Actual Deferred Percentage (ADP)

What Is Actual Deferred Percentage (ADP)?

The Actual Deferral Percentage (ADP) is a test in U.S. income tax law that is performed on the pre-tax and employee-contributed portions of 401(k) programs. It is designed to ensure that businesses do not excessively favour highly compensated employees in their company contribution match programs. Each year, the company compares the average proportion of gross income that is deferred to the 401(k) plan by each category of employee.

What Is the History of Actual Deferred Percentage (ADP)?

The concept of the Actual Deferral Percentage (ADP) test originates from the United States’ 1978 Revenue Act, which established rules for 401(k) retirement plans. The ADP test was designed to prevent potential abuses involving "discrimination" in favor of higher-income employees, ensuring that they weren't given unfairly higher contributions than lower-income employees.

In the ensuing years, the rules governing the ADP tests have been adjusted several times, primarily by the Tax Reform Act of 1986 and the Small Business Job Protection Act of 1996, to further refine the definition of a highly compensated employee and the allocation of contributions.

ADP remains a key aspect of 401(k) compliance testing today. Any 401(k) plan failing the ADP test must take corrective action to bring the plan into compliance by either refunding some contributions back to highly compensated employees or making additional contributions to non-highly compensated employees.

How Do You Calculate Actual Deferred Percentage (ADP)?

The Actual Deferral Percentage (ADP) is calculated by following these steps:

1. For each employee involved in the company's 401(k) plan, divide their contribution by their total compensation showing an individual deferral percentage.
2. Then, average those individual percentages separately within two groups: highly compensated employees (HCEs) and non-highly compensated employees (NHCEs).

The ADP for each group can be calculated as follows:

ADP (HCEs or NHCEs) = Total deferral percentages of the group / Total number of individuals in the group

This will give you two percentages – the ADP for the HCEs and the ADP for the NHCEs. It's then used to compare the two averages to ensure the plan is not discriminating in favor of HCEs.

What Are Some Examples of Actual Deferred Percentage (ADP)?

Suppose a company with a 401(k) plan has 1 highly compensated employee (HCE) and 3 non-highly compensated employees (NHCEs). Here’s an example of how to calculate the ADP:

1. HCE: The HCE makes $200,000 and defers $20,000. Their individual deferral percentage is 20,000/200,000 = 10%

2. NHCEs:

3. The first NHCE makes $50,000 and defers $2,500. Their deferral percentage is 2,500/50,000 = 5%
4. The second NHCE makes $40,000 and defers $1,000. Their deferral percentage is 1,000/40,000 = 2.5%
5. The third NHCE makes $30,000 and defers $1,500. Their deferral percentage is 1,500/30,000 = 5%

The average deferral percentage of NHCEs is (5% + 2.5% + 5%) / 3 = 4.17%

So, in this example, the ADP for HCEs is 10%, and the ADP for NHCEs is 4.17%.

How Do the Concepts of Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) Differ?

The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) are both tests to ensure 401(k) retirement plans do not disproportionately benefit highly compensated employees, but they measure different types of contributions.

The ADP test focuses on employee deferrals, i.e., the pre-tax or Roth contributions that employees elect to make from their paychecks into their 401(k) accounts.

The ACP test, on the other hand, takes into account both the employee's after-tax contributions (if permitted under the plan) and the employer's matching contributions.

In simpler terms, the ADP measures the percentage of employees' deferred income, while the ACP measures the percentage of total contributions (including matches) relative to employees' compensation. Both of these tests are designed to maintain a balance in the overall contribution scheme, preventing the plan from disproportionately benefiting the higher-income earners.

What Are Some Examples of Actual Contribution Percentage (ACP)?

