ADP and ACP nondiscrimination testing for 401(k) plans

Companies that offer traditional 401(k) plans must conduct actual deferral percentage and actual contribution percentage tests, or ADP and ACP tests. These are part of the annual nondiscrimination testing (NDT) required for plans to maintain their qualified status under IRS rules and the Employee Retirement Income Security Act (ERISA).

Particularly for smaller businesses, the ADP and ACP tests are the most common NDT tests that traditional 401(k) plans must undergo. Safe harbor plans generally do not have to complete NDT testing. (More on safe harbor plans below.) 

If a plan fails either the ADP or ACP test, the employer must take corrective action in the 12 months following the close of the plan year in which the oversight occurred. Not correcting a failed test may result in IRS penalty fees and plan disqualification.

Nondiscrimination testing and highly-compensated employees

We have a complete guide to NDT—but for the purposes of understanding the ADP and ACP tests, here’s a quick review. NDT consists of several annual tests that assess the fairness of traditional 401(k) retirement plans, specifically by ensuring that neither highly compensated employees (HCEs) nor key employees (including business owners) are unfairly benefitting from the plan, in comparison to non-highly compensated employees (NHCEs). 

A HCE is someone who was either of the following during the plan year being tested, according to the IRS:

• A 5% owner, directly or by family attribution, at any time during the current or prior year (a 5% owner is someone who owns more than 5% of the employer), or

• For the prior year, paid by the employer more than $155,000 for 2024 ($150,000 for 2023); subject to cost-of-living adjustments in later years) and, if the employer elects, was in the top-paid (top 20%) group of employees.

The main way NDT determines the fairness (or not) of a retirement plan is by measuring the plan participation levels of HCEs and NHCEs. HCEs and key employee contributions must stay within a specific rate, relative to and determined by the contribution rate of NHCEs. The higher the average salary deferral of NHCEs to the plan, the higher the HCEs’ salary deferral can be. This ensures HCEs aren’t disproportionately benefiting from the plan.

ADP/ACP: How the tests measure plan participation

The IRS measures retirement plan participation by looking at: 

• Your eligible employees’ average deferral contributions using the ADP test 

• And, if applicable, their matching contributions using the ACP test, comparing the matching contributions for HCEs and NHCEs. 

Actual deferral percentage (ADP) test

The ADP test compares the average deferral of participating HCEs to the average deferral of participating NHCEs. It does this by determining each participant's actual deferral percentage by dividing their total deferrals for the applicable year (excluding catch-up contributions) by their compensation for that same year. These deferral rates are then averaged for NHCEs and HCEs so the two groups can be compared. The prior plan year NHCE ADP is compared to the current plan year HCE ADP, unless current year testing is elected in the plan document. 

The ADP test is met in one of two ways (and are further illustrated in the chart below):

1. The “1.25” test says if the HCE ADP is not more than 125% of the NHCE ADP, the test passes. 

2. The “2 plus, 2 times” test says if the HCE ADP is not more than 2 percentage points greater than the NHCE ADP, and the HCE ADP is not more than 2 times the NHCE ADP, the test passes.

Note that plans aren’t required to pass both tests—and that the greater of the two test results is applied. Rather than reveal the total number or percentage of employees making deferrals, it measures the two groups’ level of engagement in the retirement plan. 

Actual contribution percentage (ACP) test

While similar to the ADP test, the ACP test only applies to companies that offer 401(k) matching or after-tax contributions. For the ACP test, each participant’s actual contribution percentage is calculated by dividing the total amount of their employer’s matching and after-tax contributions for the applicable year by their compensation for that year. The actual contribution rates are then averaged for NHCEs and HCEs so the two groups can be compared. 

As with ADP testing, the prior plan year NHCE ACP will be compared to the current plan year HCE ACP, unless current year testing is elected in the plan document. Refer to the chart above for more information on how to determine the maximum HCE ACP.

How to fix a failed ADP or ACP test

First, it’s worth noting that it’s fairly common for businesses to fail NDT. If your plan fails, don’t panic. The important thing is to correct a failed test (in other words, the excess contributions) before the IRS deadline, which is up to 12 months after the end of the plan year. 

Here’s how an employer can correct a failed ADP or ACP test:

• Add a retroactive 4% safe harbor contribution. A recently introduced option courtesy of the SECURE Act, plan sponsors can retroactively adopt a 4% safe harbor nonelective contribution provision. This allows a plan sponsor to pass the ADP and ACP tests automatically if they fund a 4% contribution for all participants, regardless of employee deferrals, for the entire prior plan year. If a plan sponsor wants to adopt this provision during the plan year, the contribution is lowered to 3% and must be adopted by December 1 for calendar year plans.

• Provide refunds to HCEs. The most common option, refunds are typically issued in the first quarter of the year following the plan year being tested. HCEs are liable for income tax on the refund in the year distributed (not the year of contribution) on a 1099-R (and not their W-2). Refunds are not subject to early distribution penalties. For ADP failure, excess contributions are refunded to applicable HCEs. For ACP failure, excess total contributions are funded and are usually treated the same as excess contributions (if not fully vested, however, other corrective action must be taken). Refunds must be made within 2 ½ months after the end of the plan year (March 15th for calendar year plans) in order to avoid a 10% excise tax penalty. 

