401k Cross-Testing, Age-Weighting and 401k New Comparability

What is a Cross-Tested 401k, and How Does it Differ Form Typical 401k?

There are several ways a 401k plan can be "tested" to determine its compliance with US Department of Labor regulations. If a 401k passes one of several different tests, it is deemed "qualified" under the regulations. If a 401k cannot pass any compliance test it is deemed "disqualified" which results in serious and expensive problems for the employer and the plan participants. It is essential that the qualification status of a 401k be checked frequently, and passes at least one of the compliance tests annually.

The primary compliance violations involve plans that gives significantly disproportionate benefits to highly-compensated employees (HCEs) to the determent of the non-highly compensated rank and file (NHCEs) An individual is a HCE if the individual earned over a certain dollar amount in the preceding year (e.g., $110,000 in 2009) or was a "more than 5% owner" in the business.

In cross-testing of a 401k, the company's contributions to plan participants are converted mathematically to projected benefits at retirement. These projected benefits are then tested against each other to ensure that the plan does not discriminate in favor of HCEs.

What is the Advantage of a Cross-Tested 401k Compared to a Typical 401k?

In comparison to other 401k compliance tests, a cross-tested 401k permits substantially larger contributions be made to the business owners, other HCEs, and/or older participants. Younger participants will get less of the contributions without violating compliance regulations.

Example: Suppose a 60 year-old business owner (HCE) has two younger employees. The younger employees are both non-highly compensated (NHC). The HCE wants to make a large profit-sharing contribution to himself without giving large contributions to his two workers. In this example the business owner pays himself $75,000 annually, and he pays his two employees $30,000 annually. In our example the two employees are both age 30.

In a traditional 401k arrangement, a uniform profit-sharing contribution is to be allocated to the owner and the two employees, with each individual receiving the same contribution percentage. In a cross-tested plan, the goal is to ensure that the contribution each individual receives will provide the same projected benefit at normal retirement age, generally 65. To achieve this goal a larger contribution must be made for the 60 year old business owner than for the two 30-year old employees because the 60 year old business owner has fewer years for the contributions to accumulate before he reaches age 65. The contributions for the younger employees has 35 years to accumulate, so smaller contributions are made without violating non-discrimination regulations.

Comparison of Traditionally-Tested 401k and a Cross-Tested 401k

In the chart below, note how much more money the HCEs are able to receive in company profit-sharing contributions without violating DOL antidiscrimination rules.

Employee Age Compensation Traditional 401k PS Contribution Cross Tested 401k PS Contribution
A (HCE) 50 $245,000 $49,000 $49,000
B (HCE) 45 $245,000 $49,000 $49,000
C 40 $40,000 $8,000 $3,538
D 32 $35,000 $7,000 $1,750
E 28 $28,000 $5,600 $1,400
F 25 $20,000 $4,000 $1,000
Total $613,000 $122,600 $105,688

Must an Employer Make a Contribution to a Cross-Tested 401k Plan Every Year?

Yes, a minimum contribution for each participant is required if a contribution is made to the HCEs. Generally, the non-highly compensated employees (NHCEs) must receive an allocation for the year equal to the lesser of either 5% of compensation, or 33% of the highest contribution rate provided to any HCE. In most cases a safe harbor arrangement will assure compliance.

If a Cross-Tested Contribution Amount Passes the Test in One Year, Will the Same Contribution Pass the Test in the Subsequent Year?

Not necessarily. Because of employee attrition, new hires and the fact that employees grow older each year, a contribution that passed the nondiscrimination test in one year might not satisfy the test in the subsequent year. Therefore, the proposed contribution for each year must be tested in order to determine whether it would pass the test.

How is a Cross-Tested 401k Plan Designed?

Generally, a cross-tested 401k is designed by dividing the employees into HCEs and NHCEs. The employer is then permitted to make additional groups within these two main groups, and separate contribution amounts within each group.

