Avoiding ADP, ACP, and Top-Heavy Rule Penalties
401(k) plans run mostly seamlessly in the background. But with each business offering a unique employment structure, failing the IRS' required annual testing is a high risk.
Every year, the IRS requires most plans to pass a series of compliance tests confirming fairness between highly paid employees (HCEs) and the balance of the workforce. If your plan fails, you may need to return contributions, make unexpected employer contributions, or even risk penalties.
These tests—ADP, ACP, and the top-heavy test—ensure that a 401(k) plan doesn't disproportionately benefit business owners and key executives. This guide explains how each test works and provides clear, real-world examples to help you stay compliant.
Why 401(k) Plans Must Be Tested
IRS regulations require annual testing to prevent companies from structuring their 401(k) plans in a way that favors highly compensated employees. Without these rules, high earners could max out their contributions while lower-paid employees contribute little or nothing.
Who is considered a highly compensated employee (HCE)?
- Earned $150,000 or more in the previous year (for 2024).
- Owns more than 5% of the company, regardless of salary.
Everyone else is classified as a non-highly compensated employee (NHCE).
Let's break down the three key compliance tests:
1. The ADP Test (Actual Deferral Percentage)
What it measures: The ADP test ensures that HCEs aren't contributing significantly more of their salary to the plan than NHCEs. It looks at employee salary deferral contributions (traditional and Roth) and compares the average percentages for both groups.
How it works:
- Calculate the average deferral percentage for NHCEs.
- Apply IRS limits to determine how much HCEs can contribute.
| NHCE Average Deferral |
Maximum HCE Deferral |
| 0% - 2% |
2x the NHCE rate |
| 2% - 8% |
NHCE rate + 2% |
| 8%+ |
1.25x the NHCE rate |
Example:
- NHCEs contribute an average of 4% of their salaries.
- HCEs can contribute up to 6% (NHCE rate + 2%).
- If HCEs contribute more than 6%, the plan fails the ADP test.
Fixing a failed ADP test:
- Refund excess contributions to HCEs.
- Make additional employer contributions to NHCEs to balance the ratio.
2. The ACP Test (Actual Contribution Percentage)
What it measures: The ACP test is similar to the ADP test, but instead of employee contributions, it examines employer matching and after-tax contributions to ensure they aren't disproportionately benefiting HCEs.
How it works:
- Calculate the average employer contributions received by NHCEs.
- Apply the same limits as the ADP test to determine how much HCEs can receive.
Example:
- NHCEs receive an average match of 3%.
- HCEs can receive up to 5% (NHCE rate + 2%).
- If HCEs receive more than 5%, the plan fails the ACP test.
Fixing a failed ACP test:
- Reduce excess employer contributions to HCEs.
- Increase employer contributions to NHCEs.
3. The Top-Heavy Test
What it measures: The top-heavy test checks if key employees hold more than 60% of total plan assets (including business owners and executives). If a plan is top-heavy, lower-paid employees must receive mandatory contributions to balance the plan.
How it works:
- Add up the total account balances for key employees.
- Compare that amount to the total plan assets.
- If key employees hold more than 60%, the plan is top-heavy.
Example:
- Total plan assets: $1 million
- Key employees' total balances: $650,000 (65%)
- Since key employees hold more than 60%, the plan fails the top-heavy test.
Fixing a top-heavy plan:
- Make a mandatory 3% employer contribution to all NHCEs.
- Adjust plan design to prevent top-heavy imbalances in the future.
How to Prevent Testing Failures
- Work with a Third Party Administrator (TPA). TPAs utilize software to track and test 401(k) plans for employers, removing risk and extra work.
- Adopt a safe harbor 401(k) plan. Safe harbor plans automatically pass ADP and ACP testing by requiring minimum employer contributions that are fully vested.
- Encourage NHCE participation. Use auto-enrollment and financial education to boost contributions among lower-paid employees.
- Monitor contributions mid-year. Running mid-year compliance checks can help catch potential failures before they become a problem.
- Review your matching formula. Employer matches that disproportionately favor HCEs can trigger ACP failures.
The Bottom Line
401(k) testing ensures that all employees have fair access to retirement benefits, but failing these tests can lead to unexpected refunds, additional employer costs, and compliance headaches. The good news is that employers can avoid testing failures with proactive plan design and TPA monitoring.
If your plan struggles with compliance, talk to a retirement plan advisor about safe harbor options or strategies to encourage broader employee participation.
