase their average deferral/contribution percentages, thereby helping the plan pass the nondiscrimination tests without requiring HCEs to reduce their contributions. It's crucial that QNECs and QMACs are not double-counted (i.e., used to satisfy both the ADP and ACP test in the same plan year); they can only be allocated to one test or the other for a given year.

• USERRA Make-up Deferrals: Elective deferrals made by returning military personnel under the Uniformed Services Employment and Reemployment Rights Act (USERRA), allowing them to make up contributions missed during military service, are disregarded for ADP/ACP testing purposes. This provision ensures that military service does not negatively impact a plan's nondiscrimination testing results, protecting both the participant and the plan's compliance.

• Disaggregation under SECURE 2.0: The SECURE 2.0 Act introduced provisions allowing plans to offer matching contributions based on an employee's qualified student loan repayments (QSLP), treating these repayments as elective deferrals for matching purposes. To prevent these new types of contributions from negatively affecting the plan's overall ADP/ACP test (since QSLP contributors might have different savings patterns), the Act allows employers to separate participants who receive QSLP matches into a distinct group for testing purposes (disaggregation), effectively preventing their unique contribution patterns from impacting the main group's test results. This provides flexibility and encourages employers to offer this benefit.

ADP Test: Description and Purpose

• The ADP test is an annual compliance requirement aimed at preventing discrimination in elective deferrals (employee pre-tax and Roth contributions) within 401(k) plans. It achieves this by comparing the average deferral percentage of Highly Compensated Employees (HCEs) against that of Non-Highly Compensated Employees (NHCEs). Each employee's individual Actual Deferral Ratio (ADR) is calculated, and then simple averages are derived for the NHCE group (NHCEADP) and the HCE group (HCEADP). This comparison ensures that HCEs are not deferring significantly more than NHCEs, relative to their compensation.

• The core principle is that the HCEADP cannot exceed the NHCEADP by more than a specified amount, as determined under IRS regulations. A plan passes the ADP test if the HCEADP falls within an allowable range relative to the NHCEADP, which is determined by applying either the 1.25 test or the 2% spread test, whichever yields a higher permissible limit for HCEs. If the HCE*ADP surpasses this calculated limit, the plan fails the test, necessitating corrective measures such as distributing excess contributions to HCEs (requiring them to withdraw funds and pay taxes) or making additional contributions (QNECs/QMACs) to NHCEs (which increases plan costs). The ADP test is a fundamental aspect of maintaining a 401(k) plan's qualified status and applies to virtually all 401(k) plans unless they qualify for a specific statutory exemption, like being a safe harbor plan.

The Two ADP Tests and How They Work

The ADP test employs two distinct mathematical formulas to establish the maximum permissible Actual Deferral Percentage (ADP) for HCEs, based on the average ADP of NHCEs. The plan is always permitted to use the test that yields the higher allowable HCE*ADP, offering flexibility for compliance:

• 1.25 Test: This rule states that the HCEADP must be less than or equal to 1.25 times the NHCEADP (i.e., HCEADP $\le 1.25 \times \text{NHCE</em>ADP}$). For instance, if the NHCEADP is $8\%$, the HCEADP cannot exceed $10\%$ ($8\% \times 1.25 = 10\%$). This test is generally more favorable and likely to pass when the NHCE*ADP is relatively high, as it allows for a larger absolute difference between the two groups while maintaining proportionality.

• 2% Spread Test (or 2x Test): This test specifies that the HCE*ADP must be less than or equal to the *smaller* of (NHCEADP + 2 percentage points) or (NHCEADP $\times 2$). This is designed to prevent large disparities when NHCE deferral rates are very low. For example:

  • If the NHCEADP is $3\%$, the HCEADP cannot exceed $5\%$ ($3\% + 2\% = 5\%$). In this case, $3\% \times 2 = 6\%$; since $5\%$ is smaller than $6\%$, $5\%$ is the limit.

