Actual Contribution Percentage (ACP) Test

What is the Actual Contribution Percentage (ACP) Test?

The Actual Contribution Percentage (ACP) test is an annual non-discrimination evaluation used to ensure fairness in 401(k) and 403(b) plans. It checks that employer matching contributions and employee voluntary after-tax contributions are distributed equitably between Highly Compensated Employees (HCEs) and Non-highly Compensated Employees (NHCEs).

(Note: Highly Compensated Employees (HCEs) are the employees who either earned above a specific income level set by the IRS (e.g., $150,000) or own more than 5% of the company, whereas Non-Highly Compensated Employees (NHCEs) are the employees who do NOT meet the criteria to be considered HCEs, meaning they earn less than the set income level and do not own more than 5% of the company.)

This distinction is important for ensuring that retirement plans are not disproportionately favoring higher-paid employees over the broader workforce, complying with nondiscrimination rules.

The goal is to prevent a situation where the benefits for HCEs are disproportionately higher than NHCEs, thus promoting fairness in the retirement plan’s benefits distribution.

Simply put, it’s a yearly check to ensure that contributions to 401(k) and 403(b) plans are fair and don’t favor higher-paid employees more than lower-paid ones.

How is the ACP Test Calculated?

The ACP Test checks if employer contributions, such as matching or after-tax contributions, favor Highly Compensated Employees (HCEs) over Non-Highly Compensated Employees (NHCEs).

Here’s a quick breakdown:

1. Calculate Each Employee’s Contribution Ratio (ACR):

• ACR = (Employer Matching + Employee After-Tax Contributions) ÷ Compensation.

2. Average the ACRs:

• Calculate the average ACR for both HCEs and NHCEs.
• Next, to calculate the Actual Contribution Percentage (ACP) for each group:
• ACP = Sum of all ACRs for the Group​/Number of Eligible Employees in the Group
• This step is repeated for both the HCEs and the NHCEs.

3. The plan passes if:

• The HCE ACP is not more than 125% of the NHCE ACP, or
• The HCE ACP is within 2 percentage points or 2 times the NHCE ACP.

To understand how the Actual Contribution Percentage (ACP) test is calculated, let’s consider a real-life scenario involving a fictional company, “TechSolutions Inc.”

This example will help illustrate the key concepts and calculations involved in the ACP test, along with related metrics like the Actual Contribution Percentage (ACP), Actual Contribution Test, Actual Deferral Percentage (ADP), and the ADP Test.

Actual Contribution Percentage (ACP)= Total Matching Contributions + Total After-Tax Contributions​/Compensation ×100

Calculate the Average ACP for HCEs and NHCEs:

• For HCEs: Average the ACPs of all Highly Compensated Employees.
• For NHCEs: Average the ACPs of all Non-Highly Compensated Employees.

Compare the HCE Average ACP to the NHCE Average ACP:

• The ACP test is considered passed if the HCE average ACP is not more than:
  1. 1.25 times the NHCE average ACP, or
  2. percentage points more than the NHCE average ACP.)

1. Actual Contribution Percentage (ACP)

The ACP measures the average rate of employer matching and/or after-tax contributions for Highly Compensated Employees (HCEs) compared to Non-Highly Compensated Employees (NHCEs).

Example Calculation:

1. HCEs:

• John: $275,000 salary, $8,250 employer match
• Carolyn: $200,000 salary, $6,000 employer match
• Steve: $125,000 salary, $3,750 employer match

2. NHCEs:

• Amanda: $100,000 salary, $3,000 employer match
• Mike: $50,000 salary, $0 employer match
• Lisa: $40,000 salary, $1,200 employer match
• Gary: $35,000 salary, $1,050 employer match

Calculations:

1. HCE ACP:

• John: $8,250 / $275,000 = 3.00%
• Carolyn: $6,000 / $200,000 = 3.00%
• Steve: $3,750 / $125,000 = 3.00%
• Average HCE ACP: (3.00% + 3.00% + 3.00%) / 3 = 3.00%

2. NHCE ACP:

• Amanda: $3,000 / $100,000 = 3.00%
• Mike: $0 / $50,000 = 0.00%
• Lisa: $1,200 / $40,000 = 3.00%
• Gary: $1,050 / $35,000 = 3.00%
• Average NHCE ACP: (3.00% + 0.00% + 3.00% + 3.00%) / 4 = 2.25%

2. Actual Contribution Test

The Actual Contribution Test compares the average ACP of HCEs to NHCEs to ensure fairness.

Add the ACRs for each group and divide by the number of employees.

1. HCEs:

• Average HCE ACP = 3.00% + 3.00% + 3.00% / 3 = 3.00%

2. NHCEs:

• Average NHCE ACP = 3.00% + 0.00% + 3.00% + 3.00% / 4 = 2.25%

For HCEs:

• John: 3.00%
• Carolyn: 3.00%
• Steve: 3.00%

Average ACP for HCEs: 3.00% + 3.00% + 3.00% / 3 = 3.00%

For NHCEs:

• Amanda: 3.00%
• Mike: 3.00%
• Lisa: 3.00%
• Gary: 3.00%

Average NHCE ACP = 3.00% + 0.00% + 3.00% + 3.00% / 4 = 2.25%

Test Results:

• HCE ACP: 3.00%
• NHCE ACP: 2.25%
• Comparison: HCE ACP is not more than 125% of NHCE ACP, nor is it more than 2 percentage points greater than NHCE ACP.

