Employees can use this article to understand what actual deferral percentage (ADP) and actual contribution percentage (ACP) testing mean for your 401(k) and what may happen if your employer’s plan does not pass.
Because the IRS gives 401(k) plans tax-favored status, it requires that plans be fair to all employees. ADP and ACP tests help make sure a plan does not overly favor owners and other highly compensated employees (HCEs) over rank-and-file employees.
The ADP test determines whether HCEs are contributing too much through salary deductions compared to non-highly compensated employees (NHCEs).
The ACP test determines whether employer matching contributions favor HCEs too heavily compared to NHCEs.
If your employer’s plan does not pass these tests, it may affect your account. What happens next depends on whether you are classified as an HCE or NHCE.
Your classification determines how a failed compliance test may impact you. When deciding who is an HCE based on compensation, we always look at the prior year’s compensation.
An HCE for the 2025 plan year is someone who met one of the following:
Earned over $155,000 in 2024 and is in the top 20% when ranked by compensation (plan level election, check your Summary Plan Description (SPD) to see if this applies to your plan)
Owns more than 5% of the business in the current (2025) or prior (2024) year
A family member of someone who owns more than 5% of the business
An HCE for the 2026 plan year is someone who meets one of the following:
Earned over $160,000 in 2025 and is in the top 20% when ranked by compensation (plan level election, check your SPD to see if this applies to your plan)
Owns more than 5% of the business in the current (2026) or prior (2025) year
A family member of someone who owns more than 5% of the business
An NHCE is everyone who does not meet the criteria above.
Your employer is responsible for managing compliance testing for your company’s Gusto 401(k) plan. However, if the plan fails the ADP test, your employer needs to take corrective action. They generally have two options:
Refund excess contributions to HCEs
Provide additional contributions to NHCEs
The first correction option for a failed ADP test is for your employer to refund enough employee contributions from HCEs to lower their average deferral rate to the percentage needed to pass the test.
If you are an HCE, you may get a refund of some of your contributions after the end of the year, typically in Feb or Mar. Pre-tax deferrals refunded to you will be taxable as ordinary income in the year you get them. Any investment gains on those contributions will also be calculated and included in the refund.
In these scenarios, we will send an email once the check has been issued with details about the distribution, including the amount you can expect.
What this means for your taxes
Your W-2 income will stay the same, but you will get a 1099-R the following Jan to report the taxable amount. You will use this when preparing the tax return for the year you got the refund.
For example, if excess contributions need to be returned for the 2025 plan year, funds would typically be refunded in Feb 2026 and reported on your 2026 tax return prepared in 2027.
Important: Unlike other cash distributions, these 401(k) refunds are not subject to early distribution penalties if they are made by the applicable date (Jun 30 for plans with an EACA or QACA provision, Mar 15 for all other plans), and the amounts cannot be rolled over to an IRA. By default, 10% federal tax is withheld. You can choose to have a different amount withheld.
Note: If the refunded portion of your elective deferrals had a match associated with it, that match amount may be forfeited back to your employer’s plan.
The other correction option is for your employer to make qualified non-elective contributions (QNECs) to the 401(k) accounts of NHCEs. This increases the deferral percentage or matching rate of NHCEs to bring the plan within allowable limits.
If you are an NHCE, you may get additional contributions from your employer deposited into your 401(k) account.
This article is for informational purposes and is not intended to be interpreted or construed as tax or investment advice. Please consult a qualified tax or investment professional.