Actual Deferred Percentage (ADP)

Actual Deferred Percentage (ADP) is a key metric used in 401(k) retirement plan compliance testing to ensure that a company's retirement plan does not unfairly benefit highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). The ADP test compares the average deferral rates of both groups to determine whether the plan meets federal non-discrimination rules set by the IRS.

If a plan fails the ADP test, the employer must take corrective actions such as refunding excess contributions to HCEs or making additional contributions for NHCEs.

Key Facts

• Purpose of the ADP Test:
  • Ensures fairness in 401(k) plans by preventing HCEs from contributing disproportionately more than NHCEs.
  • Is required under IRS non-discrimination rules for qualified retirement plans.
• Who is Considered an HCE Versus NHCE?
  • Highly Compensated Employees (HCEs): Employees who earned $155,000 or more in 2024 (adjusted annually) or individuals who own more than 5% of the company.
  • Non-Highly Compensated Employees (NHCEs): Employees who do not meet the HCE criteria.
• How ADP is Calculated:
  • ADP = ((Total Elective Deferrals/Total Compensation) x 100) for each group (HCEs versus NHCEs).
  • The average percentage of salary deferred into the 401(k) is calculated separately for HCEs and NHCEs.
  • The ADP for HCEs can not exceed 1.25 times the NHCEs' ADP or 2 percentage points higher (whichever is greater).
• Consequences of Failing the ADP Test:
  • Refunding Excess Contributions: HCEs may receive a refund of their excess 401(k) contributions.
  • Employer Contributions (QNEC or QMAC): The company may make additional contributions to NHCEs to pass the test.
  • Plan Design Adjustments: Companies can implement Safe Harbor 401(k) plans, which automatically pass the test by providing employer contributions to all employees.
• Ways to Prevent ADP Test Failures:
  • Encouraging Higher Participation from NHCEs (for example, offering employer matching).
  • Safe Harbor 401(k) Plan: Exempt from ADP testing if employer contributions meet specific requirements.
  • Automatic Enrollment: Increases NHCE participation, reducing the risk of failing the test.

1. What is the Actual Deferred Percentage (ADP) test in a 401(k) plan?

The ADP test ensures that highly compensated employees (HCEs) do not contribute significantly more to their 401(k) than non-highly compensated employees (NHCEs), maintaining fairness in the retirement plan. Key elements of an ADP consist of:

• Deferral Percentage: The percentage of an employee’s salary that is deferred.
• Highly Compensated Employees (HCEs): Employees who have a significant ownership stake or earn over a certain threshold.
• Non-Highly Compensated Employees (NHCEs): Employees who do not meet the HCE criteria.
• Total Compensation: The salary and wages used to calculate deferral percentages.
• Contribution Types: Includes employee and employer contributions, but only employee deferrals count for the ADP test.
• Testing Period: The annual period used to calculate the ADP.
• Maximum Allowable Difference: Safe harbor for the deferral percentage difference between HCEs and NHCEs.
• Correction Methods: Steps to correct if the ADP test fails.

2. How is the ADP test calculated?

The ADP is calculated by taking the average percentage of salary deferred by HCEs and NCHEs separately. The HCEs' percentage can not exceed 1.25 times or 2% more than the NHCEs' percentage.

ADP Calculation Example

Step 1: Gather Deferral Data

Consider the scenario where a company has 5 employees. Three are considered HCEs, and two are NHCEs. The task would consist of looking at how much each defer into the 401(k) plan.

Step 2: Calculate the Deferral Percentage for Each Group

To find the deferral percentage for each group (HCEs and NHCEs), use the following formula: ((Total Elective Deferrals/Total Compensation) x 100)

• HCE Group: (($27,000/$370,000) x 100) = 7.3%
• NHCE Group: (($5,500/$110,00) x 100) = 5%

Step 3: Compare the ADP

Using the deferral percentages - 7.3% and 5% - the task should now be a comparison of the two numbers.

The IRS requires that the ADP of HCEs must not exceed the ADP of NHCEs by more than 2 percentage points, or the plan could fail the ADP test. In this case:

• 7.3% (HCE) - 5% (NHCE) = 2.3%

Since the difference is greater than 2%, the plan fails the ADP test.

3. What happens if a company fails the ADP test?

If a company fails the ADP test, it must correct the imbalance by either refunding excess contributions to HCEs or making additional contributions to NHCEs. Corrective actions can consist of:

• Refunding Excess Contributions: The employer may refund some of the contributions made by HCEs.
• Making Additional Contributions for NHCEs: The employer can make additional contributions to the accounts of NHCEs to balance out the deferral percentages.

The IRS has published an in-depth analysis of how and why a company fails ADP testing, going into detail on ADP failure and corrective responses.

