Actual Deferral Percentage / Actual Contribution Percentage - ADP/ACP Test
Categories: Tax, Retirement, Trusts and Estates
This complex concept refers to continued tax deductible qualification for 401K plans, and specifically targets the most well-paid employees at the company. The basic notion in creating rules around the amount that the highest paid could defer in taxes revolved around the notion of "progressive" tax. That is, the CEO making a million bucks a year shouldn't be able to defer 500 grand, year after year; the taxpayers need her taxes today. Not in two decades. And the whole notion or rationale for the 401k system in the first place was to focus on the middle class wanting to save for retirement so that they could golf with the grandkids and have a decent quality of life until they had that heart attack in bed with the 27-year-old hottie. Anyway, the ADP/ACP rules dictate that, in order for employees and the company to continue benefitting from 401k tax deductibility, they must adhere to some maximum salary deferral percentages, such that the ratios compress the spread from the highest earners to the lowest earners.
The IRS defines a highly compensated employee, or HCE, as an employee who owns more than 5% of the company (and that 5% can happen even for 14 seconds at any time during that year), or that that employee has earned more than $120,000. In order to qualify for maxing out the 401k, a bunch of financial metrical tests are done to cover the highest earners. One is what's called a 410b coverage test, which basically just makes sure that all of the employees of a given status have access to that 401k plan. Like...it wouldn't be fair to only offer it to the top three earners in the company, and then the next 12,000 toil and suffer paying taxes.
Another test, the ADP (Average Deferral Percentage) test, compares the actual salary deferral percentage of highly compensated with non-highly compensated people. To figure out what the max cap is on comp, the ADP test just uses the same rules that already exist in Roth IRAs as they apply to pretax savings of dough. Because of the way in which the caps are defined and structured as to what the highest earners can tax-defer, companies are financially encouraged to make matching contributions in many cases. That is, if it's the CEO's dough at stake, and the rest of the company has to get some deal relatively close at least in structure to what she is getting, then the IRS is betting that the CEO will take care of herself along with the others so that everyone's compensation is tax-optimized. And as an outgrowth of these issues, a few other tests in qualifying for 401k treatment have evolved, like the ACP test, where the actual contribution percentage test compares average of the percentage of after-tax and matching contributions for highly compensated and non. There has to be some minimum and maximum ratio that gets tax-deferred among all employees in the company, again because Boss Hog was hogging a lot of the tax deferrals in a few cases, so amendments to the structure had to be made.
The goal was to make sure actual usage of the program was high across the whole company. And lastly, another set of tests evolves to make sure the benefits go deep in the organization, not just living or being deployed for tax deferral at the top. Specifically, if more than 60% of the assets go to to key employees (often a somewhat different group from those defined as "highly compensated") then the org is too top heavy. The broader goal? Fairness. Egalitarianism. Something like that, anyway.
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Finance: What is a Tax Deduction?102 Views
Finance allah shmoop shmoop What is a tax deduction Uh
taxes Love him Hate him You can't leave him but
you can lower them legally by being you know thoughtful
about how you spend your earnings All right How do
we do this Well let's start with the largest tax
deduction in america the home mortgage And you you the
dentist who makes one hundred fifty grand a year for
putting your fingers in wet mouth Well remember that for
individuals versus corporations we pay a graduated or quote progressive
unquote tax rate Like almost nothing On the first fifteen
grand we earned on about ten percent from fifteen to
thirty grand And then about twenty percent from thirty to
sixty grand And so on That's progressive So on the
last twenty grand of earnings you make well you might
pay say forty percent in taxes and yeah we know
the numbers own exact We're just illustrating a point Here
you have a mortgage of three hundred thousand dollars on
a home you bought for four hundred thousand dollars right
So you put a hundred grand down and borrow three
hundred The mortgage costs you six percent per year in
interest or eighteen thousand dollars to rent that three hundred
thousand before you owned the home The irs thought of
you as one hundred fifty grand a year earner but
one hundred percent of the interest on the home is
fully tax deductible So what about that last twenty grand
iii The money you earn from one hundred thirty k
to one hundred fifty k Well as faras the irs
is concerned now that you have a home you get
taxed as if you earned just one hundred thirty two
grand not one hundred fifty k actually earned Why Because
that eighteen thousand dollars in interest comes right off the
top of your earnings See there's the math right there
one hundred fifty minutes eighteen hundred thirty two taxable earnings
it's as if you didn't earn that money ever can't
all right well if you'd had no deductions on that
last twenty thousand dollars of earnings you'd have paid forty
percent or eight thousand dollars in taxes But now on
that last twenty thousand dollars thanks to your mortgage deduction
well you only have taxable income of two thousand dollars
And yes you pay forty percent on that two thousand
Or eight hundred bucks And you mumbled thank you government
for largely splitting the cost of my mortgage with me
The american dream is alive and well that's what you
say Okay And thank you jay There are other deductions
beyond home mortgages of course but well you get the
gist here of how they work from a taxpayer's perspective
Deductions like those from your home mortgages are a good
thing Common personal deductions also include things like prepaid healthcare
costs and the cost of feeding quote dependent unquote children
Aii those noisy things sleeping in your spare bedrooms until
they're eighteen Okay so those air personal deductions things that
individual citizens take But what if you're a corporation Well
in a way it's kind of easier Think of most
corporations is having a flat thirty percent tax from the
first dollar they make just keep things simple Participation trophy
company in kameda one hundred million dollars last year and
paid thirty million in taxes They netted seventy million after
tax The company really needs a new trophy smelting machine
because with so much demand for participation trophies of late
while the old one is running dullah with mediocrity the
company spends forty million box on the new machine knowing
that it will be worthless in ten years either because
it wears out or because the country gets riel or
you know simply remembers to you know have a nice
day participation trophy land Welcome to it They'd appreciate forty
million dollars in equal parts of four million box each
year over ten years so that in the next year
when they again or in one hundred million dollars well
they now get to deduct four million bucks and appreciation
from their smelting machine against their hundred million dollars in
earnings So again as faras the irs is concerned they
didn't really earn one hundred million dollars even though they
did They earned quote on ly unquote ninety six million
and yes they still pay their thirty percent tax Only
now instead of paying it on a hundred million bucks
it's paid on ninety six million of earnings or point
three times ninety six or twenty eight point eight million
in taxes they did Abducted from their taxes The four
million box expected value decline from their smelting machine Right
It goes down four million a year in value from
the forty they paid They received essentially a credit on
their taxes of one point two million dollars So instead
of that year's depreciation costing the company four million bucks
well it really cost them more like two point eight
million If you ignore a bunch of other things like
the original capital cost of the machine what else they
might have done with that money oven you know via
smelting machine Think think Corporate jet Yeah those g sixes 00:04:52.774 --> [endTime] are surprisingly tasteful
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