The Actual Deferral Percentage test is an approach for businesses to ensure that all their employees are benefiting equally and fairly under their 401(k) retirement plan. Employees are entitled to a percentage of compensation that is deferred to their retirement plan, which is also known as their 401(k) plan. The percentage that is deferred varies for each employee; in other words, each employee has their individual deferral percentage.
As a result, according to the IRS, employers are obliged to run a deferral percentage test to confirm that the plan is not unfair to employees who make less or happen to be lower down the hierarchy. Conversely, the test is meant to ensure that an employer’s 401(k) plan does not unfairly favor the higher-paid employees.
For this purpose, the workforce is divided into two categories based on their compensation packages. HCEs are Highly Compensated Employees such as managers and executives with above-average packages; whereas, NHCEs or Non-Highly Compensated Employees are individual contributors within the organization or those with relatively lower compensation packages.
How to Differentiate Between HCEs vs NHCEs?
The ADP compliance tests are based on HCE packages, and a Highly Compensated Employee is anyone with the following:
An employee with a compensation package exceeding $130,000 (as of 2020); the threshold was $125,00 in 2019.
Any employee ranked in the top 20% for their compensation package.
Shareholders owning more than 5% of the business (applies to family members owning 5% or more in the business as well).
A Non-Highly Compensated Employee (NHCE), on the other hand, is simply everyone else.
Why is Performing an ADP Test Necessary?
The objective of performing an ADP test is to assess whether the plan is leading to HCEs contributing their fair share to their 401(k) plan compared to the contributions of NHCEs.
Companies must conduct ADP tests to retain their 401(k) plans under IRS rules. If at any time, the plan seems discriminatory or fails, the employer must immediately act upon it by taking corrective action within a 12-month period. Any gaps in compliance can result in penalties, plan disqualification, and fiduciary liability.
Calculating Actual Deferral Percentage
The actual Deferral Percentage is basically the percentage of an employee’s compensation that has been deferred to the employee's 401(k) plan. An example shown below, explains how the contribution of the deferral percentage of HCEs and NHCEs is measured.
Employee A's (HCE) contribution percentage is 10%
Employee B’s (HCE) contribution percentage is 8%
Employee B's (NHCE) contribution percentage is 4%
Employee C’s (NHCE) contribution percentage is 3%
Employee D’s (NHCE) contribution percentage is 5%
This indicates that the average contribution rate of the NHCEs is 4%, whereas, the average contribution percentage for the HCEs is 9%.
1. Passing Criteria for the ADP Test
The ADP test compares the average deferral contribution percentage of HCEs to NHCEs, which will only pass only if the HCE’s ADP is either:
No more than 125% of the NHCE’s ADP. For example, the HCE’s ADP has to be within 5% if the NHCE’s ADP is 4%.
Or the HCE’s ADP should be less than the NHCE’s ADP plus 2% or less than double the NHCE’s ADP (whichever is lower).
2. Top Paid Group Provision
Organizations whose workforce is made up of more than 20% of HCEs, i.e., those earning over $130,000, fall under the Top Paid Group Provision. This means that these companies have to make adjustments to their current 401(k) plan to only include the top 20% HCEs in their ADP tests.
Benefits of ADP
The ADP test allows a comparison between matching company contributions and non-elective contributions, i.e., the contributions that employers make irrespective of contributions by the employee to their 401(k) plan.
An effective technique to measure the plan participation ratio between NHCEs and HCEs. Any major difference in participation is an indication that NHCEs are reluctant to contribute to the company’s 401(K) plan.
3. Accumulated Assets
A way to check the value of assets of “key employees” (this is a concept broader than the concept of HCEs) does not exceed 60% of total assets contained within their company 401(k) plan. This test is also called the Top-Heavy test. This is a test that many employers need to pass in addition to the ADP test.