 

Test Pass/Fail:

Result: The test passes since 3.00% is within the allowed range compared to 2.25%.

3. Actual Deferral Percentage (ADP)

The ADP measures the average rate of salary deferrals for HCEs compared to NHCEs.

The ADP measures the average rate of salary deferrals for HCEs and NHCEs

HCEs:

John:
Deferral: $18,500
Compensation: $275,000

18,500/275,000= 6.73%

Carolyn:
Deferral: $15,000
Compensation: $200,000

15,000/$200,000 = 7.50%

Steve:
Deferral: $12,500
Compensation: $125,000

12,500/125,000 = 10.00%

Average HCE ADP:

6.73% + 7.50% + 10.00% / 3 = 8.08%

NHCEs

Amanda:
Deferral: $12,000
Compensation: $100,000

12,000/100,000 = 12.00%

Mike:
Deferral: $0
Compensation: $50,000

0/50,000 = 0.00%

Lisa:
Deferral: $4,000
Compensation: $40,000

4,000/40,000 = 10.00%

Gary:
Deferral: $2,400
Compensation: $35,000

2,400/35,000= 6.86%

Average NHCE ADP:

12.00% + 0.00% + 10.00% + 6.86% /4 = 7.22%

Example Calculation:

1. HCEs:

• John: $18,500 deferral / $275,000 salary = 6.73%
• Carolyn: $15,000 deferral / $200,000 salary = 7.50%
• Steve: $12,500 deferral / $125,000 salary = 10.00%
• Average HCE ADP: (6.73% + 7.50% + 10.00%) / 3 = 8.08%

 

2. NHCEs:

• Amanda: $12,000 deferral / $100,000 salary = 12.00%
• Mike: $0 deferral / $50,000 salary = 0.00%
• Lisa: $4,000 deferral / $40,000 salary = 10.00%
• Gary: $2,400 deferral / $35,000 salary = 6.86%
• Average NHCE ADP: (12.00% + 0.00% + 10.00% + 6.86%) / 4 = 7.22%

4. Actual Deferral Percentage (ADP) Test

The ADP Test compares the average ADP of HCEs to NHCEs to ensure equitable participation.

To pass the ADP test, the plan must meet one of two conditions:

1. 125% test:

The average ADP of HCEs cannot exceed 125% of the average ADP of NHCEs

125% of NHCE ADP:

7.22% x 1.25 = 9.03%

In this case, the HCE ADP (8.08%) is below 9.03%, satisfying the requirement.

2 Plus, 2 Times Test

Alternatively, the HCE ADP cannot be more than 2 percentage points greater than the NHCE ADP, and the HCE ADP also cannot exceed 200% of the NHCE ADP

NHCE ADP + 2%

7.22% + 2.00% = 9.22%

200% of NHCE ADP

7.22% X 2 = 14.44%

The HCE ADP (8.08%) is below both 9.22% (the 2% rule) and 14.44% (the 200% rule), satisfying the requirement as well.

Test Results:

• HCE ADP: 8.08%
• NHCE ADP: 7.22%
• Comparison: HCE ADP is not more than 125% of NHCE ADP, nor is it more than 2 percentage points greater than NHCE ADP.

 

Test Pass/Fail:

Result: The test passes since 8.08% is within the allowed range compared to 7.22%.

In this example, TechSolutions Inc. successfully passes both the ACP and ADP tests, indicating that their 401(k) plan is compliant and equitably benefits both HCEs and NHCEs. Regularly performing these tests helps ensure that the plan remains fair and compliant with IRS regulations.

What are the Best Practices for Passing the ACP Test?

To pass the Actual Contribution Percentage (ACP) test and maintain 401(k) compliance, employers should follow these best practices:

Adopt a Safe Harbor Plan:

Safe Harbor Match: Ensure that your 401(k) plan meets the Safe Harbor matching requirements, which generally involve matching employee contributions up to a certain percentage of their salary.

(A Safe Harbor 401(k) plan makes it easier for employers to meet IRS rules by offering guaranteed contributions, like matching or fixed amounts, to every employee’s retirement account. This helps ensure fairness across the board, regardless of how much someone earns.)

Safe Harbor Non-Elective Contribution: Provide a non-elective contribution, where a fixed percentage of each employee’s salary is contributed to their 401(k) account, regardless of whether they contribute themselves.

Encourage Broader Participation:

Financial Education: Educate NHCEs about the benefits of retirement savings. The more they understand, the more likely they are to participate and contribute.
Automatic Enrollment: Use automatic enrollment with default contribution rates to increase NHCE participation. It’s an easy way to get more employees involved and balance contributions across the board.

