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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