4. How can companies avoid failing the ADP test?

Companies can avoid failing by offering a Safe Harbor 401(k) plan, automatic enrollment, or employer matching contributions to encourage NHCEs to participate more. Several methods companies can use to stay compliant include:

Safe Harbor 401(k) Plan

One of the simplest ways to avoid failing the ADP test is to set up a Safe Harbor 401(k) Plan as these plans automatically pass the ADP test if they meet specific contribution requirements.

Make Employer Contributions to NHCEs

Another way to avoid failing the ADP test is for the company to contribute more to the 401(k) accounts of NHCEs. These contributions can assist in balancing the ADP between HCEs and NHCEs. The company can make:

• Profit-Sharing Contributions: These are employer contributions that are not based on employee deferrals but are based on a fixed percentage of compensation or other formula. If these contributes are directed more heavily toward NHCEs, it can help balance the ADP test.
• Discretionary Contributions: Offering additional employer contributions that focus on NHCEs can aid bringing their ADP closer to that of HCEs.

Encourage Greater Participation by NHCEs

Increasing the participation of NHCEs in the 401(k) plan can help bring the ADP of NHCEs up, which in turn makes it easier to comply with the ADP test. Some tactics to encourage NHCE participation include:

• Auto-enrollment: Automatically enrolling employees in the 401(k) plan (with an option to opt out) helps increase overall participation, especially among NHCEs.
• Educational Campaigns: Providing employees with more information on the benefits of contributing to the 401(k) plan, including tax advantages, can help boost participation.
• Higher Default Contribution Rates: Setting a higher default contribution rate for automatically enrolled employees can help ensure that contributions are large enough to balance the ADP test.

Increase Employment Deferral for NHCEs

If NHCEs aren’t contributing enough to the plan, the company can try to increase employee deferrals for NHCEs through automatic escalation, where the contribution rate automatically increases over time (for example, an annual increase of 1% until a certain limit is reached). This can help raise the average deferral percentage for NHCEs, which could help bring it closer to the deferral percentage of HCEs.

Implement a Contribution Floor for NHCEs

Employers can set a minimum contribution requirement for NHCEs, ensuring they make at least a certain amount of deferral to help maintain a more balanced ADP. This could involve offering a fixed employer match or non-elective contributions that ensure NHCEs have sufficient retirement savings, improving the deferral balance between the groups.

Adjust Deferral Limits for HCEs

In some cases, if an employer is close to failing the ADP test, they can adjust how much HCEs are contributing to avoid exceeding the permissible difference between HCE and NHCE deferrals. This can be done by:

• Reducing HCE Contributions: If HCEs have contributed above the allowable limit, the company could reduce or refund excess contributions to bring the ADP percentage into compliance.

Review Plan Design and Participation Rates Regularly

A good strategy is for the employer to regularly review plan design and participation rates, especially focusing on the contribution patterns of HCEs and NHCEs. By monitoring the deferral percentages throughout the year, the employer can identify and address potential problems before the year-end testing is done.

What is a Safe Harbor 401(k) Plan?

A Safe Harbor 401(k) plan is a type of employer-sponsored retirement plan that offers special benefits to both employees and employers. It is specifically designed to encourage higher employee participation and to avoid the more complex nondiscrimination testing that typically applies to 401(k) plans - such as the ADP test.

The key feature of a Safe Harbor 401(k) plan is that the employer must make contributions to employees' accounts, either as matching contributions or as non-elective contributions, regardless of whether the employee contributes to their own 401(k). By meeting certain requirements, such as making these contributions, the plan automatically passes the IRS nondiscrimination tests, which are aimed at ensuring that the plan does not disproportionately favor highly compensated employees.

The common types of contributions an employer might make in a Safe Harbor 401(k) include:

1. Safe Harbor Matching Contributions: Employers match employee contributions, typically on a formula like 100% of the first 3% of salary, and 50% of the next 2% of salary.
2. Non-Elective Contributions: The employer contributes a set percentage (often 3%) of each employee’s compensation to their 401(k), regardless of whether the employee contributes.

These contributions must be fully vested, meaning employees own them outright without having to meet a waiting period or other vesting conditions.

The main advantage of Safe Harbor 401(k) plans is that they reduce the administrative burden for employers and make the plan more inclusive, while ensuring employees receive a solid retirement benefit.

5. Why is the ADP test important?

ADP tests are essential for making sure 401(k) plans are fair to everyone, not just highly compensated employees (HCEs). They help ensure that non-highly compensated employees (NHCEs) are also given a fair chance to save for retirement. These tests keep the plan in line with IRS rules, which are designed to promote equality in retirement savings. If the plan doesn’t pass the ADP test, it can lead to costly and time-consuming fixes, like refunds to HCEs or extra contributions for NHCEs. In short, ADP tests help keep things balanced and ensure that everyone benefits from the retirement plan.