What Are Actual Deferral Percentage and Actual Contribution Percentage Tests?

In the realm of retirement planning, particularly within employer-sponsored 401(k) plans, compliance with federal regulations is critical to maintaining tax advantages and ensuring fairness. Two key mechanisms for achieving this are the Actual Deferral Percentage (ADP) test and the Actual Contribution Percentage (ACP) test. These nondiscrimination tests, mandated by the Internal Revenue Service (IRS), are designed to prevent highly compensated employees (HCEs) from disproportionately benefiting from tax-deferred retirement plans compared to non-highly compensated employees (NHCEs). Understanding these tests is essential for plan sponsors, administrators, and participants alike. This article explores what the ADP and ACP tests are, why they exist, how they are calculated, and their implications for 401(k) plans.

The Purpose of Nondiscrimination Testing

Before diving into the specifics of the ADP and ACP tests, it’s worth understanding their broader purpose. The U.S. tax code provides significant incentives for retirement savings, such as tax deferrals on contributions and earnings within qualified plans like 401(k)s. However, to ensure these benefits are equitably distributed across all income levels—and not skewed toward top earners—the IRS imposes rules to prevent discrimination. The ADP and ACP tests are part of this framework, ensuring that lower-paid employees have comparable opportunities to save for retirement as their higher-paid counterparts.

The tests focus on contributions made to 401(k) plans, which typically include employee salary deferrals (pre-tax or Roth contributions) and employer contributions (such as matching or profit-sharing contributions). Without these safeguards, highly compensated employees could maximize their tax-advantaged savings while lower-paid employees, who might lack the disposable income to contribute significantly, are left with minimal benefits. The ADP and ACP tests help level the playing field.

Defining Key Terms: HCEs and NHCEs

To grasp how these tests work, we need to define two critical groups of employees:

Highly Compensated Employees (HCEs): For 2025, an employee is generally considered an HCE if they earned more than $155,000 (adjusted annually for inflation) in the prior year (2024) or if they owned more than 5% of the company at any point during the current or prior year, regardless of compensation. The exact threshold can vary slightly based on IRS updates, but this gives a clear benchmark.
Non-Highly Compensated Employees (NHCEs): These are all other employees who don’t meet the HCE criteria. Typically, they represent the majority of a company’s workforce and often have lower average salaries.

The distinction between HCEs and NHCEs is the cornerstone of the ADP and ACP tests, as the IRS compares contribution rates between these groups to ensure fairness.

What Is the Actual Deferral Percentage (ADP) Test?

The ADP test focuses specifically on employee elective deferrals—the amounts employees choose to contribute from their salaries to the 401(k) plan, either on a pre-tax basis or as Roth contributions. These deferrals are the foundation of most 401(k) plans, allowing workers to save for retirement while reducing their taxable income (in the case of pre-tax contributions).

How the ADP Test Works

The ADP test calculates the average percentage of salary that HCEs and NHCEs defer into the plan and compares these averages to ensure they don’t diverge too widely. Here’s a step-by-step breakdown:

Calculate Individual Deferral Percentages: For each employee, divide their total elective deferrals for the plan year by their compensation for that year. For example, if an employee earns $50,000 and defers $5,000, their deferral percentage is 10%.
Group Averages:
- Compute the average deferral percentage for all HCEs (the HCE ADP).
- Compute the average deferral percentage for all NHCEs (the NHCE ADP).
Apply the Nondiscrimination Limits: The IRS sets strict guidelines on how much higher the HCE ADP can be compared to the NHCE ADP:
- If the NHCE ADP is less than 2%, the HCE ADP cannot exceed the NHCE ADP plus 2% (e.g., if NHCE ADP is 1%, HCE ADP can be up to 3%).
- If the NHCE ADP is between 2% and 8%, the HCE ADP cannot exceed the NHCE ADP multiplied by 1.25 (e.g., if NHCE ADP is 4%, HCE ADP can be up to 5%).
- If the NHCE ADP is over 8%, the HCE ADP cannot exceed the NHCE ADP plus 2% (e.g., if NHCE ADP is 9%, HCE ADP can be up to 11%).
Pass or Fail: If the HCE ADP exceeds these limits, the plan fails the ADP test, triggering corrective action.

Example of the ADP Test

Imagine a small company with five employees:

HCE 1: $200,000 salary, $20,000 deferred (10%)
HCE 2: $160,000 salary, $16,000 deferred (10%)
NHCE 1: $50,000 salary, $2,000 deferred (4%)
NHCE 2: $40,000 salary, $1,200 deferred (3%)
NHCE 3: $30,000 salary, $600 deferred (2%)
HCE ADP = (10% + 10%) / 2 = 10%
NHCE ADP = (4% + 3% + 2%) / 3 = 3%

Since the NHCE ADP is 3% (between 2% and 8%), the HCE ADP limit is 3% × 1.25 = 3.75%. The actual HCE ADP of 10% far exceeds this, so the plan fails the test.

