What Is the Actual Contribution Percentage (ACP) Test?

The Actual Contribution Percentage (ACP) Test is a nondiscrimination test required for certain employer-sponsored retirement plans, particularly 401(k) plans that offer employer matching contributions or after-tax employee contributions. The ACP Test ensures that highly compensated employees (HCEs) do not receive disproportionately higher employer contributions compared to non-highly compensated employees (NHCEs). This requirement is part of the Internal Revenue Code (IRC) regulations established by the Employee Retirement Income Security Act (ERISA) to maintain fairness and prevent retirement plans from favoring business owners, executives, or other high earners.

How the ACP Test Works

The ACP Test calculates the percentage of compensation contributed to the plan by both HCEs and NHCEs in the form of employer matching contributions and after-tax employee contributions. The calculation follows a structured formula:

1. Determine the Contribution Rate for Each Eligible Employee:

• This includes employer matching contributions and voluntary after-tax employee contributions.
• Pre-tax and Roth 401(k) deferrals are not included in the ACP Test; they are instead subject to the Actual Deferral Percentage (ADP) Test.

2. Calculate the Average Contribution Percentage for Each Employee Group:

• The total contributions for all HCEs are averaged to determine the HCE ACP.
• The total contributions for all NHCEs are averaged to determine the NHCE ACP.

3. Compare the Two Averages Using the Allowable Limits:

• The ACP of HCEs cannot exceed 125% of the NHCE ACP.
• Alternatively, if the NHCE ACP is at least 2%, the HCE ACP must not exceed 200% of the NHCE ACP.
• If the NHCE ACP is below 2%, the HCE ACP cannot exceed NHCE ACP by more than 2 percentage points.

Consequences of Failing the ACP Test

If a plan fails the ACP Test, the employer must take corrective action to avoid penalties and maintain the plan’s tax-qualified status. Common remedies include:

• Corrective Distributions: The employer refunds excess matching or after-tax contributions to HCEs to bring the plan into compliance. This must be done within 2½ months after the plan year ends to avoid an excise tax. If corrections are made after that deadline, a 10% penalty applies to the excess contributions.
• Qualified Nonelective Contributions (QNECs) or Qualified Matching Contributions (QMACs): Employers can contribute additional funds to NHCEs to increase their ACP and bring the plan into compliance. These contributions must be 100% vested immediately to qualify.
• Recharacterization: If applicable, after-tax contributions can be reclassified as pre-tax contributions to comply with ADP/ACP testing.

ACP Test vs. ADP Test

The ACP Test is often mentioned alongside the Actual Deferral Percentage (ADP) Test, which measures pre-tax and Roth 401(k) employee deferrals. While both tests serve similar purposes in preventing discrimination, they focus on different types of contributions:

• ADP Test: Examines the deferral rates of HCEs and NHCEs based on pre-tax and Roth 401(k) contributions.
• ACP Test: Focuses on employer matching contributions and after-tax employee contributions.

A plan must pass both tests independently to remain compliant. Failing either test can result in the need for corrective actions to avoid potential penalties and tax consequences.

Safe Harbor Plans and ACP Testing

Employers looking to bypass ACP testing altogether can opt for a Safe Harbor 401(k) plan. A Safe Harbor plan automatically satisfies the ACP Test requirements by providing mandatory employer contributions that are fully vested. There are two common types of Safe Harbor contributions:

1. Safe Harbor Matching Contributions: The employer provides a matching contribution of at least 100% of the first 3% of compensation deferred, plus 50% of the next 2% of compensation deferred (totaling up to 4%).
2. Safe Harbor Nonelective Contributions: The employer contributes at least 3% of each eligible employee’s compensation, regardless of whether the employee defers any salary into the plan.

By adopting a Safe Harbor 401(k), an employer eliminates the need for ACP testing, ensuring automatic compliance and reducing administrative burdens. However, this approach also increases employer costs due to mandatory contributions.

Why the ACP Test Matters

Compliance with the ACP Test is crucial for ensuring fairness in retirement plan benefits. Without this test, companies could disproportionately allocate employer contributions to executives and business owners while providing minimal benefits to lower-paid employees. The ACP Test promotes retirement savings accessibility for all employees by requiring a more balanced distribution of employer contributions.

Additionally, failing the ACP Test can result in plan disqualification if corrective measures are not taken promptly. A disqualified plan loses its tax-advantaged status, leading to adverse tax consequences for both the employer and employees. Regular testing, along with proactive plan design strategies like Safe Harbor provisions, can help employers avoid compliance issues while maintaining a robust and equitable retirement plan.

The Bottom Line

The Actual Contribution Percentage (ACP) Test ensures that employer matching contributions and after-tax contributions in a 401(k) plan are equitably distributed between highly compensated and non-highly compensated employees. If a plan fails the test, the employer must take corrective actions to maintain compliance and avoid penalties. Employers can mitigate ACP Test risks by offering Safe Harbor contributions or implementing other strategies to balance contribution rates. Proper plan administration and periodic compliance checks are essential to keeping a retirement plan in good standing with IRS regulations.