Actual Deferred Percentage (ADP)

What Is Actual Deferred Percentage (ADP)?

ADP stands for actual deferred percentage, a measure that is critical for setting up and maintaining a compliant 401(k) plan for your business.

So what is ADP? Actual deferral percentage is the percentage of wages deferred by employees under a 401(k) retirement plan.

An employer’s ADP helps to ensure that employee 401(k) benefits are compliant with IRS and ERISA rules. These rules apply to both large and small businesses with 401(k) plans. The purpose of these rules is to ensure that your 401(k) does not unfairly favor highly compensated employees over individuals who make lower wages.

The IRS states that traditional 401(k) plans must “ensure that the contributions made by and for rank-and-file employees (non-highly compensated employees (NHCEs)) are proportional to contributions made for owners and managers (highly compensated employees (HCEs)).”

The IRS rule for traditional 401(k) plans is about fairness and balance. It’s designed to ensure that a 401(k) plan benefits all employees of a company, not just those at the top of the pay scale. The rule focuses on two groups of employees: NCHEs and HCEs.

According to this rule, the contributions made by and for the NHCEs must be proportional to those made for HCEs. This is to prevent a situation where a 401(k) plan is disproportionately beneficial to higher-paid employees while offering minimal benefits to the rest of the staff.

For example, suppose that the average contribution rate for NHCEs at your company is 4% of their salaries. However, HCEs want to contribute 6% of their salaries to their 401(k) plans. Since they make significantly more, it is presumed that they have more financial leeway to make larger contributions.

According to the IRS rule, there must be a balance between these two rates. If your HCEs are contributing a higher percentage of their salary, you could have an imbalance and face penalties from the IRS. The actual deferral percentage test helps you measure the size of the imbalance and ensure it falls within normal ranges.

What Is the 401(k) Deferral Rate?

What is a 401(k) deferral, and what are 401(k) deferral rates? Before we get into these questions, it’s important to quickly recap employee deferral and tax-deferred wages. What are tax-deferred wages? They are simply wages that employees defer or delay paying taxes on so that they can use them for an eligible purpose, such as contributing to a 401(k).

What is a 401(k) deferral? A 401(k) deferral is a pre-tax contribution that an employee makes to an employer-sponsored retirement plan. Instead of receiving those funds as part of their salary, employees allocate them to the retirement account.

The 401(k) deferral rate is the portion of an employee’s wages deducted from their paycheck that is contributed toward the employee’s 401(k) plan through their employer.

According to the Society for Human Resource Management (SHRM), the most common 401(k) deferral rate is 6%. For instance, suppose that Emily works for a company that offers a 401(k) plan. She earns $50,000 per year. Emily decides to contribute 6% of her salary to her 401(k) plan. This means that her annual contribution will be 6% of $50,000.

You can calculate this as follows:

• Annual 401(k) Contribution= Annual Salary x Deferral Rate
• Annual 401(k) Contribution= $50,000 x 6%
• Annual 401(k) Contribution= $3,000

So Emily will defer $3,000 of her annual salary into her 401(k) plan. This amount will typically be deducted from her salary in equal parts throughout the year and deposited into her 401(k) account. This is an example of a 401(k) deferral rate in action.

What Is the Actual Deferral Percentage Test?

The actual deferral percentage test is a specific assessment used by employers offering 401(k) plans to ensure that the contributions made by employees are equitable across different income levels.

You will need to perform this test to ensure compliance with IRS guidelines and verify that both classes of employees are being treated fairly within the context of your retirement plan. Here is what you need to know about how to perform the test and how the IRS defines HCEs and NHCEs.

Understanding the ADP Test

The ADP test measures average salary deferral percentages for highly compensated employees with those of non-highly compensated employees. According to the IRS, an HCE is someone who:

• At any time during the year, owns at least 5% of the company, OR
• Will be paid more than $155,000 in the year 2024 and ranks among the top 20% of paid employees.

The IRS periodically adjusts the income threshold. For example, a few years ago, the income limit was $130,000. Staying apprised of the latest income limits is critical to ensuring your ADP calculations are accurate.

