The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Tests: What Are They?
Companies must carry out the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) checks to make sure that their 401(k) plans don’t unjustly favor highly compensated workers to the detriment of others.
According to IRS regulations and the Employee Retirement Income Security Act (ERISA), businesses that provide 401(k) plans must perform the tests to maintain their plans’ qualified status.
If the plan doesn’t pass either criterion, the employer must make changes within a year of the end of the plan year in which the error was made. If this isn’t done, the IRS may impose financial penalties, disqualify the plan, and hold the employer liable as a fiduciary.
Procedure for ADP and ACP Tests
The average salary deferral percentages of highly paid workers (HCE) and non-highly compensated employees (NHCE) are compared using the ADP test. Any employee earning over $130,000 in the 2020 tax year or owning more than 5% of the firm during the current or prior plan year is considered an HCE.
The ADP test considers pre-tax and after-tax Roth contributions, but catch-up contributions, which may only be made by workers beyond 50, are not. The HCE’s ADP must outperform the NHCE’s ADP by more than two percentage points to pass the test. Additionally, the sum of all HCE contributions cannot exceed double the proportion of NHCE contributions.
Like the ADP test, the ACP test employs matching contributions or employee after-tax contributions instead of the latter.
Getting an ADP/ACP Test to Pass
Employers may make up for failing the ADP/ACP tests by returning excess contributions to HCEs in the amount required to pass the test. Nevertheless, these returns will be subject to income tax for the HCE persons.
Some businesses include safety zones in their plan papers to prevent plans from ever failing the ADP/ACP test. Setting a limit on HCE donations is one possibility. A restriction on HCE contributions may also be imposed at the point when the plan would fail the ADP/ACP test. Employers may need to make ADP/ACP test predictions, usually in the middle of the plan year, to see whether any limits must be implemented before creating plan buffer zones. Some businesses employ Safe Harbor 401(k) plans to completely sidestep the ADP/ACP test.
A Safe Harbor Plan is what?
In return for making qualifying matching or nonelective contributions on behalf of their workers, sponsors of Safe Harbor 401(k) plans may avoid ADP/ACP and other anti-discrimination tests.
A corporation must provide a minimal match to be eligible for Safe Harbor, such as a 100% match on the first 3% of deferred pay and a 50% match on deferrals between 3% and 5%. No matter how much or whether an employee contributes, they may offer each employee a nonelective contribution of at least 3% of their pay.
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