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 (source).
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% (source).
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 (source).
An employee can be considered an HCE for the ADP and ACP tests if they:
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:
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.
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:
In case a 401(k) plan fails to pass the non-discrimination tests, corrective actions must be taken:
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 (source).
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.