Here's an example of how to calculate the Actual Contribution Percentage (ACP):

Assume a company with one highly compensated employee (HCE) and two non-highly compensated employees (NHCEs):

HCE: Earns $200,000, Defers $10,000 (5% of income) Receives a company match of $4,000 (2% of income)

Therefore, their combined individual contribution percentage is (10,000+4,000)/200,000 = 7%

NHCEs: The first NHCE earns $25,000, defers $1,250 (5% of income), and receives a company match of $500 (2% of income). Their individual contribution is (1,250+500)/25,000 = 7%

The second NHCE earns $30,000, defers $1,500 (5% of income), and receives a company match of $600 (2% of income). Their individual contribution is (1,500+600)/30,000 = 7%

The average contribution for NHCEs contributors is (7% + 7%)/2 = 7%

In this example, both NHCEs and HCEs have the same ACP of 7% so the plan would pass the ACP test. The ACP test checks for discrimination in matching and/or after-tax contributions.

What Are Some Examples of Qualified Non-Elective Contributions (QNECs)?

Qualified Non-Elective Contributions (QNECs) typically come up in three main situations:

1. Correcting Retirement Plan Failures: QNECs are commonly used by employers to correct failed non-discrimination tests, such as the Actual Deferral Percentage (ADP) or Actual Contribution Percentage (ACP) tests. When a plan fails these tests, the company typically must refund some 401(k) contributions to the highly compensated employees (HCEs) or, alternatively, the company can make QNECs to the non-highly compensated employees (NHCEs) to raise their average contribution percentage.

2. Safe Harbor 401(k) Plan: Some 401(k) plans are set up to automatically pass the ADP/ACP tests. These are known as "safe harbor" plans. One method to qualify as a safe harbor plan is to make a QNEC of at least 3% of an employee's compensation to all eligible employees.

3. Automatic Enrollment 401(k) Plans: In these types of plans, known as Qualified Automatic Contribution Arrangement (QACA), employees are automatically enrolled unless they opt out. If the employees do not make an elective deferral, or if their elective deferral is less than the required minimum, the employer may make a QNEC to meet the minimum requirement.

In all these examples, the QNEC is fully vested when it is made, and it is treated as an employer contribution for the employees.

What Factors Influence the Calculation of the Actual Deferral Percentage (ADP)?

The calculation of the Actual Deferral Percentage (ADP) is influenced by several factors:

1. Employee Contributions: These refer to the deferrals made by employees to the 401(k) plan. The more an employee contributes to the plan, the higher the ADP will be.

2. Employee Compensation: The total compensation of employees is an essential part of the calculation. The deferral percentage is computed by dividing the employee contribution by their compensation.

3. Employee Classification: Employees are divided into two categories, highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). Calculations are done separately for these two groups, with the aim of preventing the plan from unfairly benefiting HCEs.

4. Excludable Employees: The ADP test does not consider certain employees, including those under 21, non-resident aliens, union employees covered by collective bargaining (unless retirement benefits were bargained for), or those with less than a year of service.

5. Corrective Contributions: If the employer makes Qualified Non-elective Contributions (QNECs) to remedy a failed ADP test in the previous year, these contributions may affect the current year's ADP.

What Are the Benefits of Actual Deferred Percentage (ADP)?

The benefits of the Actual Deferral Percentage (ADP) testing include:

1. Non-discrimination: The ADP test ensures that contributions to a 401(k) plan are not disproportionately favoring highly compensated employees (HCEs). It helps maintain a balance in regards to the percentage of salary deferrals between HCEs and non-highly compensated employees (NHCEs).

2. Regulatory Compliance: ADP testing helps companies fulfill their legal obligation to comply with the regulations set by the Internal Revenue Service (IRS) in the United States, helping them to avoid potential penalties and ensuring the plan maintains its tax-advantaged status.

3. Encourage Participation: Performing ADP tests can encourage employers to promote the 401(k) plan to lower compensated employees to increase participation and pass the test. This can lead to a broader spread of retirement savings across a company's workforce.

4. Correction Opportunities: If the ADP test fails initially, companies have the opportunity to correct this through refunds to HCEs or additional contributions to NHCEs (also known as Qualified Non-Elective Contributions, or QNECs), ensuring that businesses have a safety net to maintain regulatory compliance.