Customize Eligibility Requirements:

Extended Eligibility: Think about extending the required employment period before employees can join the plan. This can help manage participation levels and keep things balanced.

Cap HCE Contributions:

Limit HCE Contributions: Set contribution limits for Highly Compensated Employees (HCEs) to help your plan meet nondiscrimination requirements and stay compliant.

Monitor and Adjust Contributions Regularly:

Midyear Testing: Conduct midyear testing to catch any potential compliance issues early on. It’s better to spot problems sooner rather than later.
Plan Review: Regularly review how contributions are shaping up. This lets you make any necessary adjustments to keep everything on track.

Utilize After-Tax Contributions:

After-Tax Contributions: Allowing after-tax contributions can help balance out your ACP test results and ensure your plan remains compliant.

How to Correct ACP Test Failures?

If your plan fails the ACP test, taking the right corrective steps is crucial. Here’s a detailed guide on how to address the issue:

• Review Your Plan Document: Begin by thoroughly checking your plan document to see if it outlines any specific corrective measures. Understanding the rules your plan follows will guide your next steps and ensure you’re compliant.
• Refund Excess Contributions: One common solution is to return the excess contributions, along with any gains, to the Highly Compensated Employees (HCEs). This method helps bring your plan back into balance by reducing the contributions that caused the test failure.
• Provide Additional Contributions: Alternatively, you can make extra contributions to the Non-Highly Compensated Employees (NHCEs). This approach is designed to enhance equity within the plan, addressing imbalances by boosting contributions for those who didn’t exceed the limits.
• Combine Approaches: Sometimes, the best strategy involves a combination of actions. You can refund the excess amounts to HCEs and simultaneously make Qualified Non-Elective Contributions (QNECs) to NHCEs. This dual approach ensures that both sides of the equation are addressed.
• Consult a Plan Advisor: If your plan uses prior-year testing, consulting with a plan advisor is highly recommended. An expert can offer alternative strategies and ensure you’re using the most effective method to correct the failure.
• Seek Expert Guidance: Finally, reaching out to your plan services consultant can provide you with the specific advice and support you need. These professionals can help navigate complex scenarios and ensure your corrective actions are compliant.

Taking prompt and appropriate corrective actions ensures your plan remains compliant and avoids potential IRS penalties.

What is the Difference Between the ACP and ADP Tests?

The Actual Deferral Percentage (ADP) test compares how much Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs) contribute to a retirement plan through salary deferrals, simply put, from their paychecks. It ensures that HCEs aren’t contributing disproportionately more than NHCEs by measuring the average deferral rates for both groups.

The Actual Contribution Percentage (ACP) test is similar but focuses on employer contributions, such as matching contributions or after-tax contributions. It ensures that the employer’s contributions benefit both HCEs and NHCEs fairly.

In short, the ADP test looks at employee deferrals, while the ACP test looks at employer contributions. Both tests are designed to prevent retirement plans from unfairly favoring HCEs over NHCEs.

Following are the key differences between the two:

Aspect	ADP Test	ACP Test
Purpose	Ensures salary deferrals are distributed fairly between HCEs and NHCEs.	Ensures matching and after-tax contributions are distributed fairly between HCEs and NHCEs.
Focus	Average deferral percentages.	Average contribution percentages (including matching and after-tax).
Calculation	Average deferral percentage = Total deferrals / Compensation for each group.	Average contribution percentage = Total matching + after-tax contributions / Compensation for each group.
Comparison	HCE ADP vs. NHCE ADP.	HCE ACP vs. NHCE ACP.
Testing Methods	1.25 Test: HCE ADP ≤ 125% of NHCE ADP. 2 + 2 Test: HCE ADP ≤ NHCE ADP + 2% and HCE ADP ≤ 2 × NHCE ADP.	Same as ADP but for contributions (matching + after-tax).
Required For	All traditional 401(k) plans.	Only 401(k) plans with matching or after-tax contributions.
Common Correction Methods	– Refunds to HCEs. – Retroactive Safe Harbor contributions. – Qualified Nonelective Contributions (QNECs) to NHCEs.	– Refunds to HCEs. – Retroactive Safe Harbor contributions. – QNECs to NHCEs.
Safe Harbor Impact	Automatically passes the ADP test if Safe Harbor contributions are made.	Automatically passes the ACP test if Safe Harbor contributions are made.
Plan Correction Deadline	Corrective actions must be taken within 12 months after the end of the plan year.	Corrective actions must be taken within 12 months after the end of the plan year.
Additional Details	– The ADP test checks how much employees are deferring from their salaries into the plan. – Plans have flexibility in the testing method but must pass one of the tests.	– The ACP test checks how much the employer is contributing in matches and after-tax contributions. – Similar flexibility in testing methods as ADP.
Top-Heavy Plans	Not directly part of ADP but could affect the outcome; top-heavy plans require additional contributions.	Not directly part of ACP but could affect the outcome; top-heavy plans require additional contributions.