Actual Deferral Percentage - 401(k) Retirement Glossary & Terminologies

ADP Test (Actual Deferral Percentage) is a test conducted to see whether the elective deferrals made by highly compensated employees of an organization are so large that they discriminate against those elective deferrals made by non highly compensated employees such as front line workers, low level managers, analysts/clerks, etc. Under the ADP test, a percentage of elective deferrals is calculated and compared on an annual basis. To determine the actual deferral percentage, we divide the total compensation from elective deferrals (contributions) made on a pre-tax basis. The formula is outlined below:

Actual Deferral Percentage = Elective deferrals (contributions) / total compensation in 1 year

The deferral percentages of highly compensated employees (HCEs) and non highly compensated employees (NHCEs) are then computed together to determine the ADP of each group. To pass IRS rules, the ADP of HCEs may not exceed the ADP of NHCEs by 1.25% to 2%. If the ADP of highly compensated employees exceeds 2%, then corrective action must be taken to protect the qualified status of the 401(k) plan. Usually the IRS grants a 12 month "corrective period" in which the ADP must be brought in line with regulations, otherwise the plan is considered 'disqualified.'

If the 401(k) plan fails the ADP test, some of the corrective steps that can be taken include the following:

i) Refunding contributions made by highly compensated employees back to them.

ii) Recharacterizing salary deferral contributions as after-tax contributions.

iii) Contributing additional amounts for non-highly compensated employees.