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Final Regulations for Defined Contribution Plans that Test Nondiscrimination on a “Benefits” Basis

Background  A “cross-test” contribution allocation formula tests nondiscrimination based on “benefits” (not the contribution amount) provided to the highly compensated employees (HCEs) compared (or “cross-tested”) to the benefits for the nonhighly compensated employees (NHCEs). 

The plan specifies that the eligible plan participants fall into two or more “classes.”  Each class receives a different contribution allocation percent as long as the plan satisfies the law’s general nondiscrimination requirement.

The contribution for each employee is converted to an equivalent benefit rate or "EBR."  The EBR is determined by projecting the contribution allocated to each plan participant to age 65 at a specified interest rate (e.g., NHCE, the 3% of compensation contribution allocation for a 25 year old is projected to age 65 at 8½%). 

The nondiscrimination test compares each  NHCE EBR to each HCE EBR.  The plan complies with the law’s general nondiscrimination requirements as long as the result of this comparison falls within certain IRS specified parameters.

Final Regulations  Effective for plan years beginning in 2002, a Defined Contribution Plan using a “Cross-Test” allocation formula must satisfy a “Gateway Test” before it is permitted to test nondiscrimination on a benefits basis.  The “Gateway” provides a minimum allocation rate for the NHCEs that will pass one of the following:

1.       The “One-Third Test”  The lowest permissible allocation rate for any benefiting NHCE is one-third the rate for the highest allocation rate for any HCE (a 3:1 ratio) (e.g., 3% for NHCEs, 9% for HCEs); or

2.       The “5% Test”  The minimum “floor” allocation rate if the allocation ratio is more than 3:1 (e.g., 5% for NHCEs, 20% for HCEs). 

A Defined Contribution Plan using “Age-Based” allocations is not subject to these Gateways.  However, an “age-based” allocation yields a different contribution allocation percent for plan participants based on attained age not rate groups. 

The sponsoring employer must be mindful that these “age-sensitive” allocation methods provide the desired outcome as long as the relative ages and HCE/NHCE population remains static.  If the NHCE population gets older than in a prior year relative to the HCE population (or if the HCE population gets younger), a higher contribution % will be necessary to pass nondiscrimination.

Full Text of Treasury Regulation §401(a)(4)-8

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© 2002 Milberg Consulting LLC  All Rights Reserved

We intend the information in this publication as a general resource, not as legal or plan compliance advice or counsel. If you consider any actions discussed herein, we suggest that you consult a tax or ERISA professional. Milberg Consulting LLC and Barry R. Milberg do not warrant and are not responsible for any errors and omissions from this information.