There are a lot of different plans that the IRS presents to ensure that the companies and the workers are eligible for the test. The 401(k) plan is something through which the IRS can understand the people who should be paying their taxes and the people who should not. The actual deferral percentage (ADP) and actual contribution percentage (ACP) are two different types of tests that a person needs to pass to remain compliant with the IRS.

If you want to learn more about the actual deferral plan and actual contribution percentage, then this article has everything that you need to know. So, let's jump right into the article.

What are Actual Deferral Percentage and Actual Contribution Percentage?

The ADP and ACP are the two tests that come with the 401(k) plans. The companies who are paying their taxes through the 401(k) forms need to ensure that they are passing these two tests first. These tests are done so that it is ensured that the 401(k) plan does not unfairly benefit the employees who are earning more than the others.

These two tests come from the IRS rules and the Employee Retirement Income Security Act (ERISA). Hence, it becomes essential for the companies that offer the 401(k) to take these tests; otherwise, they won't be considered qualified for the status.

If the company fails to pass either of the two tests, then this means that they'll have to take another test within 12 months after failing the test. If the employer is not able to take the test, then the IRS will impose heavy penalties on the employer; they can even disqualify their plans and also impose fiduciary liabilities on the part of the employer.

Benefits of ADP/ACP Test:

Not many people know, but there are benefits of these tests that allow you to compare the difference between a non-highly and highly compensated employee.

Coverage:

The first main benefit that the companies can get from this test is to know the measure of participation and coverage. If the non-highly compensated employees don't take part in this test, then this means they don't know about it, and they don't get any coverage.

Contributions:

With the help of this, the companies can compare the contributions that they give to their employees with those of 401(k).

How Do the ADP and ACP Tests Work?

The next question that might come to your mind is how these tests work. The actual deferral test compares the average salary and the deferral percentages of the highly compensated employees with the employees who are not highly compensated.

The highly compensated employee is the person who owns at least 5% or more of the company shares in the present or even in the past years. Other than this, employees who have earned more than $130,000 during the 2020 tax year are also considered highly compensated employees.

When an employer gives the ADP tax, then the IRS will take account of both the pre-tax deferral and the after-tax Roth deferrals. Here, catch-up contributions are not added. In order for the employee to pass the test, the ADP of the highly compensated employee mustn't exceed the ADP of the non-highly compensated employee by two or more percentage points.

Another marker that is set for the passing of the ADP is that all combined ADP points of highly compensated employees should be more than two times the combined points of non-highly compensated employees.

Now, coming to the actual contributions percentage. The same method is used here; however, the matching contributions of the employee are used here, or the after-tax contributions of the employees are used to calculate the percentage.

What Happens When 401(k) Plan is Failed and How Do You Correct It?

Now, you might be thinking, what will happen if a company fails to pass the test? Then, different steps can be taken for the correction.

• The first thing you can do is refund the excess contributions back to the highly compensated employees according to the amount that is required to pass these tests. However, it is essential to know that these refunds will be considered income tax for the HCE, and they need to pay this tax on time.
• You can even review the reports again and make sure that there was no mistake in them. By conducting an independent review, you can determine the classification of the HCE and NHCE members of the company, and if they are wrongly classified, make sure you correct that.
• Companies also set buffer zones through which it becomes easy for them to pass these tests. The first thing that the companies do is set a cap for the amount that they contribute to the highly compensated employees.
• Furthermore, there is Safe Harbor 401(k), which companies can use to ensure that they can avoid these plans entirely. This means that companies with the Safe Harbor Plan won't have to take these tests.

What is the Safe Harbor Plan?

There is a plan called the Safe Harbor Plan 401(k). The companies use this plan to bypass the ADP/ACP tests and all the other non-discriminating plans that they have to give. However, you need to qualify for Safe Harbor, and here, the company must provide different documents, such as the primary match document, that ensure that there is no discrimination in the company.

Final Words:

The actual deferral and actual contributions percentages are two standard tests that the companies who are using the 401(k) plan need to pass. This ensures that there is no discrimination happening, and the highly compensated and non-highly compensated employees do not benefit from the 401(k) plan unfairly. Hence, we hope this article was helpful and you got to learn how these two tests work and their importance of them.