It’s not uncommon for business owners to want to contribute more money to their own retirement accounts and those of selected employees than they do to the rest of their employees. Similarly, companies sometimes want to contribute more to older employees’ retirement accounts, since they are closer to retirement age.
This is difficult to do with most qualified retirement plans due to the annual non-discrimination tests that must be performed on these plans. These tests ensure that Highly Compensated Employees (HCEs) do not receive proportionally higher contributions than all other employees. Any owner of more than 5% of the business and employees who earned more than $120,000 in 2015 is considered to be HCEs.
However, there is one type of Defined Contribution (DC) qualified plan that enables owners and executives to benefit disproportionately from other employees.
Benefits of Cross-Tested DC Plans
Known as a “cross-tested” or “new comparability” profit-sharing plan, this ERISA-approved plan allows shareholders to contribute higher amounts to their own and their selected employees’ retirement accounts in comparison to other employees’ accounts.
With this type of plan, nondiscrimination testing is based on the projected benefits received at retirement by the HCEs and non-HCEs, rather than the amounts of the contributions themselves. Benefit allocations are based on age, service and compensation level. An IRS-approved calculation focuses on the projected benefits at retirement age, rather than the amount of the current contribution. When viewed this way, the benefits received by HCEs are comparable to those received by non-HCEs.
Cross-tested plans tend to work especially well at companies where the owner and the HCEs are older than the general employee population. The greater the difference in the average age between HCEs and non-HCEs, the more beneficial a cross-tested plan may be for shareholders, highly compensated selected staff members, and older employees.
Contributions to cross-tested plans are discretionary so you can decide each year how much money you want to contribute (if any), based on your company’s currentfunding goals. Also, cross-tested plans can be coordinated with a safe harbor 401(k) plan to maximize the owner’s and the HCEs’ annual contributions. The defined contribution plan annual addition limit in 2016 is $53,000, or $59,000 for employees who are age 50 or over.
A Cross-Tested Plan Example
An example helps illustrate the potential benefits of a cross-tested plan. Suppose an owner and his top executive (age 58 and 56, respectively) each have a $250,000 salary and five other employees (ranging from 25 to 35 years old) earn $181,000 combined each year. If everyone received 20 percent of compensation as their profit-sharing contribution, the owner and executive would each receive $50,000 (or 73 percent of the total contribution amount) and the other employees’ total allocation would be $36,200 (or 27 percent of the total contribution amount).
With a cross-tested plan, the total allocation for the five non-HCE employees could be reduced to just five percent of compensation, or $9,050, as opposed to 20 percent as illustrated in the example above. This would free up $27,150, of which $9,000 could go to each owner (or $18,000 total) to bring them up to the annual defined contribution plan limit of $59,000. The remaining $9,150 could be kept in the company as savings. With this design approach, the owner and HCE each receive $59,000 (or 93 percent of the total contribution amount, and the other employees’ total allocation would be $9,050 (or 7 percent of that total contribution amount).
Although this is an example of a company with a total of one owner, one other HCE and five non-HCEs, the same principles can be applied to much larger companies and the results can be just as dramatic.
Talk to the Right Retirement Plan Consultant About Cross-Tested Plans
Not all retirement plan consultants and third party administrators have the knowledge and expertise required to help businesses implement more sophisticated retirement plan strategies like cross-tested plans. Here at ACG, we will work with you to customize the right retirement plan for your company and your workforce — whether this is a cross-tested plan or another custom-designed plan.
We take the time to educate our clients about all the different retirement plan options available to them — not just basic “off-the-shelf” plans. This gives you confidence that you have the right plan that meets your company’s unique goals and objectives.
Contact us today to talk about whether a cross-tested plan might be a good option for your company.