According to Internal Revenue Service (IRS) requirements, annual testing of 401(k) plans is mandatory. The goal of these tests is to promote fairness and prevent discrimination between highly compensated employees (HCE) and non-highly compensated employees (NHCE).
There are several types of 401(k) plan testing. Among these, ADP/ACP is the most common type. ADP and ACP stand for actual deferral percentage and actual contribution percentage, respectively. This test helps determine whether or not the plan is offering equitable benefits to all the participants. The objectives of different tests vary. While ADP/ACP ensures nondiscrimination and fairness, there are tests designed to make sure that the contribution limits set by the IRS are followed.
401(k) Plan Testing for Fairness
ADP/ACP tests help ensure that the 401(k) plan does not unfairly favor highly compensated employees. This group includes management staff, executives, and owners. These individuals, by virtue of their professional standing, are in a position to take unfair advantage of the plan. For instance, if a plan offers to match contributions only to those participants who pay large sums of money annually, it is unfair toward non-highly compensated employees.
In the ADP/ACP test, employees are first divided into two groups: highly compensated employees and non-highly compensated employees. The division is mainly based on the compensation of the workers. After this, the contribution percentages for both groups as a whole are examined. The allowable contribution for the highly compensated group depends on the average contribution percentage of the non-highly compensated group. The average contribution percentage of the higher income group should not exceed 1.25 times that of the lower income group.
Every plan needs to undergo various different types of tests. Because of the complexity involved in this process, the task is often outsourced. March 15 is the last date for companies to file for the ADP/ACP test. Steep penalties are levied upon companies that fail to meet this deadline and may even result in the disqualification of the 401(k) plan.
This article was updated on 6/12/2014 from the original post 5/22/2012.