By Ian Berger, JD
Many 401(k) plans must pass two annual nondiscrimination tests: the ADP test and the ACP test. The November 11 Slott Report discusses the ADP test. This Slott Report tackles the ACP test and the options available to 401(k) plans that fail one or both tests.
ACP test. While the ADP test takes into account pre-tax deferrals and Roth contributions, the ACP test considers after-tax contributions and employer matching contributions.
First, the plan must calculate a contribution percentage for each employee. Your contribution percentage is the sum of your after-tax contributions and employer matching contributions, divided by your pay for the year. (If you are eligible but don’t make any after-tax contributions and don’t receive any matching contributions, your ACP percentage is 0 %.)
Second, the plan must calculate an average contribution percentage for all of the non-highly compensated employees (NHCEs) and an average for all highly compensated employees (HCEs).
The ACP test works the same way as the ADP test:
- If the NHCE average is 2% or less, the HCE average can’t exceed twice the NHCE average.
- If the NHCE average is between 2% and 8%, the HCE average can’t exceed the NHCE average plus 2%.
- If the NHCE average is more than 8%, the HCE average can’t exceed the NHCE average times 1.25.
Example: Company B has 3 NHCEs and 2 HCEs eligible for its 401(k) plan in 2019. Company B performs the ACP test based on the following data:
Employee After-tax contributions + Match Pay Contribution Percentage
NHCE1 $ 0 $50,000 0%
NHCE2 6,000 60,000 10.0
NHCE3 7,200 90,000 8.0
HCE1 7,500 150,000 5.0
HCE2 19,000 190,000 10.0
Here, the NHCE average contribution percentage is 6.0% [(0% + 10.0% + 8.0% /3]. Therefore, to pass the ACP test, the HCE average percentage can’t be more than 8.0%. Since the HCE average percentage is 7.5% [(5.0% + 10.0%)/2], the plan passes the ACP test for 2019. The plan must also pass the ADP test for 2019.
Remedies. If the plan fails the ADP or ACP test (or both), the employer must remedy the violation. Available remedies include:
- Distributing excess contribution to HCEs;
- Requiring HCEs to limit their deferrals and/or after-tax contributions; or
- Making special contributions for NHCEs.
Safe harbor contributions. Performing the ADP and ACP tests each year can be an administrative burden. Meanwhile, the available remedies aren’t ideal because they either prevent HCEs from maximizing deferrals or are too costly (or both). Fortunately, plan sponsors can avoid testing entirely by adopting one of the following “safe harbor” contribution formulas:
- The company contributes 3% of each employee’s pay, whether or not the employee makes deferrals.
- The company matches 100% of employee deferrals made up to 3% of pay and matches 50% of deferrals made on the next 2% of pay.
- The company matches 100% of employee deferrals made up to 4% of pay.
All safe harbor contributions must be immediately 100% vested. This makes those contributions expensive compared to other employer contributions, which can be subject to a vesting schedule.