Maximizing Retirement Savings Through Cross-Testing: A Strategic Approach for Plan Sponsors

Bottom Line Up Front

• Cross-testing is a strategic method in retirement planning that allows for the fair and tailored allocation of profit-sharing contributions, focusing on individual employee needs based on their age and compensation.
• This approach ensures higher contributions for older, highly compensated employees while maintaining fairness and compliance with regulatory standards, using methods like age-weighted and new comparability.
• The cross-testing method is most beneficial for companies with diverse employee demographics, particularly where older, higher-earning employees, like owners and key executives, seek to maximize their retirement contributions.

Cross-testing is a strategic calculation used by retirement plan sponsors to allocate discretionary profit-sharing contributions. It’s a popular choice, often combined with 401(k) and safe harbor contributions, to maximize annual contribution limits for owners while minimizing overall costs. This approach aligns with the goal of allowing owners and key employees to enhance their retirement savings effectively.

Understanding Cross-Testing

The core of cross-testing lies in considering employees’ ages, recognizing that older employees have less time to save and therefore need to allocate more towards their retirement savings compared to their younger counterparts.

How Does Cross-Testing Work?

Consider a simple analogy: a pizza party. Just as people have different appetites, employees have different retirement savings needs. ‘Big Eaters’ (older, higher-earning employees) desire a larger share of the retirement savings ‘pizza’, while ‘Little Eaters’ (younger, lower-earning employees) are content with smaller portions. Cross-testing ensures everyone gets a fair share relative to their ‘appetite’.

1. Big Eaters:  These are the employees who earn more money or are older and closer to retirement. They want a bigger piece of the retirement savings “pizza” because they are closer to retirement age or need more money when they reach retirement. 
2. Little Eaters: These employees are those who earn less money are younger and have more time before retirement. They’re okay with a smaller piece of the “pizza” since they don’t need as much right now and they have more time to save before retirement. 

In a regular retirement plan, everyone might get the same-sized slice of the “pizza,” which isn’t always fair. However, cross-testing helps make sure that different employees get a fair amount of retirement savings based on their individual needs and circumstances. 

Traditional Contribution Methods vs. Cross-Testing

Traditional contribution methods, like uniform or pro-rata allocation, often distribute retirement contributions equally or proportionally among all employees. Cross-testing, however, adopts a more nuanced approach. It considers factors like age and compensation, using benefit accrual rates to project the value of an employee’s retirement portfolio at retirement age, leading to a more equitable distribution of contributions. 

A cross-tested plan is most effective when your Highly Compensated Employees (HCEs) are of a higher age bracket compared to the rest of your employees. Given that owners typically fall into an older age group than a significant portion of their employees, this plan can be exceptionally advantageous. 

Key Concepts for Cross-Testing

Cross-testing retirement plans involves several key concepts that help ensure fiar and compliant allocation of contributions among different employee groups. Here are a few of those key concepts:

1. Employee Grouping: Employees are divided into distinct groups based on specific criteria, such as age, compensation, or job classification. These groups serve as the basis for determining how contributions are allocated.
2. Age-Weighted Method: Older employees receive higher contributions, reflecting their shorter saving period.
3. New Comparability Method: Different groups receive varying contribution rates.
4. Equivalent Benefits: A fundamental principle in cross-testing is that all employees, regardless of their group, receive an equivalent retirement benefit. Even though contribution amounts may differ, the retirement income replacement ratio is intended to be similar for all employees.
5. Non-Discrimination Testing: Retirement plans must pass nondiscrimination testing to ensure that they don’t unfairly favor highly compensated employees (HCEs). Cross-testing plans go through these tests to demonstrate compliance and fairness in benefit allocation. These tests make sure the retirement plan is fairly benefitting everyone by looking at how much each employee defers, company contributions to each employee’s account, and how much of the plan’s assets belong to the HCEs.
   • There are two annual nondiscrimination tests for 401(k) plans, the Annual Deferral Percentage (ADP) and the Actual Contribution Percentage (ACP) test.
   • For profit-sharing allocations, they will need to pass testing under IRC 401(a)(4) and IRC 410(b) – basically are benefits offered to a non-discriminatory group of employees and that the benefits do not overly benefit the HCE group.

