As the IRS offers tax saving and tax deferred savings in employer sponsored retirement plans, they want to ensure that not only owners and highly compensated employees benefit from these plans. One of the ways that the IRS accomplishes this is through the Non-Discrimination testing, which consists of the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests. These tests look at the percentage at which Highly Compensated Employees (HCEs) defer and receive matching and/or After-Tax Contributions in relation to the percentage at which Non-Highly Compensated Employees (NHCEs) defer and receive matching and/or After-Tax Contributions. If the two percentages are within a certain range, then the plan is considered to pass, and no further action is needed. If the HCEs are contributing at a rate much higher than the prescribed range, then the plan is considered to fail and either refunds to the HCEs are required or additional contributions must be made to the NHCEs.
In this article, we will delve deeper into how HCEs and NHCEs are defined, the parameters of the ADP/ACP Tests, and Safe Harbor Plan design options that satisfy the non-discrimination requirements and exempt the plan from performing the tests.
Defining HCEs and NHCEs:
- Highly Compensated Employees (HCEs) – Generally, an HCE is either determined by ownership in the organization sponsoring the retirement plan or having reached a certain income threshold for the previous year. Any employee with greater than 5% ownership in the sponsoring organization is considered an HCE. The IRS sets income limits on an annual basis to determine who will be considered an HCE for the following year. We have provided a chart with these limits here.
- Non– Highly Compensated Employees (NHCEs) – The definition for this one is easy! It is any employee that isn’t an HCE.
ADP/ACP Testing:
- Actual Deferral Percentage (ADP) Test – This test looks at the percentage of compensation deferred on Pre-Tax and/or Roth basis by each eligible participant of the plan, then compares those averages as HCE and NHCE groups. To pass the test, those averages must be within a certain range. There are two tests that can be passed for the plan to pass ADP testing. For the first test, the HCE group cannot contribute more than 1.25% of the average deferral percentage of the NHCE group. If the first test does not pass, then the plan can pass using the second test. The second test is that the HCEs cannot contribute more than the lesser of two times the NHCE percentage or the NHCE percentage plus 2%. Failure of the test can result in refunds to HCEs to bring the plan within the allowed range or a Qualified Non-Elective Contribution (QNEC) to NHCE employees that brings the percentage up to the set range.
- Actual Contribution Percentage (ACP) Test – This test works identically to the ADP test but looks at the employer Matching contributions and/or voluntary Employee After-Tax contributions (not very common and not the same as Roth contributions). Failure of the test can result in refunds to HCEs to bring the plan within the allowed range or a Qualified Matching Contribution (QMAC) to NHCE employees that brings the percentage up to the set range. In the event that Employee After-Tax contributions are made to the plan, the ACP test must be passed, even if a Safe Harbor Plan design option is selected.
Safe Harbor Plan Design Options:
Plans can be designed to automatically satisfy the ADP and ACP testing requirements by becoming a Safe Harbor Plan. If the plan meets the Safe Harbor requirements, passing the ADP test is not required. Unless there are Employee After-Tax contributions, the ACP test is not required either. Below are the two safe harbor plan design options.
- Safe Harbor Non-Elective Design – This type of plan requires that all eligible participants receive 3% of compensation in an employer contribution, regardless of any deferral elections they make. One of the advantages of this type of plan is that an Annual Safe Harbor Notice is not required to be sent to employees (although it is recommended). In addition, this 3% contribution can be used towards meeting the Gateway Testing requirements in New Comparability Profit Sharing plans, effectively saving the sponsoring company money.
- Safe Harbor Match Design – This type of plan requires that NHCEs that defer to the plan (either on a Pre-Tax or Roth basis), receive a determined matching contribution. HCEs are eligible to receive the matching contribution as well, if elected. Known as the Basic Safe Harbor match, each participant receives 100% of participant’s salary deferrals that do not exceed 3% of compensation plus 50% of deferrals that exceeds 3% of participant’s compensation but that does not exceed 5% of the participant’s compensation. . A more generous version of this formula is considered an Enhanced Safe Harbor Match. An Annual Safe Harbor Notice must be sent to all employees who will be eligible for the plan 30 days before the plan year starts. One of the advantages of this plan is that employees are rewarded for personally contributing to the plan. If you have chosen a New Comparability profit sharing plan, please consult with your Analyst to ensure that you have chosen the best plan design for your needs, as the Safe Harbor Matching contribution does not count towards the Gateway test.
While this article strives to explain the basics of ADP and ACP testing and the Safe Harbor options that would allow a plan to be exempt from these tests, there are a lot of nuances that may affect your plan’s scenario. We recommend consulting with the Analyst assigned to your plan if you have any questions.
JP Perryman, QKA
Jeremiah “JP” Perryman, QKA is the Compliance and Operations Manager at Benefits² Administrators. He has more than 15 years of experience working with qualified retirement plans.