An HR Glossary for HR Terms

Glossary of Human Resources Management and Employee Benefit Terms

Actual Deferred Percentage (ADP)

What is Actual Deferred Percentage (ADP)?

Actual deferral percentage (ADP) is the percentage of wages deferred by employees under a 401(k) retirement plan.

An employer’s ADP helps to ensure that employee 401(k) benefits are compliant with IRS and ERISA rules that require such plans to be non-discriminatory against lower-paid employees or in favor of higher-earning employees.

The IRS states that traditional 401(k) plans must “ensure that the contributions made by and for rank-and-file employees (nonhighly compensated employees (NHCEs)) are proportional to contributions made for owners and managers (highly compensated employees (HCEs)).”

What Is the 401(k) Deferral Rate?

The 401(k) deferral rate is the portion of an employee’s wages deducted from their paycheck that is contributed toward the employee’s 401(k) plan through their employer.

The deferral rate is determined by the employer and applied to all plan participants. In 2018, the average deferral rate was 8.6% (an all-time high).

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What Is the Actual Deferral Percentage Test?

The Actual Deferral Percentage (ADP) test is a way to ensure employer 401(k) contributions are proportional and fair for all employees. Through this test, an employer can know if they meet the required actual deferral percentage of both nonhighly and highly compensated employees as stated by the IRS.

Another nondiscrimination test for 401(k) plans is the Actual Contribution Percentage (ACP) test, which takes into account matching employer contributions and after-tax employee contributions.

For the purposes of the ADP and ACP tests, an HCE is considered to be an employee who:

Generally, companies must also pass one more test, the Top-Heavy test. This focuses on “key employees” rather than just highly compensated employees.

For the purposes of the Top-Heavy test, an employee is considered “key” if they:

All three of these tests compare plan benefits among the nonhighly and highly compensated employees.

The three benefits measured by these tests are:

  1. Coverage: This measures the plan participation ratio of eligible NHCEs to HCEs. Lack of participation among NHCEs is a sign that there isn’t knowledge about, or a perceived value in contributing to, the company’s 401(k) plan.
  2. Contributions: This measures matching company contributions (based on employee income deferment) and nonelective contributions (made regardless of employee income deferment) to an employee’s 401(k).
  3. Accumulated Assets: This is measured through the Top-Heavy test, which checks that the value of key employees’ assets does not equal more than 60% of all the asset value held in the employer’s 401(k) plan.

How Do You Calculate Actual Deferral Percentage?

According to the IRS, a 401(k) plan must be considered nondiscriminatory by receiving a passing grade on the ADP test.

As your HR department calculates actual deferral percentage, be aware that the eligible HCEs’ contributions must be less than either:

What Happens If a 401(k) Plan Fails to Pass the Nondiscrimination Tests?

If a 401(k) plan fails to pass the nondiscrimination tests, there are three things to do:

  1. Find the mistake by conducting an independent review to determine correct classification of NHCEs and HCEs.
  2. Fix the mistake by making qualified nonelective contributions for NHCEs.
  3. Avoid making the same mistake in the future by using 401(k) automatic enrollment or by considering a safe harbor 401(k) plan.

What Is a Corrective Distribution 401(k)?

A corrective distribution 401(k) is a way the IRS ensures that NHCEs are benefited in a fair manner. Corrective distributions happen when an employer must give back part of the HCEs’ contributions in order to bring their savings down to within the required 125% of NHCEs’ savings.