Benefits and Advantages of Cross-Testing

Cross-testing allows for higher contributions to key employees and promotes fairness and compliance with regulations. It tailors contributions based on individual needs, benefiting those closer to retirement while still supporting younger employees. 

Real Life example (showcases the impact of cross-testing on contribution limits) 

Consider ABC Enterprises with two employees, Sarah (owner, higher salary, older) and Michael (younger employee, lower salary).

In a regular retirement plan without cross-testing, both Sarah and Michael might receive the same percentage of their salary as contributions, let’s say 5%. However, if ABC Enterprises uses cross-testing, they might group Sarah as an HCE and Michael as an NHCE which would allow for a more strategic allocation of contributions based on their needs. 

In this example, cross-testing has allowed ABC Enterprises to maximize contributions while staying within regulatory limits. Sarah benefits from the larger contribution percentage due to her age and income level and Michael receives a smaller contribution percentage, reflecting his longer time for the contribution to grow. 

It’s important to remember that these contributions must be tested for nondiscrimination annually under IRC 401(a)(4) and IRC 410(b) to ensure that the benefits do not overly benefit the HCE group. Before that testing may even be done, the contributions just pass a “gateway” test such that each NHCE must receive the lesser of ⅓ or 5% of the employer contribution made for any HCE.

Eligibility and Considerations for Cross-Testing 

When considering cross-testing for your defined contribution plan, you should evaluate factors like your employee demographics, owner/key employee objectives, contribution goals, budget, and company growth. 

1. Employee Demographics: Cross-testing works best when you have a diverse employee group with varying ages and compensation levels.
2. Owner/Key Employee Objectives: If you’re seeking to maximize your contributions as an owner or key employee, cross-testing can be beneficial. 
3. Contribution Goals: Cross-testing is ideal when you want to allocate contributions in a way that rewards long-serving employees or those closer to retirement, while still offering benefits to younger employees. 
4. Budget and Cost Considerations: Make sure to determine if the potential increase in contributions aligns with your budget and how it may impact your overall plan costs. 
5. Company Growth and Changes: Consider how cross-testing will adapt as your company evolves. Will it still be effective as your workforce grows or changes over time?

Implementing Cross-Testing

Implementing cross-testing in your retirement plan involves a structured process that starts with evaluating your plan’s unique needs and objectives. Here’s a simplified guide to help you get started: 

1. Assess your Employee Demographics: Begin by analyzing your employee population, considering factors such as age, compensation, and job classifications. Cross-testing works best if you have a diverse workforce with varying attributes. Identifying distinct employee groups will form the basis for contribution allocation. 
2. Design Your Plan: Work with retirement plan experts to design a plan that aligns with your goals and your employees’ needs. This includes selecting the cross-testing method that best suits your objectives, whether it’s age-weighted or new comparability. Ensure that your plan complies with IRS regulations and non-discrimination testing requirements. 

Remember to communicate the changes to your employees. Transparency and clear documentation are essential to ensure that your team understands how contributions are allocated and the potential benefits of their savings. 

To Sum It Up: The Importance of Cross-Testing in Modern Retirement Planning

Cross-testing is a powerful tool to maximize contributions while ensuring fairness and regulatory compliance. This method takes into account the diverse needs and circumstances of employees, recognizing that not everyone requires the same-sized “slice of the retirement savings pizza.” It’s increasingly relevant in today’s complex retirement planning challenges like rising healthcare costs and diminishing social security benefits. 

For personalized guidance on retirement planning and the benefits of cross-testing, contact our team of experts. We’re here to help you navigate retirement planning complexities and tailor solutions to your unique needs.