• Provide a qualified nonelective contribution (QNEC) to NHCEs. This is not a popular choice, but plan sponsors that utilize ADP/ACP testing methods can provide a contribution to their NHCEs, which is added to the NDT calculations. The QNEC contribution thus brings the plan back within the ADP/ACP limits. QNECs are always 100% vested and subject to the same distribution restrictions as elective deferrals. These contributions can be made in any of the following ways:

  • Prorated among all NHCEs, based on compensation

  • Targeting the NHCEs with the lowest compensation or deferral rates first 

  • Matching the NHCEs who contributed, or 

  • Contributing the same dollar amount to all NHCEs

If the excess contributions aren’t distributed or recharacterized by the 2 ½ month deadline after the plan year in which the excess contributions occurred, employers are liable for a 10% excise tax on excess contributions. The tax doesn't apply if the plan sponsor makes a corrective QNEC within 12 months after the end of the plan year if the plan uses current year testing. For plans that have an automatic default percentage of employees’ salary contribution (known as Eligible Automatic Contribution Arrangements or EACAs), the deadline is six months, rather than 2 ½.

If the employer doesn’t take corrective action before the end of the 12 months, the plan’s cash or deferred arrangement (CODA) is no longer qualified and the entire plan may lose its tax-qualified status. This can be corrected through the IRS’s Employee Plans Compliance Resolution System (EPCRS). Both methods available to correct ADP and ACP mistakes beyond the 12-month period require the employer to make a QNEC to the plan for NHCEs. 

A note on top-heavy plans: While not technically a nondiscrimination test, this determination may result in required contributions to your participants. In these type of retirement plans, owners and HCEs (or key employees) own more than 60% of the total plan assets or fall into any one of the following categories:

• Officers making over $220,000 for 2024 or $215,000 for 2023 (adjusted annually for inflation);

• Business owners holding more than 5% of the stock or capital, or

• Owners earning over $150,000 (not adjusted for inflation) and holding more than 1%.

Like other NDT, small businesses may be more at risk of failing the top-heavy determination simply because owners and HCEs have a chance of being a larger percentage of the total number of employees. Click here for more information about top-heavy tests.

How can small businesses reduce their risk of failing NDT?

There are a number of tactics that businesses can use to reduce their risk of failing NDT. Some tactics are offered by plan administrators. Additionally, Human Interest provides a number of the following services as part of plan administration. 

Financial literacy education 

Educating employees on the importance of saving for retirement can encourage NHCEs to increase their contribution rate and help narrow the gap between NHCE and HCE contribution rates. At Human Interest, we’ve built education for employees into our plans—including resources on our approach to building investment lineups—as well as promoting retirement saving with nudges that drive better decisions.

Midyear testing

Human Interest offers midyear ADP and ACP testing to help small businesses determine if they’re at risk of failing end-of-year NDT. Human Interest runs ADP and the ACP tests midyear, because these tests most directly impact employers and HCEs if plans fail at the end of the year. We compare compensation and contribution records from a company’s payroll provider between the dates of January 1 through June 30 of the current year to project the income and contributions by participants for the full year. 

Plan design

There are a few ways retirement plan can be designed to help increase NHCE contributions:

• Set an automatic enrollment rate (and increase it, if need be), which requires employees to opt-out of making contributions—rather than opt in. Plans with an auto-enrollment plan design have participation rates nearly 50% higher compared to those using an opt-in approach, according to 2021 research that analyzes Vanguard plans.

• Make employer matching contributions up to a certain percentage of employee deferrals. ​​Most employers match a portion of their employee’s contributions. In fact, 75% of all Human Interest plans offer an employer match, according to Human Interest internal data from January 2022.

• Set default contribution rates to drive savings from all eligible employees. Research from PGIM, the American College, and the Employee Benefit Research Institute in December 2021 shows that higher default contribution rates may have a big influence on employee savings rates. When default savings rates are set at higher levels, fewer employees move away from the default—which results in greater, more equal savings rates (when comparing higher- and lower-income employees),

Adding a safe harbor contribution

Want to automatically pass some of the required annual non-discrimination testing, while providing an opportunity for all your employees to maximize their savings? Adding a safe harbor provision may be the simplest way for most small businesses to avoid failing NDT.

A safe harbor 401(k) plan ensures all eligible plan participants receive an employer contribution. In exchange, employers get a “pass” on the ADP and ACP tests, and no longer have to restrict contributions from HCEs (relative to contribution limits for the plan year). This means that all plan participants—owners, HCEs, and NCHCEs alike—can max out contributions. Any 401(k) plan can be designed to include a safe harbor contribution, but there are some rules to follow. 

At Human Interest, there are three types of safe harbor protection options employers may select. Employers should realize this fixed, mandatory contribution is generally required to be immediately 100% vested. Additionally, safe harbor plans have strict deadlines. Depending on what safe harbor feature is right for your plan and the time of year, you may have to wait until the start of a new year to add it.

Want to learn more about how a safe harbor plan could benefit your business and your employees? Use our safe harbor calculator to get a better idea of how much a plan will cost your business. And if you’re looking for an affordable and compliant retirement benefit for your employees, click here to request more information about designing your 401(k) plan today.

*Amy Johnson is an independent contractor commissioned by Human Interest to help contribute to this article.