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What is ADP/ ACP Testing?

Businessman and botanist reviewing sample data

Understanding ADP/ACP Testing for Employers Setting Up Retirement Plans

Setting up a retirement plan for your company is not just about offering a valuable benefit to your employees. It also requires understanding the intricate compliance aspects to ensure the plan operates fairly and within federal guidelines. One key component employers should familiarize themselves with is the ADP/ACP testing, a mechanism to ensure 401(k) plans do not disproportionately favor Highly Compensated Employees (HCEs).

Breaking Down ADP/ACP Testing

Employee deferrals in a traditional 401(k) come with specific testing requirements. Here’s what employers should know:

  1. HCEs and their Contribution Limits: HCEs typically can defer up to 2% more than the average deferral percentage of Non-Highly Compensated Employees (NHCEs).
  2. Key Employee Account Balances: The total account value held by key employees should not surpass 60% of the entire plan’s value.
  3. HCE Participation Dependence: The extent to which HCEs can participate might be restricted if NHCEs don’t contribute significantly.

A Practical Scenario

Consider Devon and Taylor, two equal stakeholders in a thriving business with 10 loyal employees.

The employees, on average, save about 4% of their income. Under a traditional 401(k) structure, Devon and Taylor’s contributions are contingent upon their employee’s average deferral rate. They can save an additional 2% over their employee average. Hence, in this scenario, Devon and Taylor are capped at a 6% contribution.

The Implications

Traditional 401(k) plans are mandated to fulfill certain non-discrimination criteria. To verify these, the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests are executed annually. Here’s what they entail:

  • ADP/ACP Testing assesses the average deferral/contribution percentage of HCEs against that of NHCEs. This ensures no undue advantages are given to the HCEs.
  • Defining HCEs: HCEs encompass any owner with over 5% business interest in the present or previous year, immediate family members of such owners, and any employee whose compensation exceeds an annually defined threshold.
  • Calculating Deferral Percentage: This is determined by dividing the individual’s deferral by their compensation. Subsequently, to determine the groups’ averages, the sum of the deferral percentages is divided by the total number of eligible employees in each category (HCEs and NHCEs). To successfully pass the ADP test, the HCE group’s ADP should not outstrip the NHCE’s ADP by more than 2%.

Conclusion

For employers, understanding ADP/ACP testing is fundamental when setting up a 401(k) plan. Ensuring compliance not only helps in maintaining the plan’s tax-advantaged status but also reinforces a sense of fairness and equity among all employees, irrespective of their compensation levels.