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What is Actual Deferral & Actual Contribution Percentage Test (ADP/ACP)?

The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are compliance tests used by employers to ensure that their retirement plans, such as 401(k) plans, do not discriminate in favor of highly compensated employees (HCEs) when it comes to elective deferrals and employer contributions.

The ADP test examines the elective deferral contributions made by both HCEs and non-highly compensated employees (NHCEs) and compares their respective contribution rates. It ensures that HCEs are not disproportionately contributing to the plan. The ADP test calculates the ADP for both groups and compares them to a certain threshold determined by the Internal Revenue Service (IRS). If the ADP of the HCEs exceeds the allowed threshold, the plan may be considered discriminatory, and corrective actions may be necessary.

The ACP test, on the other hand, examines the employer matching contributions and employee after-tax contributions to the plan. It evaluates the ACP for HCEs and NHCEs separately to prevent the plan from favoring HCEs in terms of employer contributions. Similarly, the ACP test compares the contribution rates of both groups to the IRS-established threshold.

If a plan fails either the ADP or ACP test, corrective measures must be taken to bring the plan back into compliance. These measures may include refunding excess contributions made by HCEs, making additional contributions to NHCEs, or adjusting the plan design to meet the nondiscrimination requirements.

The ADP and ACP tests are essential in maintaining the tax-qualified status of retirement plans and ensuring fair participation for all employees. By conducting these tests annually, employers can monitor the plan’s compliance and make necessary adjustments to meet the nondiscrimination requirements set by the IRS.