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What is the ADP/ACP Test?

All 401(k) plans are required to be tested annually.
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  • Written By: Michael Totten
  • Edited By: O. Wallace
  • Last Modified Date: 21 July 2014
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The Internal Revenue Service (IRS) requires all 401(k) plans to be tested annually for several reasons. One test is the ADP/ACP test, which stands for actual deferral percentage/actual contribution percentage. The purpose of the test is to determine whether all participants are benefiting equitably from the plan. Other tests are designed to ensure that participants are not exceeding the contributions limits allowed by the IRS.

There are several required tests for every plan. Due to the complexity of the tests, they are usually completed by an outside company rather than the company sponsoring the plan. Similar to tax filing deadlines, each test has an annual filing deadline, and the filing deadline for the ADP/ACP test is 15 March. Failure to meet the deadline can cause a plan to incur stiff penalties, including disqualification.

The ADP/ACP test is one of the more significant tests, because most 401(k) plans have to address its consequences or consider its outcome throughout the year. This means that plan sponsors will be regularly looking at the various things that affect the test.

To understand what influences this test, it is necessary to know the reason it exists. The underlying idea is to keep employers from running a 401(k) plan that is discriminatory in favor of highly compensated employees. The highly compensated employee group is often made up of owners, executives, or management staff. These people, by the nature of their roles, are generally in the best position to operate an unfair retirement plan.

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The way a plan would favor highly compensated employees is by offering a plan that is not compelling or beneficial to the rank and file employees. For example, a plan that provides a matching contribution only to employees who contribute large sums each year is favoring highly compensated employees. It is the highly compensated who can afford to make large contributions — they will receive the employer matching contribution and therefore be receiving a better benefit from the plan than the non-highly compensated employees.

The ADP/ACP test would uncover the unfair plan described above by examining the contribution percents of each group, the highly and non-highly compensated employees. The test first separates the company’s employees into one of the two groups based largely on a set compensation amount. If compensation is greater than a specified dollar amount, the employee is highly compensated. If it is less than the specified dollar amount, the employee is non-highly compensated.

Next, the test looks at the average contribution percents of each group as a whole. The average contribution percent of the non-highly compensated group directly controls the allowable average of the highly compensated. To determine the allowed percentage of the highly compensated group, the highly compensated group must pass the 1.25 test or the 2% test.

The 1.25 test is satisfied if the highly compensated group does not exceed 1.25 times the average contribution percent of the non-highly compensated group. For example, if the non-highly compensated group’s average was 3%, the highly compensated group’s average would be limited to 3.75%.

The 2% test is satisfied if the average contribution percent of the highly compensated group is not greater than 2% or no more than twice the average of the non-highly compensated group. Put simply, the highly compensated group’s limit is determined by adding 2% to the non-highly group’s average, or doubling that average, whichever result is smallest.

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Discuss this Article

KarlM
Post 11

@shebaspice, post 1: I'll be the tie-breaker: anon154672 (post no. 5) is correct.

As far as Roth contributions being matched, you'll have to check your specific document. In general they are, but your plan may not.

KarlM
Post 10

@tina701, post 9: It depends on your specific plan's definition of compensation. Most plans work from gross compensation, meaning you take the W-2 and add back everything deducted (like 401(k), cafeteria plan deferrals, etc.). But some plans are designed to exclude certain portions of compensation (bonuses and commissions are popular choices). So there's no general answer for you.

tina701
Post 9

I have to provide our employees wages for our annual testing, and I am confused by what wages I should provide. The wages reported on the W-2 in Box 1 Wages, Tips, Compensation, or the wages in Box 5 which are the Medicare wages.

Our S corp owners health insurance benefits paid by the company are reported in Box 1, so it makes their Box 1 wages higher than the Box 5. However, all of the other employees' Box 5 wages are higher than their Box 1 wages. So what do I provide? What wages is it that IRS wants these tests performed on?

anon237094
Post 7

To the person in post #6, while I don't disagree that some reform is necessary in plan testing, you clearly have no grasp of what you're talking about. You mention solvency and funding liability, terms that apply to Defined Benefit plans. ADP/ACP rules only apply to Defined contribution plans. DC plans do not have solvency or funding liability issues as it is only the contribution that is defined, not the benefit.

anon188666
Post 6

These tests are antiquated and unnecessary in today's corporate environment. They were necessary in the early days of 401(k) plans, but it has been 30 years, for goodness sake! If an employee chooses not save for retirement, that shouldn't affect another employee, high wage earner or not, in their quest for long-term financial security.

