Cross tested retirement plan: The future of tax and asset protection planning for small business ownersArticle added by Nicholas Paleveda MBA J.D. LL.M on April 4, 2012
Nick Paleveda MBA J.D. LL.M

Nicholas Paleveda MBA J.D. LL.M

Sanford, NC

Joined: March 27, 2012

Editor's note: This article has been updated to reflect current dates, times and figures.

As the population of baby boomers need to fund more for retirement, a cross tested plan can be an ideal solution as they are generally older and more highly compensated and will achieve larger contributions on a benefits basis.


In the world of enrolled actuaries, cross tested retirement plans have been the ubiquitous choice for small business owner, physician, attorney and other professionals. In the Defined Benefit Answer Book 4th edition (Panel Publishing), the enrolled actuary G. Neff McGhie spends an entire chapter analyzing various plan options and comes to the conclusion that the cross tested, new comparability or DB/DC combination gives the business owner the largest contribution relative to a group while still maintaining compliance under the nondiscrimination rules under section 401(a)(4). Retirement plans have another advantage which is the asset protection nature of the plan. Recent case development, In Re Mortensen Case No. A09-00565-DMD, Adv. No. A09-90036-DMD. United States Bankruptcy Court, D. Alaska. July 8, 2011 demonstrated the inability of a self-settled spendthrift trust to protect assets from creditors.

Types of retirement plans

The 401(k) plan

A 401(k) plan is a plan to defer salary also known as an elective deferral plan. The 401(k) plan was passed into legislation in 1978 effective for the year 1980. Today, these plans are the most popular plans in the United States, yet the most tax inefficient.

The reasons these plans are tax inefficient is that Social Security taxes and Medicare taxes are taken out first before the assets are placed into the plan. In a pension plan or profit sharing plan, these taxes are not paid since the contributions generally come from employer contributions not employee contributions.

The reason the plans are popular is the 401(k) plan contributions generally come from the employee salary deferral and not from the company. The burden of funding is placed on the employee, not on the corporation.

The additional taxes can add up to 15.3 percent. Today, the tax load is around 13.3 percent due to the tax break that will last until 2012 under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

The 401(k) plan has advantages such as you can contribute more to the 401(k) plan than an IRA. For example, you can contribute $17,000, otherwise known as the 402(g) limit, to the 401(k) as opposed to $6,000 to an IRA. You can also add an additional $5,500 to your 401(k) if you are over age 50. Loans are also available as well as hardship withdrawals. In service withdrawals are also available to a 401(k).

The disadvantages of a 401(k) as opposed to an IRA are the administration cost can be higher since an ADP and ACP test must be completed each year. Loans and withdrawals can add additional fees.

There is a penalty of 10 percent if withdrawals are made for participants who are under age 59 ½ and they do not meet any of the exceptions under section 72(t). The stock market may make corrections prior to retirement, and the account may not be sufficient for retirement.

The IRS has certain guidelines in establishing a 401(k) plan. The rules are set forth in section 401(a) and the timing of establishing a plan is set out in Rev. Ruling 81-114. In many cases, a company will establish a safe harbor plan and contribute 3 percent of pay to the employees to satisfy nondiscrimination testing. These plans must be established by Oct. 1.

Non-safe harbor plans may be established by Dec. 31, but a plan established on Dec. 31 may receive a deduction under section 404 for employer contributions and a deferral under 401(k) for employee contributions. The plan must be in writing and communicated to the employees.
Types of 401(k) plans

There are several different types of 401(k) plans. There is the traditional 401(k) plan, the safe harbor 401(k) plan and the SIMPLE 401(k) plan. You can also have a Roth provision in the plan document along with provisions that allow loans, in service withdrawals, etc. The plan document may be a prototype, a volume submitter or even a custom plan.

Traditional 401(k) plans

In a traditional 401(k) plan, an employee can elect to defer up to $17,000 of their salary which can represent 100 percent of their salary. The employee is 100 percent vested in the amounts deferred as they are considered a form of vested compensation.

If the employer makes a contribution to the plan, such as a profit sharing contribution, the employer contribution can be subject to a vesting schedule which may be a 6-year graded vesting schedule or a 3-year cliff vesting schedule.

In many cases, the employees who are non-highly compensated employees do not defer and only the highly compensated employees defer which creates a plan failure of meeting the nondiscrimination rules and the contributions are then refunded back to the employees or a qualified non-elective contribution must be made.

Due to these plan failures, which will not be known until the end of the year, many companies elect to set up a safe harbor 401(k).

