What Is the Actual Deferral Percentage (ADP) Test?

The Actual Deferral Percentage (ADP) Test is a nondiscrimination test required by the Internal Revenue Service (IRS) to ensure that 401(k) plans do not disproportionately benefit highly compensated employees (HCEs) at the expense of non-highly compensated employees (NHCEs). This test is one of several compliance measures applied to employer-sponsored retirement plans under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC).

Purpose and Importance

The ADP Test serves as a regulatory safeguard, ensuring that all employees within a company have a fair opportunity to participate in a 401(k) plan. Without such a test, companies could potentially structure their retirement plans in a way that allows executives and other high earners to contribute significantly more while offering minimal benefits to lower-paid employees. The test levels the playing field by comparing the elective deferrals — both pre-tax and Roth contributions — of HCEs and NHCEs, preventing discrimination in favor of top earners.

401(k) plans that fail this test may face penalties, required corrective actions, or even disqualification if the issues are not properly addressed. Consequently, employers must closely monitor their plan’s contribution levels and consider strategies to maintain compliance.

How the ADP Test Works

The ADP Test calculates the average deferral rates for HCEs and NHCEs and then compares them. The actual deferral percentage (ADP) for each employee is determined by dividing their elective deferrals by their total compensation. Once calculated, the ADP for HCEs and NHCEs is averaged within each group. The IRS has set limits on how much higher the HCE average can be compared to the NHCE average:

• If the NHCE average deferral percentage is 0% to 2%, the HCE average can be no more than 2 times the NHCE average.
• If the NHCE average is greater than 2% but less than 8%, the HCE average cannot exceed the NHCE average by more than 2 percentage points.
• If the NHCE average is 8% or higher, the HCE average is limited to 1.25 times the NHCE average.

For example, if NHCEs have an average deferral rate of 4%, the maximum allowable ADP for HCEs would be 6%. If HCEs contribute at a higher rate, the plan fails the test and must take corrective action.

Highly Compensated vs. Non-Highly Compensated Employees

For ADP testing purposes, the IRS defines Highly Compensated Employees (HCEs) as individuals who meet one of the following criteria:

• Earned more than a specific compensation threshold in the previous plan year (e.g., $150,000 for 2023, subject to annual adjustments for inflation).
• Own more than 5% of the business at any time during the current or prior year, regardless of compensation.

Any employee who does not meet these criteria is classified as a Non-Highly Compensated Employee (NHCE).

Corrective Measures for a Failed ADP Test

If a 401(k) plan fails the ADP Test, the employer must take corrective action to bring the plan into compliance. There are a few methods to do this:

1. Refunding Excess Contributions – One of the most common solutions is returning excess contributions to HCEs. This process, known as "corrective distributions," must be completed within 2 ½ months after the end of the plan year to avoid IRS penalties. If done later, a 10% excise tax applies.
2. Making Additional Contributions to NHCEs – Employers can make qualified non-elective contributions (QNECs) or qualified matching contributions (QMACs) to NHCEs to raise their deferral percentage, balancing out the discrepancy.
3. Recharacterizing Excess Contributions – Some plans allow excess contributions to be reclassified as after-tax contributions rather than pre-tax deferrals, which helps meet compliance standards.
4. Adopting a Safe Harbor Plan – To avoid ADP testing altogether, some employers choose to implement a Safe Harbor 401(k) plan. Safe Harbor plans require the employer to make either matching or non-elective contributions for employees, ensuring automatic compliance with nondiscrimination rules.

Implications for Employers and Employees

For employers, failing the ADP Test can result in administrative burdens, added costs, and potential penalties if corrective measures are not taken in a timely manner. Employers may also risk plan disqualification if repeated violations occur without correction. Proactively managing contribution levels and encouraging broad employee participation can reduce the risk of failure.

For employees, particularly HCEs, ADP failures can be frustrating if they result in refunded contributions. Since refunded amounts are subject to immediate taxation, HCEs may have to seek alternative investment options for retirement savings. On the other hand, NHCEs may benefit from additional employer contributions if corrective actions involve increased employer-funded contributions.

The Bottom Line

The Actual Deferral Percentage (ADP) Test plays a critical role in ensuring 401(k) plans do not favor highly compensated employees over their lower-paid colleagues. Employers must calculate and compare average deferral rates annually to maintain compliance. If a plan fails, corrective measures such as refunds, employer contributions, or plan adjustments must be implemented promptly. Employers seeking to avoid the complexities of ADP testing may consider adopting Safe Harbor 401(k) plans, which guarantee compliance by requiring employer contributions. Maintaining compliance is essential for keeping a retirement plan in good standing and providing equitable benefits to all employees.