What it means
A 401(k) plan carries valuable tax breaks, and in return the Internal Revenue Service (IRS) requires proof that the plan does not mainly reward the best-paid people. The ADP and ACP tests are that proof.
They are run once for each plan year, usually after the year ends. A highly compensated employee (HCE) is generally someone who owns more than 5% of the business or earned above a compensation threshold in the prior year.
The threshold is set and indexed by the IRS, so it should always be checked against the current figure. Everyone else is a non-highly compensated employee (NHCE).
The ADP test compares the average deferral rate of the HCE group with that of the NHCE group, where each person's rate is their deferrals divided by their pay. Pre-tax and Roth deferrals count, while age-based catch-up contributions are excluded.
The ACP test makes the same comparison using employer matching contributions and after-tax employee contributions. The HCE average must fall within limits tied to the NHCE average.
In simple terms, it can be no more than the greater of 1.25 times the NHCE average, or the lesser of two times the NHCE average and the NHCE average plus 2 percentage points. For NHCE rates between about 2% and 8%, the plus 2 points limit is the one that binds.
A failed test must be corrected, generally within 12 months after the plan year ends, or the plan risks losing its qualified status. The usual fix is to refund excess contributions to HCEs, which are taxable to them, or to make extra employer contributions to the NHCE group.
Refunding within about two and a half months of year end avoids an extra employer excise tax. Many employers avoid the testing by design.
A safe harbor 401(k) skips the ADP test, and usually the ACP test on the match, in exchange for fixed employer contributions, such as a match of 100% of the first 3% of pay deferred plus 50% of the next 2%, or a flat 3% of pay for every eligible employee. Small businesses where the owners make up most of the highly paid group are the classic failure case, so a mid-year projection is worth running.
In practice
Real-world examples.
Example
A 40-person design firm finds that its five HCEs defer 9% of pay on average while everyone else averages 4%. The HCE average is above the 6% limit, so the plan fails, and the firm refunds the excess to the five owners, who pay tax on it.
Example
A start-up adopts a safe harbor match of 100% of the first 3% of pay plus 50% of the next 2%. In return the plan skips ADP testing, so the founders' own deferral rates no longer trigger refunds under this test, although the annual dollar limits still apply.
Example
An HR manager at a regional retailer runs a mid-year projection in June and sees the HCE average tracking 2.6 points above the NHCE average. She caps further HCE deferrals for the rest of the year, and the plan passes comfortably in December.
Formula
Calculation
HCE limit = greater of (1.25 x NHCE average) or (the lesser of 2 x NHCE average or NHCE average + 2 points). Suppose the NHCE group averages a 4% deferral rate. Then 1.25 x 4% = 5%, 2 x 4% = 8% and 4% + 2 = 6%, and the lesser of 8% and 6% is 6%. The greater of 5% and 6% is 6%, so the HCE average may not exceed 6%. An HCE average of 6.5% therefore fails the test.Case study
Seen in the real world.
Larkspur Dental is a fictional practice used for this illustrative case study. It has three owner-dentists and twelve staff, and half the staff opt out of the 401(k) entirely, so the NHCE average is tiny while the owners defer heavily.
The plan fails the ADP test two years running, and the owners receive taxable refunds each time. The practice moves to a safe harbor plan with a 3% employer contribution for every employee, participation rises because the benefit is visible, and the annual testing problem disappears by design.
Watch out
Common mistakes.
- Testing only after year end; without a mid-year projection, a failure surfaces too late to fix cheaply.
- Forgetting that Roth deferrals count toward the ADP test even though they are made from after-tax pay.
- Treating refunds as the only remedy; employer contributions to the lower-paid group can also close the gap and are often better received by staff.
Questions
People also ask.
What does the ADP test measure?
It compares the average share of pay that HCEs defer into the plan, both pre-tax and Roth and excluding catch-up contributions, with the average for everyone else.
What does the ACP test measure?
The same style of comparison, but applied to employer matching contributions and employee after-tax contributions rather than salary deferrals.
How can a plan avoid these tests?
By adopting a safe harbor design with required employer contributions, such as a basic match of 100% of the first 3% of pay plus 50% of the next 2%, or a flat 3% contribution for all eligible employees.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related