Conducting the ADP Test

To perform the ADP test, you’ll need to first determine the deferral percentage for each employee.

This is done by dividing the amount the employee contributes to their 401(k) by their compensation. If you have robust HR and payroll management software, you should be able to simply check your records and verify what deferral percentage each employee has selected.

Next, use the IRS criteria to separate employees into HCEs and NHCEs. Make sure to consider each employee’s salary, ownership stake in the company, and whether they are among the top 20% of earners.

After you’ve categorized your team, you are ready to calculate the average deferral rates for each group. To do this, add up the individual deferral percentages of each group, and then divide by the number of employees in that group. Now, you are ready to calculate the actual deferral percentage.

How Do You Calculate Actual Deferral Percentage?

According to the IRS, a 401(k) plan must be considered nondiscriminatory by receiving a passing grade on the ADP test.

Consider this scenario: you have 10 NHCE employees and 5 HCE employees. Of your 10 NHCE staff, five of them contribute 4% to their 401(k) plans, and the other five contribute 5%. All of your HCE employees contribute 5%.

You would add the percentage contributions of each group and divide by the number of employees in that segment to determine your average. The average ADP for your NHCE group is 4.5%, and the average for your HCE group is 5%.

According to the IRS, you meet the test if the ADP for eligible HCEs does not exceed the greater of one of these numbers:

• 125% of the ADP for the group of NHCEs
• The lesser of 200% of the ADP for the group of NHCEs or the ADP for the NHCEs plus 2%.

You can work backward to determine the ADP limits for your HCE group. Your NHCE average is 4.5%, and 125% of that is 5.625%. Since the average ADP for your HCE group is 5%, you are within normal IRS limits.

However, suppose that the ADP for your HCEs was 6% instead of 5%. In this scenario, their average contributions exceed the 125% threshold, which means that you would need to move on to the second provision of the IRS rule.

Using these new numbers, you would need to determine whether the 6% ADP of the HCE group is within 2% of the NHCEs contributions or 200% of the ADP (i.e., double the 4.5%). An ADP of 6% is within two percentage points of the NHCE group’s 4.5% average contribution, which means that your company is compliant with IRS rules.

Elements of an Actual Deferral Percentage Test

The actual deferral percentage test has several components, including:

• Elective Deferrals: Voluntary employee contributions to their 401(k)
• Matching Contributions: The amount you contribute to match elective deferrals
• Non-Elective Contributions: The amount that you contribute that is not related to elective deferrals
• HCEs: Top earners who are in the top 20% or own at least 5% of the company
• Testing: Annual process to compare ADP of NHCEs to HCEs.

When performing your ADP test, make sure to account for all of these factors so that your results accurately reflect the contributions of both groups.

What Happens If a 401(k) Plan Fails to Pass the Nondiscrimination Tests?

If a 401(k) plan fails to pass the nondiscrimination tests, there are three things to do:

1. Find the mistake by conducting an independent review to determine the correct classification of NHCEs and HCEs.
2. Fix the mistake by making qualified nonelective contributions for NHCEs.
3. Avoid making the same mistake in the future by using 401(k) automatic enrollment or by considering a safe harbor 401(k) plan.

What Is a Corrective Distribution 401(k)?

If the actual deferred percentage test reveals that HCE contributions are disproportionately high when compared to NHCE contributions, you may need to make a corrective distribution. During a corrective distribution, you will return a portion of your HCEs’ contributions to keep the ADP within acceptable limits.

For instance, if HCEs were 0.5% above acceptable limits in 2023, you would have to return 0.5% of their contributions. You’ll also need to ensure that the returns are properly taxed.

Safe Harbor Plans and ADP

A Safe Harbor 401(k) plan allows you to bypass actual deferred percentage tests (and other non-discrimination testing) by providing eligible nonelective or matching contributions for your employees.

To qualify, you can provide a basic matching program or offer a flat nonelective contribution. For instance, you could contribute 3% to every employee’s 401(k), regardless of whether they contribute themselves or not. Alternatively, you could match their contributions up to 3%.

This approach ensures that all employees have the same access to 401(k) plan benefits, regardless of their salary.