The Actual Deferral Percentage/Actual Contribution Percentage test, or ADP/ACP test, is a set of non-discrimination evaluations required by the IRS for 401(k) plans. The intent is to ensure that any such plan does not unduly benefit company owners or employees that are highly compensated to the disadvantage of other employees.
For any 401(k) to continue as it stands it must pass the ADP/ACP tests as non-discriminatory. If the retirement plan fails any aspect of either test the employer is required to act to fix said problems within 12 months. If such corrective actions are not taken then the plan may be terminated.
The ADP test compares the percentage of pre-tax compensation between highly compensated and non-highly compensated employees. The difference between the ADP of the groups may not exceed 2 percentage points. The ACP test is similar but it compares matching contributions and/or after-tax contributions.
A way to avoid the test is to use a Safe Harbor 401(k) plan. Such retirement plans are clearly advantageous to highly compensated individuals. They offer 100% vesting immediately and required contributions. These contributions are typically higher than those made elsewhere. Additionally, they are not available for hardship withdrawals which are available through traditional 401(k) plans.
Best suited to companies that can’t satisfy the anti-discrimination tests, Safe Harbor 401(k) plans offer a retirement fund alternative. Management fees for running such funds are normal, and vary from plan to plan. If you are an HCE and your company does offer a Safe Harbor 401(k) plan instead of, or in addition to, a traditional retirement fund, carefully consider all aspects before jumping on board.