Hot Cross…Testing?

“Hot cross buns, hot cross buns, one a penny, two a penny, hot cross buns…” Now that the famous nursery rhyme “Hot Cross Buns” plays in your mind, I want to take a few minutes to discuss the hot topic of cross-testing!

Cross-testing is a calculation method used for allocating employer discretionary profit-sharing contributions. This is often used alongside 401(k) and safe harbor contributions to maximize annual contribution limits (usually targeted to owners or highly compensated employees) at the lowest overall cost to the company.

Not all profit-sharing contributions are the same. There are four main ways to allocate a profit-sharing contribution: Pro-Rata (all employees receive the same rate in terms of a percentage of their salary), Integrated with Social Security (allows employers to contribute different amounts to employees based on their Social Security tax levels/taxable wage base), Age (equate contributions to equivalent benefits at retirement age), and Cross-Testing (creating separate benefit groups with each group having their own contribution rate).

As a refresher, qualified plans are required to be tested each year to show the plan does not discriminate in favor of highly compensated employees (HCEs). For the 2023 calendar testing year, a highly compensated employee is a term given to an employee who meets one of two criteria: someone who owns, or deemed to own via attribution rules, over 5% of the company during 2022 or 2023, or someone who earned $135,000 or more in wages in 2022. An employee who does not fall into one of those two criteria is considered a “non-highly compensated employee” (NHCE).

In a defined contribution plan (DC plan), providing an employer contribution for a year, based on a uniform percentage of all participants compensation, is not discriminatory in favor of HCEs. For example, a 401(k) plan that provides a profit-sharing contribution on a pro-rata basis utilizing compensation, is not discriminatory, such as providing everyone 10% of eligible compensation as a profit-sharing contribution.

Similarly, a defined benefit plan (DB plan) that provides a promised benefit at retirement that is based on a uniform percentage of compensation is also not discriminatory.

However, there often is a desire for a business to maximize profit sharing contributions to the older, higher paid owners and key employees, while minimizing allocations to younger employees. This is where cross-testing comes in!

A cross-testing setup works particularly well when the HCEs are older in comparison to the rest of the staff. Usually, the older employees are the ones who need the boost in savings, requiring and desiring a larger contribution to their retirement account.

The advantage of a properly structured cross-tested plan is the allowability of substantially larger contributions to be made for older participants than for the younger participants. In some cases, the employer might be able to make a 20% contribution for those older HCEs and only a 5% contribution for all other employees.

When cross-testing, those differing contribution amounts are converted to a projected retirement benefit (Equivalent Benefit Accrual Rate, or EBAR), and then reviewed to see if the projected benefit amounts are discriminatory.

Cross-tested plans are able to put employees into different classes or groups (rather than using age or a uniform percentage) and assigning each class or group a different allocation percentage or dollar amount. Each employee may be setup in their own class so that benefits can vary by person. Although the benefit dollars right now may differ, these plans are designed to pass IRS non-discrimination testing.

How does this theory work? Suppose a company has two employees, both making $50,000. One is age 60 and one is age 30. If we apply a uniform percentage of compensation to both employees, they would both receive the same dollar amount of contributions. But, if the goal is the ensure that each employee receives the same projected benefit at normal retirement age, then a larger contribution must be made to the 60-year-old than to the 30-year-old. This is because the 30-year-old has 35 years for the money to accumulate growth and earnings until retirement age; whereas the 60-year-old only has five years. We can provide the 60-year-old with a larger contribution amount today utilizing cross-testing.

So, how does a plan get to use this cross-testing benefit?

Before we can consider using this methodology, a minimum contribution (known as the gateway test) must be satisfied for all NHCEs. The NHCEs must receive an allocation for the year equal to the lesser of 5% OR one-third of the highest contribution rate provided to any HCE.

For example, if the highest HCE contribution rate is 12%, all NHCEs must receive 4%. If the highest HCE rate is 18%, all NHCEs must receive 5%.

Contributions already provided to the NHCEs throughout the year, such as profit-sharing contributions, top heavy contributions, safe harbor 3% non-elective contributions, forfeitures used as nonelectives, and qualified non-elective contributions all count toward the gateway minimum required.

Contributions of employer match, deferrals, or safe harbor matching do NOT count for this gateway minimum.

Let’s say the current plan setup is a 3% safe harbor non-elective contribution and it is determined that the gateway needed is 5%. The employer would provide an additional 2% profit sharing to get up to the required 5% amount.

Once an employer has provided the gateway contribution to all NHCEs, the plan is able to then enter the world of cross-testing to maximize contributions to HCEs. Instead of following the nursey rhyme’s methodology of pennies, this hot cross-testing could turn into thousands of dollars more to those who will need it the soonest!