What is a cross-tested plan?
A cross-tested plan is a defined contribution plan that uses a certain testing method to show that the plan does not discriminate in favor of highly compensated employees. To be entitled to favorable tax treatment, a qualified retirement plan cannot discriminate in favor of highly compensated employees (HCEs). An individual is generally a highly compensated employee for a particular year if the individual earned over a certain dollar amount in the preceding year (e.g., $130,000 in 2020) or was a "more than 5% owner" in the current or prior year.
In a defined contribution plan, providing an allocation for a year based on a uniform percentage of all participants' compensation is not discriminatory in favor of HCEs. Likewise, a defined benefit plan that provides a promised benefit at retirement that is based on a uniform percentage of compensation is also not discriminatory.
Cross-testing is the term used to describe a technique where an allocation in a defined contribution plan for a year is converted to a projected benefit at retirement. Then, the projected retirement benefits for all participants in the plan are tested to ensure that the plan does not discriminate in favor of HCEs. If all of the projected benefits at retirement are a uniform percentage of compensation for all participants, then the plan is not discriminatory. Even if the projected benefits are not a uniform percentage of compensation for all participants, a plan may still be considered nondiscriminatory depending on the level of benefits provided to the non-highly compensated employees.
What is the advantage of a cross-tested plan?
It permits substantially larger contributions to be made for older participants than for the younger participants. In some situations, the employer might be able to make a 20% contribution for the HCEs and only a 5% contribution for all other employees. The reason for this difference can be explained by a simple example.
Suppose a company has two employees who each earn $50,000. One is age 60 and the other is age 30. If a uniform percentage of compensation is to be allocated under the plan, then each individual will receive the same contribution. But, if the goal is to ensure that the contribution each individual receives will provide the same projected benefit at normal retirement age (generally age 65), then a larger contribution must be made for the 60-year-old employee than for the 30-year-old employee. This is because the older employee has fewer years for the contribution to accumulate before the employee reaches age 65 (i.e., there will only be 5 years for the contribution to accumulate earnings). The contribution for the younger employee will accumulate earnings for 35 years, thus a smaller current contribution needs to be made. When the contributions are "cross-tested" or converted to a projected retirement benefit, each individual will have the same projected benefit at age 65.
What types of defined contribution plans may use cross-testing?
A profit-sharing or money purchase plan may be designed to use cross-testing. However, in most cases, a profit-sharing plan is used because contributions are not required to be made each year. In a money purchase plan, a contribution is required to be made each year.
May a 401(k) plan use cross-testing?
Yes. A 401(k) plan is a profit-sharing plan that permits pre-tax employee contributions. Cross-testing can be used to demonstrate that any profit sharing contribution made to a 401(k) plan is nondiscriminatory.
Must an employer make a contribution to a cross-tested plan every year?
A cross-tested money purchase pension plan would have a fixed contribution requirement. However, contributions to a cross-tested 401(k)/profit-sharing plan are discretionary.
If cross-testing is used, is there a minimum level of contributions that must be made?
If a contribution is made for HCEs in a plan year, then certain minimum contributions may need to be made for other participants. Generally, the non-highly compensated employees must receive an allocation for the year equal to the lesser of (1) 5% of compensation, or (2) 1/3 of the highest contribution rate provided to any HCE.
How is a cross-tested plan designed?
Generally, a cross-tested plan is designed by dividing the employees into individual groups to maximize the benefits offered under a cross-tested allocation methodology. The employer is then permitted to make a separate contribution with respect to each group.
Are cross-tested plans subject to any other special rules?
No. Generally, the same rules that apply to any other defined contribution plan apply to a plan using cross-testing.
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