The Importance of Discretionary Testing: ACP and ADP
If you’re a business owner who is interested in offering retirement benefits like a 401k, you may have heard of the words nondiscrimination or discretionary testing.
These tests were designed to ensure fairness when it comes to employer contributions. U.S. Congress established these tests in order to make sure that retirement benefits did not only benefit high earners or core employees, and that everyone was able to get a fair percentage of employer contributions. Discretionary testing ensures that business owners and other business stakeholders are not able to take advantage of the system by putting in large and disproportionate amounts of money into their retirement plans.
Typically, discretionary testing involves reviewing the average benefits provided to two groups of employees – highly compensated employees and key employees. Before we proceed to the kinds of compliance tests that businesses may be subjected to, we’ll first go into the differences between highly compensated employees and key employees.
What Kinds of Employees Are Being Reviewed for Compliance?
As mentioned above, there are two kinds of employees that will be looked at for compliance testing. So what exactly makes an employee highly compensated or key?
Highly Compensated Employee (HCE)
According to the IRS, an employee can be considered highly compensated if they have achieved any of the following within the business:
- Owns 5% or more of the business during the year or the preceding year.
- Received compensation of more than $130,000 in 2021 or more than $135,000 in 2022 or was in the top 20% of employees when ranked by compensation.
It’s important to know who the HCEs are because the contributions that they are able to make are dependent on the participation of the non-HCEs to the plan.
Key employees are those with major decision-making roles within a business. Some of them own huge shares in the business, are very highly compensated or have excellent benefits and incentives.
Based on IRS guidelines, key employees are considered as such if or when they meet the following criteria:
- They are officers of the company with gross compensation of more than $180,000
- Employees of the company in the current year who:
- Own 5% or more of the company in the current or previous year.
- Own 1% or more of the company with an annual pay of more than $150,000.
Key employers are typically well-compensated or have better-than-average benefits, so it’s important to identify and test the benefits of these workers to ensure fairness across the board.
What Is Discretionary Testing and Why Is It Important?
These tests check to make sure that the retirement plans you offer do not disproportionately benefit HCEs and key employees and that no IRS contribution limits are exceeded.
These tests are typically conducted by a Third Party Administrator (TPA), a hired organization that’s typically involved in running and processing the day-to-day administration of your company’s retirement plans. TPAs make it easier for you to stay on top of your plans and ensure that your plans are tested ahead of the deadline so that any necessary corrections can be made in order to avoid penalties and potential plan disqualification.
However, as a business owner, knowing the basics of 401k plans and compliance will help you keep track of your TPA and stay up to date on IRS regulations.
Now, going back to testing. In this post, we’ll be discussing 2 important tests that will help you check against disproportionate contributions made in favor of HCEs and key employees – Actual Contribution Percentage (ACP) Test and Actual Deferral Percentage (ADP) Test.
Actual Contribution Percentage (ACP) Test
The Actual Contribution Percentage (ACP) Test works to ensure that the percentage of the highly compensated employee’s (HCEs) contribution matches against that of the non-highly compensated employee’s (NHCEs). What happens is that each participant’s ACP is calculated by dividing the total amount of employer-matching contributions received during the year by their compensation for the year.
Actual Deferral Percentage (ADP) Test
On the other hand, the Actual Deferral Percentage (ADP) Test looks at the average deferral (or the money that’s been deducted from an employee’s salary) percentage of HCEs and compares it to those of the NHCEs. Comparable to the ACP test, the ADP will calculate the total deferrals for the year and divide this by the compensation for the same year.
Both tests look to compare the percentage of contributions/deferrals made by each employee and compares the percentage of contribution/deferral to the compensation. This works to make sure that no one has a disproportionate amount of employer contributions to their retirement plans.
After all, what these tests are trying to protect against are stakeholders who may be gaming the system to reduce their taxes through retirement plans or contributing more to their own retirement plans to get more benefits.
Where Does Peppermint Come In?
Peppermint is a pooled plan provider (PPP) that helps businesses of all industries and sizes offer 401ks to their employees through a pooled employer plan (PEP). Pooled employer plans pool resources from multiple employers or businesses, removing the need for individual businesses to put forward the large investment needed to open a traditional 401k.
PEPs are basically 401k plans with less risk, less upfront investment, and less administrative work because the PPP shoulders the risk and admin work for you.
Here at peppermint, we have several retirement plan options that you can choose from depending on your financial capability and contribution preferences. We have plans that are considered safe harbor, which means that you don’t have to go through any compliance or discretionary testing, and we also have plans that are non-safe harbor, which gives you more flexibility on the contributions you make but is subject to testing.
The beauty of selecting any plan with peppermint is that, as your PPP, we are the ones responsible for making sure that your plan is doing well based on the funds that you have selected. The responsibility of filing forms and documents, engaging participants (your employees,) notifying employees, and other administration and compliance requirements are handled by us.
This goes for plans that need to undergo ACP and/or ADP discretionary testing. If you choose to jump onboard the peppermint family under a non-safe harbor plan, we as your PPP will also handle the contribution calculations and compliance testing needed in order to make sure that your retirement plan stays compliant within IRS regulations.
With peppermint, you will worry less about managing and maintaining your retirement plans and spend more time on things that matter most: like growing your business.
If you’re interested in opening a plan with us or want to learn more about PEPs, simply fill out this form or email us at email@example.com and one of our retirement plan specialists will reach out to you as soon as possible.