5. Employee Benefit Plan Quality: Regularly performing ADP tests is an important component of maintaining a high-quality benefit plan that serves all employees equitably. This can enhance job satisfaction and help in talent retention and recruitment.

What Are the Negative Effects of Actual Deferred Percentage (ADP)?

Potential negative effects associated with the Actual Deferral Percentage (ADP) test can include:

1. Restrictions on Employee Contributions: If a company fails their ADP test, highly compensated employees (HCEs) may have their contributions limited in the following plan year to prevent the plan from failing again, which could potentially restrict these employees from saving as much as they would like for retirement.

2. Administrative Burden: Performing the ADP test requires administrative resources, time, and expertise. It can be particularly burdensome for small businesses without a dedicated HR or finance department.

3. Potential Refunds: If the plan fails the ADP test, corrective action must be taken, which usually involves refunding part of the HCEs' contributions, potentially pushing those employees into a higher tax bracket for that year.

4. Discourages Generous Employer Matches: Because a significant disparity between HCE and non-HCE deferral rates causes the ADP test to fail, some employers may choose to reduce or eliminate matching contributions to avoid this potential hassle.

5. Lack of Awareness/Uncertainty for Employees: Some HCEs might be unaware of the possibility of a refund when they contribute to their 401(k) plan, and may be caught by surprise if they receive a refund as a result of a failed ADP test. This uncertainty can result in dissatisfaction and confusion among these employees.

6. Delays in Retirement Saving: The testing process and any needed corrections can cause delays, creating a potential obstacle for HCEs who are trying to maximize their retirement savings.

How Can You Rectify a Failed Actual Deferred Percentage (ADP) Test?

If a company's 401(k) plan fails the Actual Deferral Percentage (ADP) test, it has a few options to bring the plan back into compliance:

1. Refund Excess Deferrals to Highly Compensated Employees (HCEs): The company can calculate and distribute excess contributions, plus any earnings, back to the HCEs. These refunds must be made within 2.5 months after the end of the plan year to avoid a 10% excise tax.

2. Make Additional Contributions for Non-Highly Compensated Employees (NHCEs): The company can make a Qualified Non-elective Contribution (QNEC) or Qualified Matching Contribution (QMAC) to the accounts of NHCEs in order to increase the average contribution of this group. These contributions must be immediately vested.

3. Use a Combination of Both: The company can opt to do a combination of both refunds and additional contributions to reach compliance.

Moreover, a company can also take proactive steps to avoid failing the ADP test:

• Adopt automatic enrollment for all employees
• Improve plan education and encouragement to NHCEs to participate
• Implement a safe harbor 401(k) plan design that would naturally pass ADP testing requirements.

Any corrections must be done promptly to maintain the tax-advantaged status of the 401(k) plan and avoid potential penalties.

Which Employers Are Likely to Be Affected by Actual Deferred Percentage (ADP)?

While all employers who sponsor traditional 401(k) plans must perform the Actual Deferral Percentage (ADP) test, there are certain types of companies that are more likely to be affected by or fail this test:

1. Small Businesses: Small employers, particularly those where ownership and a few select employees earn significantly more than other employees, tend to have higher failure rates because the discrepancy between highly compensated employees (HCEs) and non-highly compensated employees (NHCEs) is often greater.

2. Companies with Disparity in Salaries: Companies where there's a large gap between the highest and lowest paid employees often struggle with the ADP test. If higher earners contribute more substantially to their 401(k) plans than lower earners, it can cause the company to fail the test.

3. Companies with Low Participation Rates: Companies with low retirement plan participation among NHCEs also run a high risk of failing the ADP test, since the percentage of income deferred by HCEs must be proportionate to that of NHCEs.

However, these companies can avoid the complications of the ADP test by adopting a safe harbor 401(k) plan. Safe harbor plans bypass ADP testing, provided mandatory employer contributions are made to participants.