“New Comparability” testing is an IRS approved method for testing non-elective profit sharing contributions made to a defined contribution retirement plan (or a defined contribution plan used in concert with a defined benefit (i.e. cash balance) plan) which allows for non-discrimination testing to be performed with regard to the benefit rather than the contribution. Because it tests benefits in a defined contribution plan, it is also known as cross-testing.
In many defined contribution plans, non-discrimination testing is not necessary. For example, in a plan which uses only statutory exclusions for eligibility and makes profit sharing contributions on a pro rata basis or as a set dollar amount to all eligible employees, those profit sharing contributions are by definition non-discriminatory because they are allocated to all employees, HCEs and nHCEs, in the same manner.
With cross-testing, however, a plan can permissibly use different allocation rates for different groups of employees. Depending on demographics, this can result in significantly higher profit sharing allocation rates for principals/HCEs versus those for nHCEs. To get to this result, there are a few hoops to jump through, and a number of additional concepts that need to be understood by the administrator.
The first hoop to jump through is the minimum allocation gateway contribution. As its name implies, this is the prerequisite for being allowed to use cross-testing in a profit sharing plan. Thus passing it does not mean that the plan has passed non-discrimination testing for the year, only that they have met the preliminary requirement for testing contributions on a benefits basis.
The reason the gateway contribution exists is to prevent principals from making contributions to very low paid employees which might equal a high percentage of their total pay, thus skewing testing and allowing them to contribute large sums to themselves while making miniscule payments to the bulk of the rank and file employees.
Simply stated, the minimum allocation gateway requires that every nHCE who benefits under the plan receive an allocation equaling the lesser of: (1) one-third the rate given to the HCE with the highest rate of allocation as a percentage of compensation; or (2) 5% of compensation as defined in IRC §415.
The compensation definition under the one-third option can be any definition that satisfies IRC §414(s), so long as it is the same for both HCEs and nHCEs, but for the 5% option it must be defined in accordance with §415, though the actual profit sharing allocation can, again, use any definition that satisfies §414(s).
In general, only employees who benefit from the profit sharing portion of the plan for coverage testing purposes need to receive the minimum allocation gateway contribution. However, special non-elective contributions may expand the group of employees required to receive the minimum allocation gateway contribution.
Employees who receive a safe harbor non-elective contribution, a top heavy minimum contribution, or a QNEC must receive a minimum allocation gateway contribution, unless they are separately tested under 401(a) as part of a disaggregated group.
(Note: There is also an exception to the gateway requirement called the “broadly available allocation rate” rule. This requires, essentially, that several nHCEs would be receiving allocation rates equal or greater to that of the HCE(s) with the highest rates (i.e. not just benefit accrual rates), or at least that those rates are “broadly available” based on a reasonable and non-discriminatory classification such as age or length of service).
401(a)(4) Non-discrimination Testing
Once the gateway test has been passed, the administrator can proceed to cross-testing. This process involves two fundamental concepts, however, which are central to cross-testing under 401(a)(4) and must first be defined based on the allocation rates being tested: EBAR and rate-groups.
The “EBAR” is a number that is reached by converting, for testing purposes, the non-elective contribution made to each employee into an accrued benefit at the normal retirement age (usually stated in the plan document, but in any case must be a uniform age for all participants), then stating that benefit in terms of the equivalent monthly benefit payable under a single life annuity beginning at retirement age, either as a percentage of compensation or as a dollar amount. This is known as the EBAR, or equivalent benefit accrual rate. In determining the EBARs of each participant, and hence in determining rate groups, elective deferrals and matching contributions are disregarded.
A “rate group” includes an HCE as well as all employees (HCEs and nHCEs) who have a rate of accrual (i.e. EBAR) equal to or greater than that of the HCE upon whom the rate group is based. All HCEs have their own rate group.
401(a)(4) – Rate Group Testing
For a rate group to pass non-discrimination testing, there are two main options, both of which basically involve more or less modified versions of the 410(b) coverage rules, as applied to each respective rate group, each of which must pass on its own (i.e. as if the employees covered were the only participants in the plan). Technically, a rate group need only pass one of the tests. However, in practice, it would be very rare that a group would pass the first option and not the second, and in such a hypothetical case it would seem very difficult for the plan as a whole to pass if any other rate group is relying on the second option.
Option 1: The Ratio Percentage Test
To perform this test, you must first divide the number of nHCEs in the rate group (i.e. with an EBAR greater than or equal to the relevant HCE’s EBAR) by the total number of nHCEs benefiting under the plan (i.e. receiving non-elective/gateway contribution). Then divide the number of HCEs in the group by the number of HCEs benefiting under the plan. If the first quotient is greater than or equal to 70% of the second quotient, then the rate group passes.
Option 2: The Average Benefits Test
This test has two parts – the average benefits percentage test and the non-discriminatory classification test. Both parts of the test must be passed by the rate group in order to use this option to pass 401(a) general non-discrimination testing.
a) Average benefits percentage test: Convert all annual additions that would be counted under the 410(b) average benefits test (i.e. deferrals, match, all non-elective, and forfeitures of any kind) to an EBAR for each eligible employee. To pass, the average EBAR for all nHCEs (other than those excluded from the plan by a statutory exemption) must be greater than or equal to 70% of the average EBAR for all HCEs. Thus, because of the requirements, if any rate group uses this test to pass 401(a) testing, the plan as a whole must pass as well.
b) Non-discriminatory classification test: this test is basically a less stringent version of the ratio percentage test, whereby the same calculation is made for each rate group, only the minimum requirement, instead of 70%, is equal to a percentage between 20-45% depending on the “concentration” of nHCEs within the company. The exact percentage is the mid-point between a so-called “safe harbor percentage” and an “unsafe harbor percentage.” (The names are somewhat misleading, because it is actually the mid-point which is the “safe harbor”). These numbers can be found in a chart provided for this purpose by the IRS. (Basically, the formula begins with a safe harbor percentage of 50 and unsafe harbor percentage of 40 for an nHCE concentration percentage of 0-60. The safe and unsafe harbor percentages each decrease by .75% with each 1% increase in the nHCE concentration, and the unsafe harbor has a lower limit of 20%). Excludable employees are ignored.