When Cross-Tested Plans Become Integrated Plans

By David J. Kupstas, FSA, EA, MSPA

David J. Kupstas, FSA, EA, MSPA

David J. Kupstas, FSA, EA, MSPA Chief Actuary

Many 401(k) and profit sharing plans are set up to be cross-tested plans. (Most of those that aren't probably should be.) There are times, however, when using cross-testing is not the best way to satisfy the nondiscrimination rules. Sometimes, you might want your cross-tested plan to “revert to” being an integrated plan.  In this article, we describe what this means and how it is done.

First, let us define a few terms:

  • A “uniform allocation” profit sharing plan is a plan under which the employer contributes the same dollar amount or same percentage of compensation to each eligible participant. Perhaps the employer will give a flat $2,000 to each participant or 10% of compensation to all participants.
  • An “integrated” profit sharing plan is a plan under which the employer allocates a slightly higher percentage of pay to those whose compensation exceeds a certain threshold, maybe the Social Security Taxable Wage Base. Originally, the term “integrated” referred to the fact that these plans were integrated with Social Security contributions or benefits.  The regulations now use the term “permitted disparity.”  As an example, if employees whose pay does not exceed the integration level receive a 10%-of-pay profit sharing contribution, it might be possible in an integrated plan for higher earners to receive around 13% of pay.
  • Under a “cross-tested plan,” the employer has the freedom to allocate however much profit sharing contribution it wants to each employee, so long as a nondiscrimination test and certain other requirements are satisfied. The term cross-tested plan is actually somewhat of a misnomer. It makes it sound like cross-testing is a permanent feature or somehow baked into the plan’s terms. Cross-testing is just a tool that can be used to prove a given year’s contribution allocations are not discriminatory. You might utilize cross-testing some years and not in other years. Nevertheless, “cross-tested plan” is a popular colloquialism referring to any plan in which the method of allocating contributions to employees is not mandated but rather is left up to the employer to decide for each individual or class of employees.  “Class-based” is probably a better name for these arrangements.

When Cross-Testing No Longer Works

Consider Ben, the third party administrator for the ABC Company 401(k) Plan ever since the plan was established three years ago.  The ABC 401(k) is a cross-tested plan.  The owner of ABC Company, Mr. Adams, has been receiving the maximum contribution allowed under the law.  In order to receive this big contribution while satisfying the nondiscrimination rules, Mr. Adams has had to contribute 5% of pay to his employees, all of whom are Non-Highly Compensated Employees (NHCEs).  Mr. Adams was fine with this amount.  Life was good.

But then 2019 rolls around.  The employee population of ABC Company has changed in such a way that giving a profit sharing contribution of 5% of pay to employees will not satisfy the nondiscrimination test.  In fact, to pass cross-testing, ABC Company has to give 16% of pay to employees in order for Mr. Adams to receive his usual 13%. Mr. Adams hadn’t planned on contributing 16%. Ben calls up Mr. Adams to give him the bad news.

Do you see anything wrong with this picture?  The NHCEs are receiving a higher percentage of pay than Mr. Adams, the sole Highly Compensated Employee (HCE). That’s great if Mr. Adams feels like being super generous to his employees.  However, he didn’t budget 16%.  He budgeted around 5% for his staff.  There is no reason an employer should have to give a higher percentage of pay to the NHCEs than the HCEs are receiving.

At this moment, Ben wishes ABC Company had a uniform allocation plan instead of a cross-tested plan.  At least then Mr. Adams would have to contribute to employees only the same 13% Mr. Adams himself is getting. That’s not as good as the 5% from previous years, but it’s better than the 16% Ben comes up with using cross-testing.

Poor Ben.  He hasn’t been studying his regulations.  What Ben fails to realize is just because ABC Company has a cross-tested plan doesn’t mean it’s stuck using cross-testing. Another option is testing on a contributions basis.

