The Internal Revenue Service (IRS) requires all 401(k) plans to be tested annually for several reasons. One test is the ADP/ACP test, which stands for actual deferral percentage/actual contribution percentage. The purpose of the test is to determine whether all participants are benefiting equitably from the plan. Other tests are designed to ensure that participants are not exceeding the contributions limits allowed by the IRS.
There are several required tests for every plan. Due to the complexity of the tests, they are usually completed by an outside company rather than the company sponsoring the plan. Similar to tax filing deadlines, each test has an annual filing deadline, and the filing deadline for the ADP/ACP test is 15 March. Failure to meet the deadline can cause a plan to incur stiff penalties, including disqualification.
The ADP/ACP test is one of the more significant tests, because most 401(k) plans have to address its consequences or consider its outcome throughout the year. This means that plan sponsors will be regularly looking at the various things that affect the test.
To understand what influences this test, it is necessary to know the reason it exists. The underlying idea is to keep employers from running a 401(k) plan that is discriminatory in favor of highly compensated employees. The highly compensated employee group is often made up of owners, executives, or management staff. These people, by the nature of their roles, are generally in the best position to operate an unfair retirement plan.
The way a plan would favor highly compensated employees is by offering a plan that is not compelling or beneficial to the rank and file employees. For example, a plan that provides a matching contribution only to employees who contribute large sums each year is favoring highly compensated employees. It is the highly compensated who can afford to make large contributions — they will receive the employer matching contribution and therefore be receiving a better benefit from the plan than the non-highly compensated employees.
The ADP/ACP test would uncover the unfair plan described above by examining the contribution percents of each group, the highly and non-highly compensated employees. The test first separates the company’s employees into one of the two groups based largely on a set compensation amount. If compensation is greater than a specified dollar amount, the employee is highly compensated. If it is less than the specified dollar amount, the employee is non-highly compensated.
Next, the test looks at the average contribution percents of each group as a whole. The average contribution percent of the non-highly compensated group directly controls the allowable average of the highly compensated. To determine the allowed percentage of the highly compensated group, the highly compensated group must pass the 1.25 test or the 2% test.
The 1.25 test is satisfied if the highly compensated group does not exceed 1.25 times the average contribution percent of the non-highly compensated group. For example, if the non-highly compensated group’s average was 3%, the highly compensated group’s average would be limited to 3.75%.
The 2% test is satisfied if the average contribution percent of the highly compensated group is not greater than 2% or no more than twice the average of the non-highly compensated group. Put simply, the highly compensated group’s limit is determined by adding 2% to the non-highly group’s average, or doubling that average, whichever result is smallest.