Actual Deferred Percentage (ADP)

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Actual Deferred Percentage (ADP)

What is Actual Deferred Percentage (ADP)?

The Actual Deferral Percentage (ADP) is a critical component of American labor laws, specifically in relation to 401(k) retirement plans. It measures the percentage of salary that employees choose to defer under such a plan.

The ADP calculation aims to ensure the retirement plan's compliance with non-discrimination rules established by the Internal Revenue Service (IRS) and the Employee Retirement Income Security Act (ERISA).

As per IRS and ERISA guidelines, 401(k) plans must not discriminate against Non-Highly Compensated Employees (NHCEs) or in favor of Highly Compensated Employees (HCEs). Therefore, the contributions made on behalf of NHCEs should be proportionate to those made for HCEs

What Is the 401(k) Deferral Rate?

The 401(k) deferral rate pertains to the percentage of an employee’s compensation that is deducted from their paycheck and redirected towards their 401(k) plan via their employer.

This rate is set by the employer and is uniformly applicable to all plan participants. As of 2018, the average deferral rate reached an all-time high of 8.6%

The Actual Deferral Percentage Test: Ensuring Fairness in 401(k) Contributions

The ADP test is a key tool for employers to ensure that their 401(k) contributions are fair and proportional for all employees.

Through the ADP test, employers can verify their compliance with the actual deferral percentage required by the IRS for both NHCEs and HCEs.

In addition to the ADP test, another nondiscrimination test, the Actual Contribution Percentage (ACP) test, takes into account both the employer's matching contributions and the after-tax contributions made by the employee

An employee can be considered an HCE for the ADP and ACP tests if they:

  1. Own at least 5% of the company either directly or via familial attribution at any point during the year, or
  2. Earn more than $130,000 for the years 2020 or 2021 (this figure can change yearly), and the employer includes them in the top 20% of the highest-paid employees at the company.

The Top-Heavy Test: Another Check for Fairness

Alongside the ADP and ACP tests, companies generally must pass the Top-Heavy test, which focuses on "key employees" rather than just HCEs. A "key" employee is defined as an individual who:

  1. Meets the above criteria for HCE employees, or
  2. Earns more than $150,000 during the year and owns over 1% of the business.

These three tests collectively compare the retirement plan benefits between NHCEs and HCEs. The three key aspects evaluated by these tests are coverage, contributions, and accumulated assets.

Lack of participation by NHCEs can be an indication of inadequate knowledge or perceived value in contributing to the company's 401(k) plan.

Calculating the Actual Deferral Percentage: A Step-by-Step Process

For a 401(k) plan to be deemed nondiscriminatory according to the IRS, it must earn a passing grade on the ADP test.

As per the IRS regulations, while calculating the ADP, it must be ensured that the eligible HCEs’ contributions are less than either:

  1. 125% of the ADP for the group of NHCEs, or
  2. The lesser of these two values:
    • 200% of the ADP for the group of NHCEs, or
    • The ADP for the NHCEs plus 2%.

Addressing Non-Compliance: The Aftermath of Failing Nondiscrimination Tests

In case a 401(k) plan fails to pass the non-discrimination tests, corrective actions must be taken:

  1. Identify the error by initiating an independent review to ascertain the correct classification of NHCEs and HCEs.
  2. Rectify the error by making qualified nonelective contributions for NHCEs.
  3. Prevent future errors by considering options like 401(k) automatic enrollment or a safe harbor 401(k) plan.

What is a Corrective Distribution 401(k)?

A Corrective Distribution 401(k) is an IRS mechanism to ensure fair benefits for NHCEs. It happens when an employer must return a part of the HCEs’ contributions to bring their savings down to within the required 125% of NHCEs’ savings.

The above guidelines elucidate the essential aspects of the Actual Deferred Percentage (ADP) and its role in maintaining the fairness of 401(k) retirement plans.

By understanding and abiding by these principles, companies can contribute to their employees' secure and equitable financial futures.