And as an economist, I find it profane that someone is designated a "high wage earner" based on the current test/formula. That is just made up IRS nonsense and is relative.

These tests should have been replaced by funding liability and solvency testing years ago. That would have headed of the current rash of defaults in these plans. Many of the plans that passed these tests are not fully funded and employers fudge on their contributions to them.

But leave it to your government full of state school bureaucrats to keep things as antiquated as possible to create an environment of "fairness" where market conditions would be sufficient. These tests and requirements are burdensome for most firms, large and small, thus reducing the incentive for firms to even have these type of plans.

Let's hope most of the baby boomers who created these once needed rules bite the dust in the near future. We can then implement rational, financially and economically sound principles for administering these plans so that employers and employees can take advantage of them and plan accordingly for retirement.

anon154672
Post 5

the ADP Test include Roth Deferrals and Pre-Tax Deferrals. The ACP includes ER Match, and after-tax voluntary (which are practically non-existent). Roth (while after-tax) do not go in the ACP Test - they always go in the ADP Test.

anon89135
Post 4

No, Roth Contributions are not included in ADP Test. ADP Test is of After Tax and Employer Contributions only. Roth and Before Tax Contributions are included in the ACP Test.

anon56492
Post 3

An “Orphan” match is a fancy name for matching contributions which must be forfeited as a result of a reduced 401(k) Wage Reduction.

Let’s say that your employer matches 50 cents for every dollar you as an employee contribute to the Plan as a wage reduction under 401(k). Obviously if your wage reduction is reduced due to the ADP test (say by $ 500) you got too much of a match (in this case $ 250) to which you were not entitled. This is then called an Orphan Match since the basis for which the match was made no longer exists.

The more complicated question is why only two out of twelve HCEES were impacted. This could be caused either by the terms of the Plan or by the leveling method used to correct the ADP Test.

Rather than reduce the ADP for every HCEE across the board, the leveling method calculates the total amount which needs to be reduced and then reduces those HCEES with the highest deferral amount first until either: (1) the total correction amount has been distributed, or (2) the next highest HCE dollar amount is reached. If the next highest dollar amount is reached before the total correction amount is refunded, the HCEs at that next dollar amount level are also reduced until the total correction amount is refunded or the next highest HCE dollar amount level is reached. This process is repeated until the total correction amount is distributed.

Another possibility is that the wage reduction was “re-characterized” as either employee after tax contributions or as “Catch-up” contributions.

If the plan is written to allow after tax employee contributions, it can further provide that to the extent the ADP test fails, pre tax (401(k)) contributions will automatically be re-characterized as employee after tax contributions, provided that when these contributions are added to any other after tax employee contributions and employer matching contributions they don’t exceed the ACP tests under IRC § 401(m) (which are similar in nature to the ADP tests).

In addition, again if the Plan is written to allow for Catch-up contributions, it can further provide that to the extent the ADP test fails, pre tax (401(k)) contributions will automatically be re-characterized as Catch-up contributions. IRC § 414(v) allows participants in a 401(k) Plan who have attained age 50 (or older) to make an additional contribution of up to $ 5,500 (in 2009 and 2010) as a “catch-up”.

In either instance your Plan may also provide that the Employer Matching contribution is based on employee contributions (including re-characterized contributions) and on catch-up contributions.

In addition, the matching contribution may have a cap that is a set maximum amount of either a specific percentage of compensation or a maximum dollar amount. If there was no match made on the returned 401(k) contribution, there would not be any “orphan” matching contributions to forfeit.

Finally where a plan matches employee contributions, and refunds are required to correct a violation of the ACP test, the document could provide for a proportionate refund of employee contributions and the related match.

dowellm
Post 2

Can anyone help me understand what an orphan match is? Our plan failed the ADP test and several of our HCEs received a return of deferrals and our senior managers also had a amount called orphan match removed from their accounts and move to our plan's forfeiture account.

I could never get a clear answer as to what an orphan match is, how it is calculated and why it effected only two people out of 12 who received returns of deferrals.

Any advice is appreciated.

shebaspice
Post 1

Are Roth contributions included in the ADP test?

Are Roth contributions included when calculating match?

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