Contributions Testing vs. Benefits Testing

Recall that under cross-testing, the Equivalent Benefit Accrual Rate (EBAR) is the monthly retirement benefit as a percent of pay that the current year contribution could theoretically buy at some future age, usually age 65.  Thus, cross-testing is also referred to testing on a “benefits basis” or an “accrual basis.” Another way to test is simply comparing the current percentages of pay without converting to future retirement benefits.  That is called testing on a “contributions basis” or an “allocations basis.”  This is actually more intuitive than testing on a benefits basis.  Simply comparing whether a 5%-of-pay contribution is fair compared to a 10% contribution makes more sense than going through a bunch of calculations and declaring that it is fair for one person to get 20% of pay while another one gets only 5%.

When testing on a contributions basis, the EBAR is replaced by an Equivalent Allocation Rate (EAR), which is simply the current year contribution divided by the current year pay.  Otherwise, the mechanics of the test are largely the same.

Getting back to ABC Company, the first thing they should do is lower the employee profit sharing to 13% of pay to match what Mr. Adams is getting.  This will pass nondiscrimination testing on a contributions basis.  When allocating a uniform percentage of pay, all of the EARs are by definition the same.  And when all of the EARs are the same, the nondiscrimination test passes easily.  Giving the same percentage of pay to all employees is always considered “fair” under the nondiscrimination regulations.

We don’t have to stop there, though.  Integrated plans tend to be more “efficient” than uniform allocation plans, meaning more of the contribution dollars go into the pockets of the owners and other favored employees.  That’s what Mr. Adams wants – more of the contribution dollars to go into his pocket.  We have just shown that we can make our cross-tested plan into a uniform allocation plan.  Can we also make our cross-tested plan into an integrated plan?  Yes, indeedy-doody.  We can do something called “imputing permitted disparity.”

Just like permitted disparity (integration) is a way to give higher-paid employees a bigger share of the contributions than under uniform allocation, imputing permitted disparity is a technique that can be built into a nondiscrimination test which allows more favorable allocations to those earning more than a certain threshold.  This technique may be used either when testing on a benefits basis or a contributions basis.  When testing on a contributions basis, it effectively can transform a cross-tested profit sharing plan into an integrated profit sharing plan.

If ABC Company tests on a contributions basis and imputes permitted disparity, for Mr. Adams to receive 13% of pay the contributions to employees need to be only 10% of pay, assuming those employees all earn less than the Social Security Taxable Wage Base and Mr. Adams’ pay is at the annual cap.  This is better than the 13% of pay they would need to receive if testing on a contributions basis without imputing permitted disparity and better than the 16% that would be needed under cross-testing as determined by Ben, the soon-to-be-former TPA.

Minor Drawbacks

We have been saying that generally it is better to do integrated allocations within a cross-tested plan framework than it is to have the plan document expressly be an integrated plan.  There’s just more flexibility with a cross-tested plan.  However, there are two minor drawbacks to doing an integrated allocation in a cross-tested plan:

  1. When the integrated provisions are expressly in the plan document, the plan is exempt from performing the nondiscrimination test, since permitted disparity is considered a nondiscrimination safe harbor. If the plan has cross-tested contribution language but allocates contributions using integration, the nondiscrimination test must be performed.  That said, this is a very minor concern; you have to run the test, but it is assured of passing since every participant’s EAR will be the same. That’s not so bad, is it?  It’s like taking a final exam in college which consists of nothing but going online, entering your name and address, and printing out a piece of paper to receive a passing grade.  You’d rather avoid that step if you could, but it is certainly nothing to whine about.
  1. In true integrated plans, instead of using the taxable wage base as the integration level, we often use 80% of the wage base plus $1.00. There’s a reason for using that exact weird number; it usually gives a more efficient outcome.  When making an integrated contribution in a cross-tested plan, you must use the taxable wage base as your integration level or else the test won’t work.  Assuming a 10%-of-pay contribution to his employees, Mr. Adams would receive about $1,000 more (0.355% of pay) with an integration level equal to 80% of the wage base plus $1.00 vs. the taxable wage base.  He would be better off in 2019 with a true integrated plan.

Thus, one of the few times we would recommend not using cross-tested language in a plan is when the integrated allocation works best right now and appears that it will continue to be best in the future.  In that case, put integrated language in your plan document and allow yourself to pick an integration level other than the taxable wage base.  If there’s a good chance the plan will utilize cross-testing now or in the future, then give yourself the most flexibility and put cross-tested provisions in your plan.

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— Topics: 401(k), cross-tested, integrated