The Actual Deferral Percentage (ADP) is used in retirement plans, like 401(k)s, to make sure the contributions from highly compensated employees (HCEs) aren’t too much higher than those from non-highly compensated employees (NHCEs). Basically, it compares how much each group is contributing to ensure the plan is fair and follows IRS rules. This ensures the benefits are spread across all employees, not just the top earners.
The ADP is calculated by dividing the total contributions of a group (either HCEs or NHCEs) by their total compensation. This percentage helps confirm the plan meets the nondiscrimination requirements. The goal? To keep things balanced between employees, no matter their pay.
What is the ADP test?
The ADP test is an annual check that ensures 401(k) plans (and similar retirement plans) are fair to everyone—not just the top earners. It compares the contribution percentages of HCEs (employees making above a certain threshold, like $130,000 in 2025) with NHCEs (everyone else). The test ensures HCEs don’t over-contribute compared to NHCEs.
The test is one of the nondiscrimination rules set by the IRS for 401(k) plans. If the plan passes, it’s good to go. If it fails, corrective actions are needed to stay compliant and avoid penalties.
What are the elements of the actual deferral percentage test?
There are a few key parts to the ADP test:
- Deferral Percentage Calculation: First, calculate the deferral percentage for both HCEs and NHCEs. This is done by dividing the total contributions (pre-tax or Roth) by each individual’s compensation during the testing period.
- Comparison of HCE and NHCE Deferral Percentages: Once the percentages are calculated, they’re compared. For the plan to pass, HCEs’ deferral percentage must fall within a certain range of NHCEs’.
- Test Limits: The ADP test has limits. Typically, if NHCEs defer an average of 3%, HCEs can defer no more than 6%. If NHCEs defer less than 3%, HCEs may be allowed to defer up to twice the NHCEs’ percentage, plus 2%.
- Correction Methods: If the plan fails, the employer must take corrective actions. This could mean refunding excess contributions to HCEs or increasing NHCE contributions to balance things out.
What happens if employers fail the actual deferral percentage (ADP) test?
If a plan fails the ADP test, employers have to fix it. If they don’t, there could be penalties, plan disqualification, or other serious consequences. Here’s what typically happens:
- Corrective Refunds: If the ADP test fails, employers may need to refund excess contributions from HCEs to bring things back in line with the rules.
- Qualified Matching Contributions (QMAC) Adjustments: Employers can also increase contributions for NHCEs, like qualified matching or profit-sharing contributions, to help them catch up. This can help the plan pass the ADP test in the future.
- Re-Testing: After making corrections, employers often have to re-test the plan to make sure it meets the ADP requirements. If everything checks out, the plan passes in the next cycle.
- Plan Disqualification: In rare cases, if corrective measures aren’t taken or the issue continues, the plan could lose its tax-qualified status. This would result in both the employer and employees losing tax benefits.
- Penalties and Fees: If corrections aren’t made properly or on time, the IRS may impose penalties. These could include extra fees or taxes, impacting the business.
To avoid failing the ADP test, employers can take steps like offering automatic enrollment, increasing NHCE contributions, or reducing HCE contributions. Monitoring deferral percentages regularly can help spot issues before they become problems, keeping the plan compliant with IRS rules.
