What is Actual Deferred Percentage (ADP)?
Actual Deferred Percentage (ADP) is the average percentage of an employee’s compensation that is deferred into a retirement savings plan, such as a 401(k), within a specific group of employees during a plan year.
This calculation is used to ensure compliance with non-discrimination testing regulations set by the IRS, which aim to confirm that highly compensated employees (HCEs) are not disproportionately benefiting from the plan compared to non-highly compensated employees (NHCEs).
How to Calculate Actual Deferred Percentage (ADP)
Identify the Relevant Employee Groups
Start by dividing employees into two categories: highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). The classification is based on IRS criteria, such as income thresholds or ownership stakes. This separation is essential for accurate calculation and compliance testing.
Determine the Deferral Amount for Each Employee
For every employee, calculate the total amount deferred into the retirement plan during the plan year. This includes pre-tax contributions and any Roth contributions if applicable. Ensure the deferral figures are precise, as inaccuracies can impact the results.
Calculate Compensation
Next, determine each employee’s total compensation for the year. This figure should include all forms of income considered eligible by the plan document, such as wages, bonuses, and commissions. Double-check that the compensation aligns with the rules specified in the retirement plan.
Compute the Deferral Percentage for Each Employee
Divide the employee’s deferred amount by their total compensation. This will give you the individual deferral percentage. For example, if an employee earning $50,000 defers $5,000, their deferral percentage is 10%. Perform this step for every participant in the plan.
Find the Average Deferral Percentage for Each Group
Once you have the deferral percentages for all employees, calculate the average for the HCE and NHCE groups separately. Add the individual percentages within a group, then divide by the number of participants in that group. For example, if three NHCEs have deferral percentages of 5%, 7%, and 10%, the average for the NHCE group would be (5+7+10)Ă·3=7.33%
Verify Compliance with IRS Rules
Compare the average deferral percentage of HCEs with that of NHCEs to ensure compliance. The IRS imposes limits to prevent discrimination, often referred to as the ADP test. Generally, the average deferral percentage of HCEs cannot exceed NHCEs’ average by more than two percentage points or 1.25 times, depending on the plan’s specific rules.
Address Failures if Necessary
If the ADP test is not passed, corrective actions may be needed. Options include refunding excess contributions to HCEs or increasing contributions for NHCEs. Addressing failures promptly helps maintain the plan’s qualified status.