What Are My Retirement Plan Design Options? Part 5: Cross-Tested Plans
In part 5 of our series, we’re covering cross-tested plans. We've covered profit sharing plans, 401(k) plans, safe harbor plans, and last week, social security integration plans. Cross-tested plans offer the most targeted approach to employer contributions. Cross-tested plans may enable some companies to direct a greater portion of contributions to highly compensated employees. Whether this type of plan design is appropriate for your company will depend greatly on the demographics and goals of your company. Cross-testing refers to one method by which a qualified defined contribution plan can demonstrate compliance with non-discrimination testing requirements.
Unlike a traditional profit sharing plan which allocates contributions using a uniform percentage of participants’ compensation, a cross-tested plan allocates contributions using a non-uniform formula and passing the non-discrimination tests requires actuarial analysis. Effectively, a cross-tested plan employs a testing methodology that is customarily used in defined benefit plans and applies it to a defined contribution plan, hence the term “cross-tested.”
Traditional 401(k) plans are typically designed to benefit your employees, partners, owners and targeted group(s) alike. But if you are currently making a traditional profit sharing contribution to your 401(k), you know that your ability to strategically target those contributions is limited.
What can a cross-tested plan design do for you?
Depending on your firm’s demographics, the owners or other targeted group(s) may be able to receive a much larger allocation as a percentage of pay than other plan participants. For many companies, especially for small to mid-size companies, the flexibility to target employer contributions can be a powerful strategic benefit, offering potential savings in corporate and personal taxes.
How does it work?
Cross-tested plans define different employee groups within the plan document. Employers make separate contributions to each employee group, and contributions are allocated to employees within their respective groups in proportion to salaries. Because of cross-testing, the age of employees is an important factor. Cross-tested plans work best in organizations where owners and highly compensated employees are older on average than non-highly compensated employees.
If you’re an owner with younger employees, the contribution amounts that result from applying cross-testing may be more beneficial to older employees than profit-sharing plans that use a pro-rata formula.
While IRS non-discrimination tests must be met, cross-tested plans feature flexibility that can provide greater benefits for small to mid-size firms than a typical retirement plan. Because of the added work involved in establishing a cross-tested plan, and the complex nature of the rules governing qualified benefit plans, you will need a pension specialist to develop a plan that meets legal requirements and the unique needs of your company.
As you can see, the more options you have in plan design, the more complex things can get for business owners. Every situation is different, so it's important to work with a professional to help guide you in what would make the most sense for your company and employees.
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The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.