In previous years, choosing a profit sharing allocation method was simple. Pro-rata, percentage of compensation or a formula utilizing the social security wage base just to name a few. However, in the 1990’s, a new method for determining nondiscrimination in benefit allocations was introduced. The new method of calculation is called “New Comparability”.
A new comparability plan allows a plan sponsor to maximize the plan contributions to the older, higher-paid owners (HCE’s) while minimizing allocations to younger, lower-paid employees. New comparability plans designate employees into different groups or categories and each category may have a different contribution formula.
All qualified retirement plans are required to provide benefits that do not discriminate in favor of highly compensated employees (HCE’s). The IRS Code demands that these plans illustrate nondiscrimination compliance by satisfying specific tests as they relate to each particular contribution. For example, a 401(k) plan must demonstrate its compliance by having its salary reduction contributions satisfy the Actual Deferral Percentage Test (ADP) and its matching contributions satisfy the Actual Contribution Percentage Test (ACP).
A profit sharing contribution plan needs to prove that the benefits are non-discriminatory. One method is by allocating the contributions as an equal percentage for all participants. This formula satisfies a regulatory “safe harbor test.” However, there are other types of tests that can be performed allowing benefits that are not uniform. This allows allocations that skew favorable benefits to HCE’s while providing comparable benefits to lower-paid employees.
The General Test
A complex objective test can illustrate that a plan’s discretionary profit sharing contribution does not discriminate in favor of HCEs. In simple terms, the defined contribution plans “general test” operates as follows:
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 compensation.
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 who have an allocation rate equal to or greater than the HCE.
Each rate group is treated as if it were a separate plan and as such each rate group must then satisfy the coverage rules. Each rate group must pass one of the two coverage tests provided under the Code.
While the general test compares contributions of HCE’s to NHCE’s, a defined contribution plan can “cross-test” these contributions based on the actuarial benefit these contributions could theoretically provide.
In very simple terms, cross-testing is illustrated as follows:
- Determine the increase in the participant’s account which is limited to contributions and forfeitures allocations only.
- Project this amount with interest to a testing age which is usually age 65. The interest rate is 7.5% and 8.5%.
- The amount determined above 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 each and every participant.
- The determined annuity value is divided by the participant’s compensation and creates an “equivalent accrual rate.”
- These equivalent accrual rates are then tested in the same manner as the general test described above as if they were allocation rates.
Allocation Rates versus Gateway Rates
The results of cross-testing can produce contributions to HCEs, who are typically older, and the contributions to NHCEs, who are typically younger, that are alarmingly discriminatory. To remove this illusion, the Plan must either have “broadly based allocation rates” or pass a fixed “gateway.”
Broadly Based Allocation Rates
An allocation rate is broadly based if it meets the following criteria:
- Available to all employees who are covered in the minimum coverage test under IRS Code 410(b).
- The rate increases as the participant ages or accumulates additional service.
- All participants must be able to move into the next rate group.
- The rates must increase at regular intervals for age or service.
Which Gateway to select?
To eliminate the need to utilize broadly based allocation rates, a plan can be designed to pass either of the two gateways.
- 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 a HCE gets 9% allocation rate, the allocation rate for NHCEs will be 3%); or
- Each NHCE receives a minimum contribution of at least 5% of compensation.
To General Test or to Cross Test – That is the question
When designing a plan that will permit specific HCE’s to receive the largest contribution allowed by current regulations (the maximum of $51,000 for 2013) and significantly lower contributions for the NHCE’s, a plan must utilize either the general test or the cross-testing method of proving nondiscrimination.