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What Are ACP and ADP Tests?

ADP/ACP Tests Explained

More commonly known as the non discriminatory tests associated with 401k plans -- the ADP (Actual Deferral Percentage) and ACP (Actual Contribution Percentage) tests compare the average of salary deferral and employer match percentages for highly compensated employees (HCE) to the average of salary deferral and employer match percentages for non-highly compensated employees (NHCE).

HCE's include anyone who owns more than 5% of the company, the spouse, children, parents and grandparents of a 5% owner, or anyone who received more than $100,000 (indexed) in gross compensation from the employer in the previous year. There is no minimum income required for a 5% owner or family member to be classified as an HCE. For example, they could earn only $1,000 and still be classified as an HCE.

To perform the ADP test, a salary deferral percentage is calculated for every eligible employee. The numerator is the amount of salary deferred by the employee. The denominator is the employee's pay before salary deferral. The employees are then grouped into HCE's and NHCE's. The percentages are added together and an average is calculated. Eligible participants who did not contribute to the plan are included as zeros.

The example below shows a calculation for an NHCE group. The ACP test is calculated in the same manner, except the numerator is the dollar amount of matching contributions to the employee's account.

 

Salary

Deferral

ADR

Employee #1

$25,000

$1,000

4.00%

Employee #2

$33,000

$2,500

7.58%

Employee #3

$25,000

$0

0.00%

Employee #4

$35,000

$3,000

8.57%

Employee #5

$28,000

$1,500

5.36%

Average ADP 5.10%

Once the averages have been calculated, the HCE average is compared to the NHCE average. As a general rule, the HCE average cannot exceed the NHCE average by more than 2%. There are more restrictive rules if the NHCE average is less than 2%.

If the tests are not satisfied, a correction must be made. There are two ways to correct a failed ADP or ACP test. The employer can make a contribution to the plan to raise the NHCE average so that the test passes or return a part of the HCE's contribution to lower the HCE average so that the test passes. The best method to use depends on the individual circumstances of each plan. The Plan Administrator is responsible for deciding which method is to be used to correct the test. For more details visit our ACP and ADP Failed Test links.

What To Do?

If you want to avoid getting headaches and seasickness due to your 401(k) planís testing failures each year and subsequent corrections, consider adopting a safe-harbor design. Otherwise, test early and test often.

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Revised July 18, 2005

This information is of a general nature and is subject to change. It is provided to give you a broad overview of these matters and should not be construed as legal advice. It is not our position to offer legal or tax advice. You should consult with a tax advisor about your particular situation.

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Information is provided for review and consideration only. Please consult legal and tax advisors for practical advice pertaining to your business and personal situations.

This page was last reviewed and/or updated on Friday, July 03, 2015 05:22 PM

 

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