What Happens When You Fail ADP/ACP Testing?

As a retirement plan consultant, I spend a lot of time helping employers design and optimize their 401(k) and other qualified retirement plans. One topic that consistently comes up—and often catches companies by surprise—is what happens when a plan fails ADP/ACP testing.

If you sponsor a 401(k), you may not be familiar with these acronyms until your administration provider notifies you of a failed test. That’s why I want to break it down in simple terms: what ADP and ACP tests are, why they exist, what it means if you fail, and—most importantly—what steps you can take to prevent failure in the future.

What Are ADP and ACP Tests?

Every year, most 401(k) plans are required to undergo nondiscrimination testing. These tests exist because the IRS wants to ensure that retirement plans don’t disproportionately benefit only a company’s highly compensated employees (HCEs).

• ADP Test (Actual Deferral Percentage):
  This test compares the average deferral rates (employee contributions) of highly compensated employees versus non-highly compensated employees. For 2025, “highly compensated” generally means anyone earning more than $160,000. If the difference between the two groups exceeds a threshold (typically 2%), the plan fails. ‍
• ACP Test (Actual Contribution Percentage):
  This test looks at employer contributions—usually the company match. It ensures that matching contributions are being provided fairly to both HCEs and non-HCEs. Failures here are less common because most employers offer uniform matches, but errors or irregular contributions can still cause problems.

What Happens If You Fail?

When a plan fails testing, the IRS requires it to be corrected promptly. There are essentially two correction methods, and neither are painless:

1. Refunds to Highly Compensated Employees (HCEs):
   Excess contributions are returned to HCEs until the plan comes back into compliance. Unfortunately, this creates a taxable event for those employees and undermines the value of the plan. Imagine a key executive who contributed $20,000 to his or her 401(k), only to get a surprise refund check of $5,000—now taxable—because the plan failed testing. That’s not an attractive outcome for your top talent. ‍
2. Qualified Non-Elective Contributions (QNECs):
   Alternatively, the employer can make additional contributions to non-HCEs to raise their average contribution level. This brings the plan into balance without penalizing HCEs. The downside: QNECs cost the employer real dollars.

Either way, the company pays a price, through frustrated employees or unexpected expenses.

Why Failing Hurts Employers

From an employer’s perspective, failing ADP/ACP testing creates multiple headaches:

• Surprised Employees: Failures often come as a surprise, and HCEs are typically your most valued and productive leaders. Having to refund their contributions diminishes morale and makes your benefits package less competitive to the most attractive talent in the market. ‍
• Unexpected Costs: Paying QNECs can quickly become expensive, especially for larger workforces or those with low participation among non-HCEs.
• ‍Administrative Burden: Failures require corrective action, documentation, and reporting to maintain compliance.

The bottom line: failing ADP/ACP testing means you’re either disappointing your top employees or draining company resources, and neither is a good outcome.

How to Prevent Failures in the First Place

Fortunately, there are proactive strategies that employers can take to reduce or eliminate the risk of failing.

1. Adopt a Safe Harbor Plan

The simplest way to avoid testing failures altogether is to adopt what’s known as a Safe Harbor contribution formula. Plans that meet Safe Harbor requirements are automatically deemed to satisfy the ADP and ACP tests.

Common Safe Harbor formulas include:

• Basic Safe Harbor Match: 100% on the first 3% of deferrals, plus 50% on the next 2%. ‍
• Enhanced Matches: 100% on the first 4% of deferrals (minimum), 100% on the first 5% of deferrals, or 100% on the first 6% of deferrals.
• ‍Non-Elective Contribution: 3% of pay given to all eligible employees, whether they contribute or not. ‍
• QACA Safe Harbor (Qualified Automatic Contribution Arrangement): This requires automatic enrollment of employees at 3% deferral, paired with a 100% match on the first 1%, plus 50% on the next 5% (for a total of 3.5%). Additionally, the plan must include automatic escalation of at least 1% each year, up to a minimum of a 6% deferral. QACA plans are subject to a two-year cliff vesting schedule, unlike other Safe Harbor contributions, which are immediately vested.

By implementing a Safe Harbor design, you essentially get a proverbial “get out of jail free card” from ADP/ACP testing failures.

2. Encourage Participation Among Non-HCEs

If Safe Harbor isn’t feasible, raising participation and deferrals among non-HCEs can help balance contribution rates:

• Stretch Match: Instead of 100% on the first 4%, consider 50% on the first 8%. This incentivizes employees to defer more, lifting the overall average. ‍
• Automatic Enrollment & Auto-Escalation: These features typically drive 80 to 90% participation, particularly among non-HCEs. ‍
• Tailored Eligibility: Align eligibility periods with turnover patterns to avoid counting employees unlikely to stay long enough to contribute. ‍
• Exclude Certain Groups: With legal guidance, some seasonal or part-time employees can be excluded from testing, reducing risk.

3. Invest in Education

Sometimes, the biggest barrier to employee participation is simply that employees don’t understand the benefit of contributing to the plan. Good employee education, often by your plan’s independent consultant, can boost participation and improve financial wellness, which in turn reduces the likelihood of testing failures.

Key Takeaways and Final Thoughts

To summarize:

• ADP/ACP testing is required each year to ensure fairness in 401(k) plans.
• Failure is an unwelcome surprise, leading to either refunds (bad for HCEs) or QNECs (costly for employers).
• The best prevention is adopting a Safe Harbor contribution strategy, which bypasses testing altogether.
• If Safe Harbor isn’t an option, creative plan design and employee engagement strategies can help.

ADP/ACP test failures aren’t just a compliance issue, they’re a business problem. They affect your top employees, your bottom line, and the perceived value of your retirement plan. The best approach is to be proactive: review your plan design, evaluate your workforce demographics, and consider Safe Harbor or other participation-boosting strategies before testing season rolls around.

As a retirement plan consultant, my role is to help you navigate these complexities, educate your employees, and design a plan that’s compliant, competitive, and cost-effective.  

If you’d like to explore solutions—or if you’ve recently failed a test and need help addressing it—let’s talk.