What You Need to Know About ADP/ACP Discrimination Testing

Plan sponsors must test 401(k) plans every year to ensure that contributions made by and for non–highly compensated employees (NHCEs), generally the majority of a company’s workforce, are reasonably proportional to contributions made for highly compensated employees (HCEs), generally a company’s owners and managers. All employers should understand the tests known as the actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test.

Testing Formulas

Generally, plans can’t disproportionately benefit HCEs. For 2014, plan participants are considered HCEs if:

  • Their compensation in 2013 or 2014 was more than $115,000, or
  • They owned more than 5% of the business at any time during the year, or the preceding year, regardless of their compensation.

Once it is determined who the company’s HCEs are, the deferral and contribution percentages for each test can be calculated.

ADP Test

Under the ADP test, you calculate both HCE and NHCE pre–tax deferral rates. The deferral percentage is the average of the deferral percentages (the ratio of each employee’s annual deferrals to their eligible pay for that year) of those in the group. Eligible employees who don’t participate in the plan are included with a zero deferral percentage. Since most eligible nonparticipating employees tend to be NHCEs, that group’s deferral percentage is scaled downwards. To pass the test, the HCEs’ average ADP can’t be higher than the greater of: (1) 125% of the NHCEs’ average ADP, or (2) the lesser of two percentage points above, or two times the NHCEs’ average ADP.

Generally, catch-up contributions for participants age 50 and older aren’t included in the ADP test. Consult your benefits specialist for more information.

ACP Test

This test is similar to the ADP test in that it compares the average ratios of the employer matching contributions to the compensation received by both HCEs and NHCEs for the year. For example, if the average matching contribution percentage for NHCEs is 3% of pay, the average matching contribution percentage for HCEs must be limited to 5% of pay.

Another important discrimination test is to determine whether a plan is “top heavy” or “super top heavy.” That determination is based on the proportion of plan assets held by “key employees” (defined differently from HCEs) relative to the total plan assets (at least 60% for top-heavy plans and 90% for super top-heavy plans). A plan that is deemed top heavy may be required to make minimum contributions to NHCE accounts.

Safe Harbor Design Alternative

If a plan has failed discrimination tests, or employers want to avoid the testing completely, they can instead adopt a safe harbor provision for the plan. However, keep in mind that the safe harbor plan contribution formula can potentially increase plan costs.

A safe harbor plan can be created in two ways:

  1. Matching deferrals dollar for dollar up to 3% of compensation, plus 50 cents on the dollar on the next 2% of compensation, or
  2. Making a non-elective annual contribution of 3% of compensation to all eligible participants’ accounts, regardless of whether they make employee pretax contributions.

Under either method, employer contributions are considered fully vested immediately. This differs from the usual six-year graded schedule (20% after one year, 40% after two years, etc.)

Prior to adopting a safe harbor plan design, carefully analyze the plan to determine why eligible NHCE’s aren’t deferring. Furthermore, if the plan narrowly failed the discrimination testing, it may not be worth the added expense to switch to a safe harbor plan.

Don’t Be a Testing Failure

If your defined contribution plan failed the discrimination test in the last testing cycle, you’re not alone. According to a recent survey by Judy Diamond Associates, approximately 12% of plans failed. Try to avoid having your plan become one of these statistics. Talk to your benefits specialist to learn more about ADP/ACP discrimination testing.

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