Actual Deferral Percentage / Actual Contribution Percentage - ADP/ACP Test
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.