Regulation 1.401(k)-3: The 401(k) ADP Test Rules

Treasury Regulation 1.401(k)-3 provides the rules for the Actual Deferral Percentage (ADP) test, a compliance requirement for 401(k) plans. This regulation ensures that retirement plans do not unfairly benefit high earners over the broader employee population. The test compares the contribution rates of two employee groups to verify the disparity between them remains within federally mandated limits. If a plan favors the company’s highest earners, the employer must take corrective actions to bring the plan into compliance and maintain its tax-qualified status.

Key Definitions for ADP Testing

The ADP test distinguishes between two classes of employees: Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). An HCE is defined by the Internal Revenue Service (IRS) based on ownership or compensation. An employee is an HCE if they owned more than 5% of the business during the current or preceding year. For 2025, an employee is also an HCE if they received more than $155,000 in compensation during 2024. All other eligible employees are classified as NHCEs.

The contributions subject to the test are elective deferrals, which are the funds employees choose to have withheld from their paychecks for their 401(k) accounts. This includes both traditional pre-tax and Roth contributions.

In some situations, employers can include specific employer contributions in the test to help achieve a passing result. These are known as Qualified Matching Contributions (QMACs) and Qualified Nonelective Contributions (QNECs). A QMAC is an employer match tied to an employee’s deferrals, while a QNEC is an employer contribution made for all eligible employees, regardless of whether they contribute. To be considered “qualified,” these contributions must be 100% vested immediately.

The ADP Test Calculation

The test begins by determining an Actual Deferral Ratio (ADR) for every employee eligible to participate in the 401(k) plan. An individual’s ratio is calculated by dividing their total elective deferrals for the year by their total compensation for that year. If the employer uses QMACs or QNECs, those amounts are added to the employee’s elective deferrals in the formula.

Once an ADR is established for each employee, they are separated into the HCE and NHCE groups. The individual ADRs within each group are then averaged to produce one ADP for the HCE group and one for the NHCE group. These two figures are compared against IRS nondiscrimination limits.

A plan passes the ADP test if it satisfies one of two conditions. The first is met if the HCE group’s ADP is no more than 125% of the NHCE group’s ADP; if the NHCE ADP is 4%, the HCE ADP cannot exceed 5%. The second test allows the HCE ADP to be no more than two percentage points higher than the NHCE ADP, and no more than double the NHCE ADP. For instance, if the NHCE ADP is 2%, the HCE ADP can be up to 4%.

Plan sponsors can elect to use the current plan year’s data or the prior plan year’s data for the NHCE group’s ADP. Using prior-year data provides predictability, as the NHCE ADP is known at the beginning of the year. Using current-year testing offers more flexibility but introduces uncertainty, as the passing threshold is not known until after the year ends.

Correcting a Failed ADP Test

Failing the ADP test requires the employer to take corrective action. The most common method is making corrective distributions to HCEs. This involves calculating the total “excess contributions” from the HCE group and refunding that amount to the individual HCEs, starting with those who deferred the highest dollar amounts. To avoid a 10% employer excise tax, these distributions must be completed within 2.5 months following the end of the plan year. The refunded amounts are taxable income to the HCEs in the year they are received.

Another correction method is for the employer to make additional contributions to the NHCEs. The employer can contribute a QNEC to all eligible NHCEs, which raises the NHCE group’s ADP. The amount of the QNEC must be sufficient to raise the NHCE ADP to a point where the HCE ADP passes the test.

A third correction method is recharacterization, which involves reclassifying HCEs’ pre-tax elective deferrals as after-tax employee contributions. While this lowers the HCE ADP, it subjects the recharacterized amounts to the separate Actual Contribution Percentage (ACP) test. This method is only viable if the plan allows for after-tax contributions and can pass the subsequent ACP test.

Safe Harbor Plan Design as an Alternative

Employers can adopt a Safe Harbor 401(k) plan design to be automatically deemed to satisfy the ADP test. This provides certainty and eliminates the need for year-end testing and potential corrections.

To qualify for Safe Harbor status, an employer must make specific, mandatory employer contributions that are 100% immediately vested. One option is a nonelective contribution, where the employer contributes at least 3% of compensation to all eligible employees, regardless of whether they defer their own money.

Another Safe Harbor option is an employer match. The basic matching formula requires the employer to match 100% of employee deferrals up to the first 3% of their compensation, and 50% on the next 2% of their compensation. These contributions are only made to employees who actively contribute to the plan.

Adopting a Safe Harbor plan design comes with communication duties. Employers must provide an annual notice to all eligible employees 30 to 90 days before the start of each plan year. This notice must detail the Safe Harbor contribution formula, explain employee rights and obligations, and provide information on how to make or change deferral elections.