A fundamental requirement for every qualified retirement plan is that the benefits or contributions be provided in a manner that does not discriminate in favor of highly compensated employees (HCEs). The IRC requires a qualified plan to demonstrate its compliance with this nondiscrimination requirement by satisfying a particular test. Some tests are specific to the type of contribution. For example, a 401(k) plan demonstrates its compliance by having its salary reduction contributions satisfy the actual deferral percentage (ADP) test and its matching contributions satisfy the actual contribution percentage (ACP) test.
Other types of contributions or benefits must demonstrate compliance by passing other tests. Typically, profit sharing or discretionary contribution plans will prove their contribution or benefits are nondiscriminatory by allocating the contributions as an equal percentage for all participants. This formula satisfies a regulatory “safe harbor” test.
The effect of using the general test or cross-testing described below is to permit a plan to target HCEs for what could be relatively large contributions (the maximum of $49,000 for 2009 for a defined contribution plan) and make significantly lower contributions to non-highly compensated employees (NHCEs).
THE GENERAL TEST FOR CONTRIBUTIONS
A discretionary contribution plan can show that its contributions or benefits do not discriminate in favor of HCEs by satisfying a fairly complex objective test described in the regulation. The basic test or what the regulation describes as the “general test” for defined contribution plans, works as follows (see Treas. Reg. § 1.401(a)(4)-2(c)):
1. Determine allocation rates for all participants. An allocation rate is determined by taking the sum of all employer contributions and forfeitures allocated to the participant’s account for the year and dividing it by the participant’s annual compensation.
2. The allocation rates for all participants are compared by rate groups. A rate group exists for each HCE. A rate group for a particular HCE includes all participants, both HCEs and NHCEs, who have an allocation rate equal to or greater than the HCE.
3. Each rate group is treated as if it were a separate plan and as such each rate group must then satisfy the coverage rules of IRC § 410(b).
Specifically, each rate group must satisfy either of the typical coverage tests provided under the IRC:
a. 70% ratio percentage test; or
b. The average benefits test.
In lieu of the general test that tests contributions to HCEs in comparison to the contributions for NHCEs, a defined contribution plan can test contributions on the benefits such contributions could theoretically provide. Because the plan is testing contributions based on the benefit provided, it is “cross-testing.” Cross-testing works as follows (see Treas. Reg. § 1.401(a)(4)-8(b)):
1. Determine the increase in the participant’s account. (Typically, this is just employer contributions and forfeitures).
2. Project that amount with interest to a testing age (typically age 65). The interest rate is between 7.5% and 8.5%.
3. The amount determined in Step Two is converted actuarially into a straight life annuity at the testing age using a standard mortality table specified in the regulations and an interest rate between 7.5% and 8.5%. This is done for every participant.
4. The annual annuity amount so determined is divided by the participant’s annual compensation and creates an “equivalent accrual rate.”
5. The equivalent accrual rates are then tested in the same manner as the general test described above as if they were allocation rates.
SPECIAL RULES FOR CROSS-TESTING
Because cross-testing can result in very large disparities between the contributions to HCEs who are typically older and the contributions to NHCEs who are typically younger, to demonstrate nondiscrimination, a plan must either have broadly based allocation rates (also known as rate group testing) or pass a fixed “gateway.”
An allocation rate is broadly based if it is available to a group of employees that would satisfy the 70% ratio percentage test under section 410(b). In addition, an allocation rate is broadly available if the rate increases as a participant ages or accumulates additional service. All participants in the plan must be able to potentially “grow” into the increasing rate. The rates must also increase smoothly at regular intervals of age or service.
A plan does not need broadly based allocation rates if it passes either of two gateways: (1) Each NHCE has an allocation rate that is at least one-third of the allocation rate of the HCE with the highest allocation rate (for example, if an NHCE gets a 3% allocation rate, the maximum allocation rate for HCEs can only be 9%); or (2) each NHCE receives an allocation of a contribution of at least 5% of compensation.
Dale R. Vlasek , Esq., chairs the employee benefits practice group at McDonald Hopkins LLC in Cleveland. His e-mail address is email@example.com.