What is 401(k) Plan Testing?
Plan sponsors must test traditional 401(k) plans each year to ensure that the contributions made by and for rank-and-file employees (non-highly compensated employees (NHCE)) are proportional to contributions made for owners and managers (highly compensated employees (HCE)).
According to the IRS, ADP or Actual Deferral Percentage is an annual test in a 401(k) plan that compares the average salary deferrals of highly compensated employees to that of non-highly compensated employees. Each employee’s deferral percentage is the percentage of compensation that has been deferred to the 401(k) plan. The deferral percentages of the HCEs and NHCEs are then averaged to determine the ADP of each group. To pass the test, the ADP of the HCE group may not exceed the ADP for the NHCE group by 1.25 percent or the lesser of 2 percentage points and two times the NHCE ADP.
Highly Compensated Employees & The ADP & ACP Tests
As the NHCEs save more for retirement, the rules allow HCEs to defer more. These nondiscrimination tests for 401(k) plans are called the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests.
The ADP test counts elective deferrals (both pre-tax and Roth deferrals, but not catch-up contributions) of the HCEs and NHCEs. Dividing a participant’s elective deferrals by the participant’s compensation gives you that participant’s Actual Deferral Ratio (ADR). The average ADR for all eligible NHCEs (even those who chose not to defer) is the ADP for the NHCE group. Do the same for the HCEs to determine their ADP.
Passing the Test
Calculate the ACP the same way, instead dividing each participant’s matching and after-tax contributions by the participant’s compensation.
The ADP test is met if the ADP for the eligible HCEs doesn’t exceed the greater of:
- 125% of the ADP for the group of NHCEs, or
- the lesser of:
- 200% of the ADP for the group of NHCEs, or
- the ADP for the NHCEs plus 2%.
The ACP test is met if the ACP for the eligible HCEs doesn’t exceed the greater of:
- 125% of the ACP for the group of NHCEs, or
- the lesser of:
- 200% of the ACP for the group of NHCEs, or
- the ACP for the NHCEs plus 2%.
You may base the ADP and ACP percentages for NHCEs on either the current or prior year contributions.