P-1 Q: What is a cross-tested 401(k) plan? -TOP

A: There are several ways a 401k plan can be “tested” to determine its compliance with US Department of Labor regulations. If a 401(k) passes one of several different tests, it is deemed “qualified” under the regulations. If a 401(k) 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 401(k) be checked frequently, and passes at least one of the compliance tests annually. The primary compliance violation involves a plan 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 401(k), the company’s profit sharing 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. Our online software has 401(k) compliance testing “build-in” and available to be run anytime to monitor the plan’s compliance status.

P-2 Q: What is the advantage of a cross-tested 401(k) plan? -TOP

A: In comparison to other compliance tests, a cross-tested 401(k) permits substantially larger contributions be made to HCEs, or older participants than to younger participants, without violating compliance regulations.
Example: Suppose a 60 year-old business owner (HCE) has two younger employees, both non-highly compensated, and wants to make a large profit-sharing contribution to himself. 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. If a uniform profit-sharing contribution is to be allocated to the owner and the two employees, then each individual will receive the same contribution percentage. In a cross-tested plan, however, the goal is to ensure that the contribution each individual receives will provide the same projected benefit at normal retirement age, generally age 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. The business owner has fewer years for the contributions to accumulate before he reaches age 65 and the contributions for the younger employees has 35 years to accumulate, so smaller contributions are made without violating non-discrimination regulations.

P-3 Q: Must an employer make a contribution to a cross-tested 401(k) plan every year? -TOP

A: 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.

P-4 Q: If a contribution amount passes the test in one year, will the same contribution pass the test in the subsequent year? -TOP

A: 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.

P-5 Q: How is a cross-tested401(k) plan designed? -TOP

A: Generally, a cross-tested 401(k) 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.

P-6 Q: How many cross-testing methods exist? -TOP

A: There are two distinct methods for cross-testing. Passing the cross-test by either method is valid. The original cross-testing method relied upon the age of plan participants in determining compliance. This method, called “age weighting” resulted in the following:

- Profit-sharing contribution based upon participant’s age.
- Advantaged older plan participants and disadvantaged younger plan participants.
- Resulted in HCEs getting unequal amounts of profit-sharing contributions.

The second method for cross-testing is called “new comparability”, and it is slightly different that “age weighting” in the following ways:

- Profit-sharing contribution is based upon a participant’s classification within the organization.
- Advantages owners and key employees over all other plan participants.
- Owners receive the same profit-sharing contribution amount.

Comparison of traditionally-tested 401(k) and a cross-tested 401(k) Notice how much more money the HCEs are able to receive in company profit-sharing contributions without violating DOL antidiscrimination rules.

Employee	Age	Compensation	Traditional 401(k) PS Contribution	Cross Tested 401(k) 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