Understanding ADP/ACP Compliance Testing: Employee Salary Deferrals and Employer Match Contribution
In the realm of retirement planning and 401(k) management, ensuring compliance with the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests is paramount. These tests serve as critical benchmarks to ensure that Highly Compensated Employees (HCEs) are not disproportionately benefitting more than the Non-Highly Compensated Employees (NHCEs). This guide outlines basic principles of ADP/ACP compliance testing, including classification criteria, calculation methods, and corrective measures.
Determining HCEs and NHCEs
The first step in verifying the ADP/ACP tests are done correctly is to identify the HCE group. The HCE group includes any employee who meets either an Ownership test or a Compensation test at any time during the current or preceding plan year.
Ownership Test: Any employee or owner-employee with more than 5% ownership or partnership interest in the current or prior year. This would include direct and attributed ownership, extending to an individual's spouse, children, grandchildren, or parents.
HCE Compensation Test: Employees whose compensation in the prior year equals or exceeds the HCE limit for the prior year. The HCE limit is a set dollar amount ($140,000 for 2023). The HCE Compensation limit is adjusted annually for inflation as part of the government’s annual Cost-of-Living-Adjustments (COLA).
All other eligible employees who do not meet the HCE ownership or compensation test are considered non-HCEs (NHCEs).
Selecting the Year for Testing
A pivotal decision in ADP/ACP testing is choosing whether to use the NHCE average for the prior year or the current year when performing the test each year. The Plan Document specifies the method to be used. Any amendments to the test period must adhere to IRS timing restrictions. The prior year method provides predictability but may pose challenges if a year lacks a matching contribution.
Permitted Difference between HCEs and Non-HCEs
A core principle of ADP/ACP testing is that the HCE group average cannot be significantly higher than the NHCE group average. The following table reflects the maximum allowable HCE average ADP percentage based on the NHCE average ADP percentage:
NHCE Average ADP % Max HCE Average ADP %
Less than 2.00%: NHCE average times 2.00%
Between 2.00% - 8.00%: NHCE average plus 2.00%
More than 8.00%: NHCE average times 1.25%
Excess Amounts and Corrective Actions
In cases where the HCE Average ADP % exceeds the maximum limit, corrective actions are required to maintain the plan’s tax qualified status. Several correction options are available:
Reclassify excess amounts for HCEs as catch-up contributions, subject to certain limits.
Distribute (or refund) the excess amounts to the HCEs.
Make additional Employer Contributions to the NHCE group of employees.
There would be no penalty for a failed ADP/ACP Test as long as the corrections are made on a timely basis.
Safe Harbor Contributions: An Alternative Solution
For those seeking to bypass the intricacies of ADP/ACP testing, "safe harbor" contributions provide an attractive solution. These contributions can automatically satisfy the ADP test and potentially the ACP test, relieving plan sponsors from testing-related hassles. To explore this option further, consider consulting your account representative at CRI TPA Services.
Considerations
ADP/ACP compliance testing is a vital aspect of managing 401(k) Plans, ensuring fairness in contributions between HCEs and NHCEs. Proper classification, choice of testing year, adherence to percentage limits, and corrective actions are all crucial components of this process. For those seeking a simpler path, safe harbor contributions offer an attractive alternative. Understanding ADP/ACP compliance testing is essential for effective retirement planning and regulatory compliance.