Actual Deferred Percentage (ADP)
Understanding Actual Deferral Percentage (ADP) in 401(k) Plans
Actual Deferral Percentage (ADP):
Actual deferral percentage (ADP) signifies the percentage of wages that employees defer under a 401(k) retirement plan. This metric is pivotal in ensuring compliance with IRS and ERISA regulations, preventing discrimination in favor of higher-earning employees.
401(k) Deferral Rate:
The 401(k) deferral rate is the portion of an employee’s wages contributed to their 401(k) plan. Determined by the employer, the average deferral rate in 2018 was 8.6%, marking an all-time high.
Actual Deferral Percentage Test:
The ADP test evaluates employer 401(k) contributions to ensure fairness. It checks if actual deferral percentages for both highly compensated employees (HCEs) and nonhighly compensated employees (NHCEs) align with IRS requirements. The Actual Contribution Percentage (ACP) test, which considers matching and after-tax contributions, is another relevant nondiscrimination test.
Key Considerations in Test Evaluation:
- HCE Definition: Employees owning 5% or more of the company or earning over a specified threshold may qualify as HCEs.
- Top-Heavy Test: Examines plan benefits for key employees in relation to overall assets in the 401(k) plan.
Benefits Evaluated in Tests:
- Coverage: Assesses participation ratios of NHCEs to HCEs.
- Contributions: Measures matching and nonelective contributions to employees’ 401(k).
- Accumulated Assets: Examined in the Top-Heavy test to prevent disproportionate asset accumulation.
Calculation of Actual Deferral Percentage:
To pass the ADP test, eligible HCE contributions must be less than either 125% of NHCEs’ ADP or the lesser of 200% of NHCEs’ ADP or NHCEs’ ADP plus 2%.
Addressing Test Failures:
- Identify Mistakes: Conduct an independent review to identify misclassifications of NHCEs and HCEs.
- Correct Mistakes: Make qualified nonelective contributions for NHCEs.
- Prevent Future Mistakes: Implement measures like 401(k) automatic enrollment or consider a safe harbor 401(k) plan.
Corrective Distribution 401(k):
A corrective distribution occurs when HCEs’ contributions must be reduced to align with the required 125% of NHCEs’ savings. This ensures fairness and compliance with regulations.
Understanding and navigating ADP tests are crucial for maintaining fairness and compliance in 401(k) plans, promoting equal participation and contributions among employees.