What Is Cross-Testing and Is It Worth the Cost?

You may have seen it on a recent invoice or heard it come up in conversations about your 401(k) plan, but cross-testing your 401(k) plan’s profit sharing contribution (a.k.a. New Comparability) often results in an additional fee levied by your TPA so perhaps it’s worth understanding more about it so you can decide whether it’s worth the cost!

Company contributions are tested each year for Non-Discrimination

Traditionally, allocating a profit sharing contribution is based on either a flat-dollar amount or a uniform percentage of eligible compensation. In order to demonstrate that the allocation of this benefit satisfies the IRS conditions for “non-discrimination”, these two approaches are tested for Coverage by comparing the ratio of employees classified as “highly compensated” (HCE) who benefitted from the contribution to the ratio of everyone else (NHCE) who benefitted. As long as the NHCE ratio when divided by the HCE ratio results in a figure of 0.7 (70%) or more, the test passes coverage; simple! A participant would typically be prevented from benefiting if they either did not meet the “allocation conditions” (e.g., 500 hours worked during the year, employed on the last day of the plan year) or were a part of an excluded class of employees. A common coverage failure is when a significant amount of the NHCE cohort do not receive a benefit due to failing to meet the allocation conditions. In order to remedy this issue, a plan amendment may be necessary to allow more NHCEs to benefit, or your plan may include a process to have this correction occur automatically. The bottom line is that you can’t fail Coverage!

Why call it “cross-testing”?

Unlike the traditional methods which look only at compensation, cross-tested profit sharing allocations take both compensation and participant age into account when determining whether non-discrimination is satisfied. Since age is now a factor, the non-discrimination tests (yes, there are quite a few now) resemble more how pension plans are tested. Since 401(k) plans are classified as “defined contribution” (DC) plans and most pension plans are “defined benefit” (DB) plans, the concept of testing a profit sharing plan like a pension plan led to the terms “cross-testing” and “New Comparability” being created to allude to this strategy.

Why would I want to consider including age as a factor in my profit sharing allocation? 2

Long story short, instead of simply looking at dollars as only a percentage of income to see if it’s fair to everyone, projecting those dollars into what they’re worth once a participant reaches retirement age before making that determination could open up a fantastic opportunity! The IRS code allows for an assumed 8.5% annual rate of return on benefits made to employees when evaluating the projected benefit at retirement. Using a number of factors, including actuarial tables and current participant age and compensation, each participant’s contribution is converted to an “equivalent benefit at retirement” (EBAR). Imagine a $1,000 benefit provided to a 25 year old in a 401(k) plan with a retirement age of 65 versus a $10,000 contribution made to a 55 year old in that same plan… If they both made $50,000 in compensation that year, the traditional allocation method couldn’t allow it. However, if we’re talking about what those contributions might be worth to each of them once it’s compounded in the market for the time it takes for them to hit retirement age, all of a sudden that ten-fold contribution to the senior employee doesn’t seem so unfair, does it? Well, the IRS agrees (and that’s what’s most important)! Are the owners of the company older than the average employee and might suppress their wages a bit to keep the business afloat? Well, fancy that!

What else can cross-testing do for my plan?

Since traditional DC plans define the contribution as what was received as a benefit that year, there is no room for considering other factors (e.g., tenure, individual performance) when making a profit sharing contribution. However, cross-tested plans allow sponsors to provide different benefits to different groups or classes of employees, even going so far as allowing them to treat everyone individually when designing their allocation! Ultimately, regardless of the groups defined or the individuals chosen for improved benefit, everything boils down to the EBARs when deciding if everything is fair.

 What’s different about testing a cross-tested allocation, then?

You guessed it: Now we’re looking at EBARs instead of just looking to see who’s benefiting to determine whether the profit sharing allocation passes non-discrimination testing. Yes, the traditional Coverage test, IRC §410(b), may be used in cross-tested plans, but it’s applied a little differently now. Here’s what cross-tested plans have to go through to demonstrate passing Coverage:

  • The Gateway Test, plus
  • Rate Group testing, where HCEs are put into separate groups and must pass either
    • The Ratio Percentage Test, or
    • The Average Benefit Test, which means you have to pass:
      • The Nondiscriminatory Classification Test, and
      • The Average Benefit Percentage Test

Honestly, each of these tests could warrant their own articles but here’s the gist:

  1. You gotta pass Gateway in most cases which requires a minimum allocation to NHCEs equal to the lesser of 1/3rd the rate of the HCE with the highest rate or 5%. This means some HCEs can receive nothing at all (this may be a good strategy to leverage when trying to pass these other tests).
  2. Now we use EBARs to figure everything else out. First, we set our Rate Groups, one for each HCE (unless some share the same EBAR). The Rate Group will look to see how many NHCEs have an EBAR greater or equivalent to that HCE’s. As the Rate Groups progress, all participants regardless of whether they’re HCE or NHCE are reflected in the subsequent groups. All three tests described above are applied to each Rate Group. If the Ratio Percentage test for any Group is less than 70%, you’ll need to pass both components of the Average Benefit Test,
  3. The Average Benefit Percentage Test is also applied to the plan as a whole and compares the average EBAR of HCEs to that of the NHCEs, and as long as the NHCE rate is better than 70% of the HCE rate, you’re good! However, if it’s not better than 70%, as long as all of the individual Rate Groups pass Coverage using the Ratio Percentage Test, then you still pass.

Clear as mud? Well, I did my best! Is it worth the cost? As long as your ability to make profit sharing contributions meets your expectations, perhaps even opening up the opportunity for you to cut yourself a bigger piece of the pie, any additional cost for this service can take the appropriate perspective. There are plenty of strategies plan sponsors can use to try to claim as great of a percentage of the overall plan contribution, and we here at Benefit Resources have been helping them do just that for coming up on 37 years now. Not all providers’ skill sets are made equal: Whether you already have a cross-tested plan or if you’re not sure if it’s right for you and your team, feel free to reach out to us for a complimentary analysis!


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