Cross-Testing 401k: A Very Flexible Arrow in the Retirement Plan Quiver by Ilene H. Ferenczy, Esq
Suppose you are the plan administrator for a larger company and you want to design your profit sharing plan to give special benefits to the Michigan office. Or, suppose you are the owner of a small business and you want to benefit yourself and your executive group to a greater degree than the other employees. Can you do that in a profit sharing plan?
The answer is: YES!
But what about nondiscrimination testing? Yes, profit sharing plans must be nondiscriminatory under IRS rules. But, those rules provide enormous flexibility as to how one demonstrates fairness in a plan and proper plan design can use that flexibility to meet your goals.
One way to take advantage of testing flexibility is called “cross-testing.” Like the cash balance plan designs discussed last month, a cross-tested plan takes advantage of the fact that older (often more senior, highly paid, and key) employees have less time until retirement to accumulate savings. Therefore, to have a benefit equal to what the younger employees will have at retirement, each year’s contribution must be more.
Here’s an example:
Say a company has two employees, A and B. Both employees earn $275,000 per year. Employee A is age 55 and Employee B is age 35. If the company makes the largest permissible contribution (25% of compensation, but no more than $55,000 per year) on behalf of both employees this year, A’s contribution will grow in 10 years with compounded earnings to be about $124,000 at age 65. On the other hand, B has 30 years to retirement, and her contribution will grow to $636,000 at age 65. That means that a contribution for the younger employee is worth five times more in terms of retirement benefits than the same contribution for an older employee.
If we judge discrimination as comparing benefits at retirement, we could contribute less than $11,000 this year for Employee B, and she would have a benefit at retirement equal to that of Employee A. So, a contribution for a 35-year-old may be less than 5% of pay (compared to Employee A’s 20%) to have a comparable benefit.
This is a simplified version of how cross-testing works. A cross-tested plan can target older employees for larger contributions. In addition, because cross-testing looks at employee groups, and not each employee individually, this design can work even when some of the targeted employees are not significantly older than everyone else.
In addition, cross-testing works very well with safe harbor 401(k) plans that use the 3% profit sharing contribution option for the safe harbor contribution. They also mesh well with defined benefit or cash balance plans. While the lowest contribution for the non-highly compensated employees in such circumstances may increase to between 5% and 7½% of pay, the cost of that increased contribution may be offset – or more – by the increased contributions for the targeted employees and the tax savings for the company.
Finally, you can define the groups of employees who get a given tier of contributions in a very flexible fashion – by job, by location, or even by name in many circumstances.
Are there disadvantages? Yes, but they are manageable.
First, this is not a “plain vanilla” design, so you need to hire an experienced third-party administrator who understands these more complex rules.
Second, the design is demographically sensitive. Significant changes in your employee make-up can mean that the structure is not as effective. However, because the contribution is discretionary each year, you can reduce or eliminate the contribution in a year in which the numbers don’t work out.
Talk to your plan consultant about cross-testing as a means of designing your plan to work the way you want it to. You may be amazed at the results!
Ilene H. Ferenczy, Esq., CPC, APA is the managing partner and thought leader for Ferenczy Benefits Law Center, an Atlanta firm focusing on the practical issues affecting retirement plans, the companies that sponsor them, and the people who service them. She is the author of five books and more than 100 articles about retirement plans and is a former third party administrator.