Cross-testing is a plan design concept which allows a company to define classes of employees and contribute profit sharing contributions on a percentage basis to each class. Cross-testing works best in a company which has a business owner who is slightly older than the rest of the employees. Annually, the contribution formula must pass an average benefits test. In addition to the average benefits test, the plan must also satisfy a minimum allocation gateway where each non-highly compensated employee (NHCE) in the plan has an allocation rate that is at least one-third of the allocation rate of the highly compensated employee (HCE) with the highest allocation rate, or, each NHCE receives an allocation percentage of at least 5% of the NHCE's compensation.
For clients who want to utilize cross-testing and safe harbor but want to contribute the minimum total amount and receive the maximum individual amount available, the owner would receive 9% of compensation and the other eligible employees would receive 3%, which passes the allocation gateway described above.
A cross-tested plan allows the business owner to allocate a higher contribution rate to the owner and other highly compensated employees while also providing a benefit to the rest of the employees. In a typical cross-tested plan, HCEs receive a higher allocation rate, often 14% to 25% of compensation, while NHCEs, regardless of their age or years of service, receive comparatively lower allocation rates of 5% or less of compensation. The business owner could also allocate different contribution percentages to different groups of employees in order to reward them differently.
In conjunction with a safe harbor 401(k) plan (see Safe Harbor 401(k) Plan article), cross-tested contributions allow the owners and highly compensated employees to maximize their employee 401(k) contributions up to the limit for the year without any testing issues. The cross-tested contributions also may allow the owners and highly compensated employees to maximize their total contributions for the year in accordance with the annual limit.
In the example below we have demonstrated two business owners at different wage levels receiving the maximum 401(k) contribution amount of $18,000 plus $6,000 as a catch-up contribution by utilizing the Safe Harbor Non-Elective 3% contribution. The company is also contributing Profit Sharing contributions of 1.42% to the employees and 10.21% to the owners, which are subject to the plan’s normal vesting schedule. Under this scenario, the business owners receive 73% of the employer contributions.
|Cross-Tested Profit Sharing with Safe Harbor Non-Elective 3% Example|
|Percent to Owners||100%||47%||87%||85%|
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