  • If the NHCEADP were $1.5\%$, the HCEADP limit would be $3\%$ ($1.5\% \times 2 = 3\%$). Here, $1.5\% + 2\% = 3.5\%$; since $3\%$ is smaller than $3.5\%$, $3\%$ is the limit. This test is often more advantageous when the NHCE*ADP is low, as it provides a flat 2 percentage point increase or a doubling effect, whichever is less restrictive for the HCEs while still limiting disparity.

• General Rule for HCE Limit: The plan is allowed to use the higher of the two limits derived from the 1.25 test and the 2% spread test. This ensures maximum flexibility for the plan in passing. The application of these tests can be summarized into three primary scenarios based on the NHCE*ADP:

  • If NHCEADP is $2\%$ or less (NHCEADP $\le 2\%$), the HCE limit is twice the NHCEADP (HCE limit = NHCEADP $\times 2$). This is because the 2% spread test (NHCEADP + 2%) would yield a higher result. For example, if NHCEADP is $1\%$, HCE limit is $2\%$ (as $1\% \times 2 = 2\%$ and $1\% + 2\% = 3\%$; $2\%$ is the smaller of the two, meaning it's the result of the 2x test, which is selected over the 1.25 test at this low rate).

  • If NHCEADP is greater than $2\%$ but not more than $8\%$ (2\% < \text{NHCEADP} \le 8\%), the HCE limit is the NHCEADP plus 2 percentage points (HCE limit = NHCEADP + 2 percentage points). In this range, the 2% spread test (NHCEADP + 2%) is typically more favorable than the 1.25 test. For instance, if NHCEADP is $6\%$, HCE limit is $8\%$ (as $6\% + 2\% = 8\%$ and $6\% \times 1.25 = 7.5\%$; $8\%$ is taken as the higher allowed limit).

  • If NHCEADP is greater than $8\%$ (NHCEADP > 8\%), the HCE limit is 1.25 times the NHCEADP (HCE limit = NHCEADP $\times 1.25$). At higher NHCE deferral rates, the 1.25 test becomes more generous than simply adding a flat 2 percentage points. For example, if NHCE*ADP is $10\%$, HCE limit is $12.5\%$ (as $10\% \times 1.25 = 12.5\%$ and $10\% + 2\% = 12\%$; $12.5\%$ is taken as the higher allowed limit).

Safe Harbors and When ADP Is Not Performed

• To encourage employer contributions and simplify compliance, the IRS provides statutory exemptions from ADP/ACP testing for plans that include certain mandatory employer contributions that inherently ensure non-discrimination. These are known as "Safe Harbor" provisions because they offer a "safe harbor" from the complex annual testing. The primary attraction for employers utilizing a safe harbor plan is the administrative relief from ADP/ACP tests, which can be costly and burdensome to administer and correct. For a plan to qualify as a safe harbor 401(k) and thus be exempt from ADP/ACP testing, it must adhere to specific requirements regarding employer contributions, immediate vesting, and employee notice. The main types of safe harbor contributions include:

  • Basic Matching Contribution: The employer matches $100\%$ of the first $3\%$ of compensation deferred by an employee, and $50\%$ of the next $2\%$ deferred. This means a $4\%$ match on a $5\%$ deferral ($3\% + 1\%$ (from the $50\%$ on the next $2\%$)).

  • Enhanced Matching Contribution: Requires the employer to match at least $100\%$ of the first $4\%$ of compensation deferred. This is often more generous than the basic match.

  • Non-Elective Contribution: The employer contributes $3\%$ (or more) of compensation for all eligible NHCEs, regardless of whether they defer into the plan. This ensures a baseline contribution for all eligible employees, even those who choose not to participate in deferrals.
    All safe harbor contributions must be immediately 100% vested and subject to the same withdrawal restrictions as employee elective deferrals. These features ensure that NHCEs receive a substantial and accessible benefit, thus satisfying non-discrimination aims. Additionally, SIMPLE IRA and SIMPLE 401(k) plans, designed for small businesses (generally those with 100 or fewer employees), are also exempt from ADP/ACP testing due to their own mandatory employer contribution formulas and simplified designs.