A Cross-Tested Profit-Sharing Plan is a type of 401(k) profit-sharing plan that allows employers to allocate contributions unequally among employees based on certain predetermined factors.  These plans are particularly attractive for businesses with a diverse workforce, varying compensation levels, and different age groups.  By using this design, employers can strategically allocate contributions to favor specific groups of employees, such as highly compensated employees (HCE) or older employees, while still satisfying the nondiscrimination testing requirements set by the Internal Revenue Service (IRS).

Here’s how a 401(k) Cross-Tested Profit-Sharing Plan works:

1.       Establishing Plan Criteria:  The employer identifies specific factors to classify employees into different groups.  Common criteria included job classification, compensation levels, age, and years of service.  Employees are grouped based on these criteria.

2.       Setting up Contribution Groups:  Once the employee groups are established, the plan sponsor creates contribution groups that consist of employees with similar characteristics.  These groups may include HCEs, non-highly compensated employees (NHCEs), different departments, or any other relevant segments of the workforce.

3.       Allocating Contributions:  The employer determines the total employer contribution to be made to the plan for a particular year.  The allocation of contributions is based on a percentage of each employee’s compensation, typically expressed as a fraction of the employee’s salary.

4.       Passing Nondiscrimination Testing:  One of the critical aspects of a Cross-Tested Profit-Sharing Plan is passing the nondiscrimination testing requirements imposed by the IRS.  These tests ensure that the plan does not unfairly favor HCEs and discriminate against NHCEs.

a.       Coverage Testing:  The plan must cover a sufficiently broad group of employees, including both HCEs and NHCEs, to ensure it does not disproportionately benefit higher-paid employees.

b.       Actual Deferral Percentage (ADP) Testing:  The ADP test compares the average deferral percentages of HCEs to those of NHCEs.  If the difference between these two groups is substantial, corrective actions may be necessary.

c.       Actual Contribution Percentage (ACP) Testing:  The ACP test examines the employer matching and profit-sharing contributions made to HCEs versus NHCEs.  Like the ADP test, any significant disparities may require corrections.

5.       Corrective Actions:  If the plan fails any of the nondiscrimination tests, the plan sponsor has options to correct the imbalance.  Corrective actions may include returning excess contributions to HCEs, implementing a Qualified Non-Elective Contribution (QNEC) for NHCEs, or adopting a Safe Harbor 401(k) plan design to bypass the testing altogether.

6.       Annual Review and Adjustment:  Cross-Tested Profit-Sharing Plans should be reviewed annually, considering the company’s financial situation, workforce composition, and retirement objectives.  Adjustments may be made to the contribution allocation to remain compliant and align with the company’s goals.

It’s important to note that implementing a Cross-Tested Profit-Sharing Plan requires careful planning and consultation with retirement plan experts, as the design can be complex and must comply with IRS regulations.  Plan sponsors should work closely with a qualified retirement plan advisor to ensure proper plan design, administration, and compliance with all regulatory requirements.