What it means
ADP looks at employee salary deferrals, meaning the money staff choose to divert from their pay into the plan. ACP looks at employer matching contributions and employee after-tax contributions, so between them the two tests cover most of what goes into a typical plan.
Both tests work in the same way. Each employee's contribution is expressed as a percentage of that employee's own pay, those percentages are averaged separately for the higher-paid group and for everyone else, and the two averages are then compared.
The tests exist because the tax relief given to retirement saving is intended to benefit the whole workforce rather than just senior staff. Without a test a plan could be technically open to everyone while in practice only the well-paid could afford to use it.
The permitted gap is set by formula rather than by judgement. Broadly, the higher-paid average may reach the greater of 1.25 times the other group's average, or the lesser of that average plus 2 percentage points and twice that average, within thresholds that the tax authority maintains.
Failing is awkward but fixable. The usual corrections are refunding part of the higher-paid employees' contributions, making an additional employer contribution for lower-paid staff, or redesigning the plan as a safe harbour arrangement that is exempt from the tests altogether.
Who counts as highly compensated is defined by rules rather than by impression, normally an ownership stake in the business or pay above a threshold that the tax authority updates. The tests are usually run by the payroll or plan provider after the year has ended, which means a failure often surfaces months after the money went in.
In practice
Real-world examples.
Example
A 40-person engineering consultancy finds that its five owners and senior engineers defer an average of 9% of pay while the other 35 staff average 3%. The plan fails the ADP test, and the firm refunds part of the owners' contributions in the spring, creating an unexpected taxable amount for each of them.
Example
A dental practice tired of annual refunds adopts a safe harbour design with a guaranteed employer contribution for all staff. The practice now pays more into the plan for its hygienists and assistants, and in exchange the owners can contribute the full amount every year without testing.
Example
A retailer with many part-time hourly staff fails the ACP test because few of them take up the match. Rather than refunding, the company automatically enrols new staff at 3% with the option to opt out, and participation rises enough that the following year's test passes comfortably.
Formula
Calculation
Each employee's deferral percentage = Employee contributions / That employee's pay
Group average = Average of the individual percentages within the group
Permitted maximum for the higher-paid group = the greater of (1.25 x other group's average) or the lesser of (other group's average + 2 percentage points) and (2 x other group's average)
Suppose the average deferral percentage for the non-highly compensated group is 4%.
Route one: 1.25 x 4% = 5%
Route two: the lesser of (4% + 2 percentage points = 6%) and (2 x 4% = 8%), which is 6%
Permitted maximum = the greater of 5% and 6% = 6%
If the higher-paid group's average is 7%, the plan fails by 1 percentage point. Where that group has ten members with combined pay of $2,000,000, cutting the average by one percentage point means refunding about $2,000,000 x 1% = $20,000 of contributions, allocated to the highest contributors first.Case study
Seen in the real world.
This is an illustrative and entirely fictional case. Kestermill Tooling, an invented 60-employee machining business, ran a retirement plan that its three owners valued highly and its shop floor largely ignored. Participation among hourly staff sat near 20%, so the non-highly compensated average was low and the owners were refunded part of their contributions three years in a row.
The finance manager worked out what the refunds actually cost. Each owner lost tax-advantaged saving they had intended to make, the refunds arrived as taxable income with no notice, and the plan administrator charged a fee for processing the correction each time. Set against that, a safe harbour design requiring a 3% employer contribution for every eligible employee cost around $54,000 a year across the workforce.
Kestermill chose the safe harbour. The owners could then contribute the maximum with certainty, the shop floor received a contribution whether or not they saved themselves, and the annual testing exercise disappeared. The illustrative point is that failing these tests repeatedly is not just a compliance irritation; it is a signal that the plan is not working for most of the people it supposedly covers.
Watch out
Common mistakes.
- Treating the tests as a payroll formality, when a failure produces taxable refunds to senior staff and real administrative cost for the employer.
- Assuming the two tests are interchangeable, when ADP covers employee deferrals and ACP covers matching and after-tax contributions.
- Ignoring low participation among lower-paid staff, which is the actual cause of nearly every failure and the only durable thing a business can fix.
Questions
People also ask.
What happens if a plan fails one of these tests?
The employer must correct it within a set period, usually by refunding excess contributions to the higher-paid group or by making an additional contribution for everyone else.
How can a business avoid the tests entirely?
By adopting a safe harbour plan design, which commits the employer to a defined contribution for all eligible staff in exchange for exemption from the testing.
Does automatic enrolment help?
Yes, it reliably raises participation among lower-paid employees, which lifts their group average and widens the room available to the higher-paid group.
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