What Is the Actual Contribution Percentage (ACP) Test?

While the ADP test focuses on employee deferrals, the ACP test evaluates employer contributions (such as matching contributions or profit-sharing contributions) and any after-tax employee contributions (if allowed by the plan). Matching contributions, for instance, are funds employers contribute based on an employee’s deferrals—e.g., a 50% match on the first 6% of salary deferred.

How the ACP Test Works

The ACP test follows a similar process to the ADP test but applies to different contribution types:

Calculate Individual Contribution Percentages: For each employee, divide the sum of employer matching contributions and after-tax contributions by their compensation.
Group Averages:
- Compute the average contribution percentage for HCEs (the HCE ACP).
- Compute the average contribution percentage for NHCEs (the NHCE ACP).
Apply the Nondiscrimination Limits: The same limits used in the ADP test apply here:
- NHCE ACP < 2%: HCE ACP ≤ NHCE ACP + 2%
- NHCE ACP 2%–8%: HCE ACP ≤ NHCE ACP × 1.25
- NHCE ACP > 8%: HCE ACP ≤ NHCE ACP + 2%
Pass or Fail: If the HCE ACP exceeds the allowable limit, the plan fails the ACP test.

Example of the ACP Test

Using the same company:

HCE 1: $10,000 employer match (5% of $200,000)
HCE 2: $8,000 employer match (5% of $160,000)
NHCE 1: $1,000 employer match (2% of $50,000)
NHCE 2: $600 employer match (1.5% of $40,000)
NHCE 3: $300 employer match (1% of $30,000)
HCE ACP = (5% + 5%) / 2 = 5%
NHCE ACP = (2% + 1.5% + 1%) / 3 = 1.5%

With an NHCE ACP of 1.5% (< 2%), the HCE ACP limit is 1.5% + 2% = 3.5%. The HCE ACP of 5% exceeds this, so the plan fails the ACP test.

Consequences of Failing the Tests

Failing either the ADP or ACP test doesn’t mean the 401(k) plan is invalidated, but it does require corrective action within a specified timeframe (typically by the end of the following plan year, though earlier correction avoids penalties). Common remedies include:

Refunding Excess Contributions: Excess deferrals or contributions (plus earnings) are returned to HCEs. These refunds are taxable in the year distributed and may incur a 10% early withdrawal penalty if the recipient is under 59½.
Additional Contributions: The employer can make qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs) to NHCEs to boost their ADP or ACP, bringing the plan into compliance.
Plan Design Changes: Employers might revise the plan to avoid future failures, such as reducing HCE deferral limits or enhancing NHCE participation.

Safe Harbor Plans: An Alternative Approach

To avoid the hassle of ADP and ACP testing altogether, some employers adopt safe harbor 401(k) plans. These plans automatically satisfy nondiscrimination requirements by mandating specific employer contributions, such as:

A 100% match on the first 3% of salary deferred, plus a 50% match on the next 2%, or
A nonelective contribution of at least 3% of compensation for all eligible employees, regardless of whether they defer.

Safe harbor plans simplify administration but may increase costs for employers, making them a strategic choice depending on workforce demographics and budget.

Why These Tests Matter

The ADP and ACP tests serve a dual purpose: they protect the tax-advantaged status of 401(k) plans and promote equitable retirement savings. For employees, passing these tests ensures that the plan remains a viable tool for building wealth over time. For employers, compliance avoids IRS penalties and maintains employee goodwill. However, the tests can also highlight disparities in financial literacy or income levels, as NHCEs may defer less due to limited disposable income rather than lack of interest.

Challenges and Criticisms

While well-intentioned, the ADP and ACP tests aren’t without flaws. Small companies with few HCEs and NHCEs can face volatile results year-to-year, making compliance unpredictable. Additionally, refunding excess contributions can frustrate HCEs who feel penalized for saving diligently. Some argue that the tests discourage higher participation rather than encouraging broader savings, though safe harbor provisions mitigate this to an extent.

Conclusion

The Actual Deferral Percentage and Actual Contribution Percentage tests are vital cogs in the machinery of 401(k) plans, ensuring that tax benefits don’t disproportionately favor the highest earners. By measuring and comparing contribution rates between HCEs and NHCEs, these tests uphold fairness while preserving the integrity of retirement plans. For employers, understanding and managing these tests—or opting for safe harbor alternatives—can streamline compliance and enhance employee benefits. For participants, they underscore the importance of a balanced, inclusive approach to retirement savings. As workplace demographics and regulations evolve, the ADP and ACP tests remain a cornerstone of equitable retirement planning in the United States.