What is Cross-Testing?

Cross-testing, also known as "New Comparability" testing, is an advanced method used in certain defined contribution retirement plans, such as profit-sharing plans, to provide varying levels of contributions across different groups of employees. Unlike traditional testing methods, which evaluate the contributions based on the current year’s allocations, cross-testing assesses the benefits each group will receive at retirement. This distinction allows for greater flexibility in plan design and can make it easier to meet non-discrimination requirements under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC).

In traditional retirement plan testing, contributions are generally required to be uniform across all employees to avoid discrimination against lower-paid employees. However, cross-testing allows employers to allocate contributions in a way that benefits older or higher-paid employees more, while still passing the required non-discrimination tests. This is achieved by converting current contributions into projected retirement benefits using factors like age, expected retirement age, and salary growth. The resulting equivalent benefit values are then compared across different employee groups, such as highly compensated employees (HCEs) and non-highly compensated employees (NHCEs).

For example, in a cross-tested plan, an employer might allocate a higher percentage of salary to older employees who are closer to retirement. Since these employees have fewer years to accrue benefits, their contributions are weighted more heavily when converted into future benefits. This allows the plan to skew benefits in favor of key employees while still passing IRS non-discrimination tests. By focusing on the end benefit rather than the current contribution, cross-testing provides a strategic advantage for businesses that want to maximize retirement benefits for certain employee groups.

However, cross-testing is complex and requires careful plan design and annual testing to ensure compliance with IRS rules. Employers typically need the assistance of actuaries or retirement plan specialists to conduct these tests accurately. If the plan fails to pass the cross-testing requirements, it may need to increase contributions for lower-paid employees or make other adjustments to comply with non-discrimination regulations. Therefore, while cross-testing offers significant flexibility and potential benefits, it also involves a higher administrative burden.

In conclusion, cross-testing is a valuable tool for employers who wish to tailor their retirement plan contributions in a way that favors specific groups, particularly older or higher-paid employees, without violating ERISA's non-discrimination rules. It allows for a more customized and potentially more advantageous retirement plan, but requires careful management to ensure ongoing compliance.

References:

[1] Internal Revenue Service. (2021). Retirement Topics - Cross-Testing. Retrieved from https://www.irs.gov/retirement-plans/retirement-topics-cross-testing 

 [2] U.S. Department of Labor. (2020). Understanding Retirement Plan Fees and Expenses. Retrieved from https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/publications/understanding-retirement-plan-fees-and-expenses 

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