Actual Deferred Percentage (ADP) | Meaning and Definition

What is Actual Deferred Percentage (ADP)?

Actual-deferred-percentage, or ADP for short, is a method of testing the terms of 401k in an employee’s contract. This test ensures that the highly paid employees are not getting any unfair advantages at the cost of lower-paid employees. As such, it is a very important part of the employment. 

A 401k is a plan created to provide retirement and investment benefits to employees. While not all companies provide this benefit to the employees, those need to undertake the ADP test. The ADP test of an employer is an Internal Revenue Service’s requirement. Every employer must comply with the rules and those of ERISA (Employee Retirement Income Security Act, 1974).

As per the Internal Revenue Service rules, employers must make proportional contributions toward the 401k benefits of NHCEs (non-highly compensated employees) to those made towards the 401k benefits of the HCEs (highly compensated employees).

What happens in the ADP Test?

In the ADP test, the average HCE payments and average NHCE payments are compared. The payments taken into account are both pre-tax as well as after-tax payments. For a company to successfully pass the ADP test, they need to ensure two things: –

The 401k contributions for the Highly compensated employees should not be over two percentage points higher than the contributions made towards the 401k plan of the non-highly compensated employees.

The total amount of contributions for the highly compensated employees should not be more than double the number of contributions for the non-highly compensated employees.

If a discrepancy is found, the employers need to find the issue and figure out what the correct balance of contributions must be, correct the affected 401k plans by making necessary changes, and avoid incurring the same mistake in the future to avoid trouble with the IRS.