The Basics of New Comparability Plans

New comparability plans are qualified defined contribution plans that allow an employer to allocate different profit-sharing contribution percentages to different groups of employees at the employer’s discretion. These plans are subject to complicated discrimination tests that take into account the equivalent benefit at retirement of the current contribution allocated to each participant. Specifically, new comparability plans are profit-sharing plans designed so owners and highly compensated employees can receive higher contribution amounts while minimizing allocations for staff.

To compare the most popular types of profit-sharing plans

• In a traditional profit-sharing plan, all employees would receive the same percentage of compensation,
• In an integrated profit-sharing plan, employees whose wages exceed the social security tax limit get an additional contribution up to 5.7% of the wages between the social security wage base and the maximum plan compensation under IRC Section 401(a)(17)
• In an age-weighted plan, an older owner could get the same allocation as a staff employee of the same age
• In a new comparability plan an older owner can receive a large contribution while providing a lower rate of contribution for staff employees. In fact, through a new comparability plan, employers are able to allocate different levels of contribution for different classes of employees. Many new comparability plan documents allow for maximum flexibility by designating each employee as his or her own rate class.

Generally,

• Employees are divided into two or more groups based on age, length of service and/or compensation
• Each group in the plan receives a different level of contribution
• Separate classes are defined in the plan document while the contribution percentage can be determined each year

The allocation flexibility is not unlimited. The plan must pass discrimination testing. New comparability plans work best when there is a big disparity in compensation and/or age between the owner and any favored employees and the rest of the workforce.

The nondiscrimination tests include

A minimum allocation gateway test, which, as its name implies, is the gateway to cross-testing, which compares the equivalent benefit at normal retirement age for each participant. The minimum allocation gateway test requires that the lowest allocation rate for a Non-Highly Compensated Employee is at least one-third of the highest allocation rate for a Highly Compensated Employee (HCE), or a minimum 5%. Nondiscrimination testing must use the 415(c ) definition of compensation regardless of the definition of compensation in the plan’s adoption agreement. In general, 415(c) comp is gross wages including any pre-tax salary deferral.

Below are two examples of a Minimum Allocation Gateway test where the highest allocation rate was not more than 3 times as much as the lowest allocation rate:

The following example illustrates a plan that meets both the 1/3 test and also the 5% gateway allocation:

IRS Sec. 1.401(a)(4)-8(b) regulations allow 401(a)(4) cross testing (i.e. contributions can be tested as equivalent benefits) if:

1. If the plan passes the Minimum Allocation Gateway Test
2. The plan has Broadly Available Allocation Rates (i.e. for the group of employees at each allocation rate or higher, the group passes 410(b) without regard to the average benefit test of 1.410(b)-5 (i.e. generally it passes either the ratio percentage or the nondiscriminatory classification test), or
3. The plan has Age-Based Allocation with either a gradual age or service schedule (i.e. smoothly increasing allocation rates that an NHCE can grow into with increasing age or service) or is based on a Uniform Target Benefit Allocation

The 401(a)(4) Gateway can be passed by passing with All participants tested together or by passing with the otherwise excludable participants tested separately.

Under the gateway test, the lowest permissible allocation rate for any non-HCE is one-third of the highest allocation rate for any HCE who benefits. However, as long as each non-HCE receives an allocation of at least 5% of compensation, the gateway is deemed satisfied.

• General nondiscrimination testing (often referred to as new comparability testing) involves applying minimum coverage testing principles to every rate group, as defined by testing criteria. A rate group exists for every HCE and all others benefiting at the same or higher testing rate. Each rate group must yield a nondiscriminatory ratio of HCEs and non-HCEs benefiting from that testing rate. The specifics of this test are beyond the scope of this article.
• Cross-testing— Cross-testing, also known as “new comparability”, is a method that converts a contribution into a projected retirement benefit. The projected retirement benefits for all participants are then tested to ensure that the allocations are not discriminatory. Most often, testing rates are developed by converting contributions into projected benefit amounts at normal retirement age (NRA). Those amounts are then converted into a single life annuity and divided by compensation to form a testing percentage. These rates are referred to as equivalent benefit accrual rates (EBARs). Generally, cross-testing is very effective, as non-HCE populations are usually much younger than their HCE counterparts. In converting to EBARs, a reasonable rate of interest is applied to each individual’s contribution amount for the number of years remaining to the participant’s NRA. Cross testing computations recognize that a $1,000 contribution is more valuable for a young participant’s retirement than it is for a participant who is close to normal retirement age.
• If the plan is not a safe harbor 401(k) plan, then the deferrals will be subject to the average deferral percentage (ADP) discrimination test and employer match contributions must satisfy the average contribution percentage, or (ACP) test.
• Plans must also monitor 402(g) maximum deferral limits, maximum annual addition limits under Section 415 and maximum compensation under 401(a)(17).

The following chart illustrates how a plan sponsor and its Third-Party Administrator (TPA) may design a new comparability plan to maximize the owner’s contributions:

Please refer to our limits blog for a link to the IRS announcement of the limits affecting retirement plans.

Contributions that count toward the gateway minimum include profit-sharing contributions, top heavy contributions, and forfeitures. Contributions that don’t count toward the gateway minimum include employer match, salary deferrals, and safe harbor match. Nonelective safe harbor contributions are an efficient use of employer contributions because they do triple duty ensuring that HCEs can defer the maximum allowed under IRC Section 402(g), count towards the new comparability gateway minimum allocation rate that NHCEs must receive in a cross tested plan and satisfy the minimum required employer contribution in a top-heavy plan.

New comparability plans make sense for businesses that want to maximize employer contributions for older, higher-paid owners and key employees while providing a modest contribution for younger employees. If you and your accountant or financial advisor think a new comparability plan is right for your business, you must consult with a TPA to determine the appropriate plan design for your business and conduct the required discrimination testing annually.