The employer will then place the employees that it wants to receive the highest allocations in one group, and the other employees in the other groups. However, the employer may want to benefit certain classifications of employees differently. In such a case, the employer would establish another group by specifying characteristics that are unique to that group of employees (e.g., highly compensated employees who are owners, highly compensated employees who are not owners, paralegals, etc.). Although the cross-testing rules do not impose any requirements for defining groups, the employer may not use criteria such as race, religion or gender.

Although the rules do not specify a method for allocation, generally, the plan allocates the profit-sharing contribution uniformly among employees within the group. In other words, the employer will make a contribution to a group and then allocate it proportionately based on the compensation of all participants in that group. The separate contribution made for each of the other groups is allocated in the same manner (i.e., based on the compensation of all participants in the group).

The process begins by determining the profit-sharing contribution that is desired to be made for a specific group, typically the owner or other HCEs. For example, the maximum allocation that may be made to an individual in 2009 is generally $49,000. If this is the contribution that is desired to be made to the HCEs for the year, then the amount to be contributed for the other participants is the amount necessary to satisfy the cross-testing nondiscrimination test.

What is the potential down-side for Cross-Testing?

Cross-testing looks at two variables: the difference in age, and the difference in compensation between the key group(s) and the least benefiting group.

For example, an ideal situation would be a 60-year-old owner earning $200,000 annually, with three employees averaging age 25 and an annual compensation of $20,000. New Comparability contributions are maximized with a large difference in age and compensation, as it takes into account what the current contribution would be worth to the individual at retirement as a method of income replacement.

The closer an owner is to retirement age, the more dollars he or she can direct to the plan because contributions don't have to be invested for a long period of time. All in all, New Comparability is a great choice for business owners who are nearing retirement.

The other "catch" is that the IRS requires a minimum contribution to all eligible employees. There are two ways to meet this requirement: Give a 5% contribution to all eligible employees or a contribution equal to 1/3 of the maximum contribution the key employees receive.

Age-Weighting Cross-Testing Method

New Comparability Cross-Testing Method

What types of businesses are best suited for New Comparability?

Accountants/CPAs Advertising Firms Architects Pharmacists
Contractors Dentists Doctors Veterinary Clinics
Engineers Law Firms Financial Planners Medical Clinics

However, it can work in any business with a wide disparity in compensation and age between the targeted employees and the remaining employees.

What groups can be targeted in a New Comparability Plan?

New Comparability allows you, the employer, to divide your employees into two or more groups and provide a different level of contribution to each group in the 401(k) plan.

For instance, a plan can be divided into the following groups:

Group 1: Doctors and family members of doctors
Group 2: All other employees
OR Group 1: Owner and family members of owners
Group 2: Sales force
Group 3: All other employees

How does New Comparability work?

Traditional 401k Plan vs. New Comparability 401k Plan

  Traditional Profit-Sharing Plan New Comparability Plan
Description Annual Salary Amount Allocated % of Salary % of Total Contribution Amount Allocated % of Salary % of Total Contribution
Owner, 55 yrs. old
$225,000 $36,000 16% 77.59% $45,000 20% 93.26%
Employee, 30 yrs. old
$30,000 $4,800 16% 10.34% $1,500 5% 3.11%
Employee, 35 yrs. old
$35,000 $5,600 16% 12.07% $1,750 5% 3.63%
Total Contribution   $46,400     $48,250    

Can New Comparability contributions have a vesting schedule?

Yes. The IRS allows profit-sharing contributions, like New Comparability, to have a vesting schedule that rewards employees for their service and allows the plan to recycle the forfeited contributions of employees who are no longer employed by the company to offset future contribution costs.

Is the entire New Comparability contribution tax-deductible for the business?

Yes, the business owner may be able to deduct the entire plan contribution so long as the contribution does not exceed 25% of the total compensation of all eligible employees. Therefore, the contribution has a much lower after-tax "cost" than the actual amount contributed.

Below are two spreadsheets available for download. They are both useful for calculating and testing cross-testing EBAR scenarios.

Cross-Testing EBAR Calculation Spreadsheet-open

Cross-Testing EBAR Spreadsheet-populated with sample data