401(k) Actual Deferral Percentage Compliance Test Basics
By Anna Noble, CPC, QPA, QKA, TGPC, CIP, CHSP
What is the ADP test?
The actual deferral percentage (ADP) test is a compliance test that many 401(k) plans are subject to. (Exceptions include owner-only plans, and so-called “safe harbor” plans.) This is only one of many nondiscrimination tests. The ADP test measures or determines whether elective deferrals that are made in the plan are disproportionate between two groups of employees: the highly compensated employees (HCEs) and the non-highly compensated employees (NHCEs). This status is determined by such things as compensation and company ownership.
More specifically, the ADP test is a numerical test in which average salary deferral rates are compiled for each employee group. Employers must determine what the maximum allowed average rate for the HCE group is: this is based on the NHCE group’s average deferral rate. The results vary depending on the average rate complied by the NHCE group. In general, the HCEs’ deferral rate cannot exceed the lesser of two times, or two percent more than, the non-HCEs’ deferral rate. For example, if the NHCEs in the plan defer on average five percent of their salary, then the maximum allowable average rate for the HCE group is seven percent.
What happens if a plan fails the ADP test?
Testing failures happen and there are several ways to address them. First, there are permitted correction methods. These vary from having the employer make additional contributions to the NHCE group, distribute to the HCE group amounts necessary to pass the ADP test, or recharacterize HCE elective deferrals to nondeductible contributions (the last option is the least common, requires specific plan design, and would be subject to matching contribution testing, which could still fail). A second option is to adopt an ADP safe harbor plan design. This plan design requires specific employer contributions, but if implemented properly, it could allow the plan to avoid the ADP test all together. A safe harbor plan design can now also be added to a 401(k) plan retroactively.
In addition to these basic options, employers could choose some more advanced options that could help lessen the failure.
Apply the prior-year testing option (using the NHCE deferral rate from the prior plan year);
Use the top-paid group election (in some cases, this allows some HCEs to be moved to the NHCE group).
Implement auto enrollment, which could increase the NHCE group’s average deferral rate and lessen the ADP test failure.
Use permissive disaggregation, which is available for plans that allow employees to participate in the plan before they meet the maximum eligibility requirements of age 21, 1 year of service, and semi-annual entry dates. Under permissive disaggregation, such employees—often NHCEs—can be tested separately from the rest of the employee population.
This is only a basic explanation of the test, there are several more advanced nuances, methods, and variables that could be considered. Therefore, the testing should be performed by a competent professional.