Safe harbor 401(K)

A safe harbor plan must provide for employer contributions which are fully vested. These contributions usually consist of a 3 percent of pay contribution, or a match. The 3 percent of pay contribution cannot be used to pass the gateway test to cross test a plan. The gateway test under 1.401(a) (4) basically mandates a 7.5 percent contribution to the noon-highly compensated employees who are in the profit sharing plan to allow a defined benefit plan for the highly compensated employees.(These safe harbor plans must make an election by Oct. 1.)

SIMPLE 401(k)

A SIMPLE 401(K) is not subject to nondiscrimination testing. This plan must have fewer than 100 employees who receive at least $5,000 in compensation to be a participant in the plan.

If another plan is found along with a SIMPLE plan, the SIMPLE plan is terminated and the assets are refunded. No penalty will apply according to ASPPA technical tip 71. Administration is basically following the terms of the plan document.

In all 401(k) plans, the assets are held in a trust and are in the custody of an asset manager who is also a fiduciary of the plan. A trustee who selects the platform and asset manager may be held liable for selecting the asset manager. See the LaRue v. DeWolff, Boberg & Associates et. al 128 S. Ct. 1020 (2008) Supreme Court of the United Stated decision granting standing to plan participants that file lawsuits against plan administrators.

A 401(k) plan requires information to be sent to the employees known as a summary plan description, or SPD. The SPD is created with the plan document and must be given to all plan participants. The SPD is not the plan and if found in conflict with the plan, the plan document controls (see Cigna v. Amara, 161 S. Ct. 1866 (2011) Supreme Court of United States 2011).
A plan in operation must follow rules concerning contributions, vesting, nondiscrimination testing, investment options, fiduciaries, government reports, distribution options and compliance. Eligibility and participation are also important. A participant is eligible if they are over age 21; however, if the plan document allows, a younger age may be used to become a participant.

For example, your document can allow participants who are age 18 to become eligible in the plan. Your document cannot exclude participants who are over age 21. Union employees or nonresidents may also be excluded from eligibility in a plan.

A plan can also require one year of service before an employee becomes eligible. A plan can also use a shorter period such as all employees are immediately eligible. A plan can have a two-year eligibility, however, in this case the employees are now 100 percent vested in company contributions.

A plan can provide that at least 1,000 hours of work must be done to become eligible to participate in a plan. The plan document could have a lower amount of hours, such as 700 or 500, but cannot state 2000 hours or 1100 hours to become eligible.

Contributions are limited by what is known as the 402(g) limit which this year is $17,000. Excess contributions may be carried over into a future year without penalty, but cannot be deducted in the year contributed.

The 404(a) (7) limit also applies if the participant receives contributions from more than one plan. This limit does not affect the elective deferrals, but does limit the amount of employer contributions the participant can receive. The participant can work for many corporations, but the limit is $17,000 per person under 402(g).

A SIMPLE 401(k) provides a match of up to 3 percent of compensation or a non-elective contribution of 2 percent of pay. The maximum amount that can be deferred by the employees into a SIMPLE 401(k) plan is $11,500 by the employees. The total contribution to a plan is 100 percent of compensation up to a maximum of $49,000. If the participant is over age 50, the participant can add another $2,500.

Combining plans under Section 404(a) (7)

This section is also known as the combined plan limitation. There has been a recent change allowing the deduction of both a profit sharing plan and a defined benefit plan contribution provided that the defined benefit plan is covered by the Pension Benefit Guarantee Corporation.

This law was enacted in the Pension Protection Act of 2006 to encourage pension plans to become fully funded. However, some plans are not covered by the PBGC, such as professional service providers with fewer than 25 employees (see ERISA 4021 (13)).

If the defined benefit plan is not covered by the PBGC, the tax deductible contribution to a profit sharing plan will be limited to 6 percent of pay. This can create problems in a cross tested DB/DC plan where 7.5 percent of pay is needed to pass the gateway test and perhaps additional contributions are needed to pass 401(a)-4 independently.

The maximum deduction of 6 percent of pay also uses a maximum considered compensation of $250,000 under 401(a) (17).

PBGC coverage is not elective. A plan is covered by the PBGC according to the rules of the PBGC or they are not covered. The definition of professional service providers leaves open a question of medical technicians. You may obtain a letter ruling from the PBGC if you are not clear about the status of PBGC coverage.
Other rules


The employer contributions are vested over time only if the employee remains employed by the corporation. Vesting can be graded over six years or 100 percent after three years. These schedules are deemed equivalent. Employee funds are always 100 percent vested to the employee. Employer funds may be forfeited back to the plan if the employee quits or is terminated. If the plan is terminated, the employee becomes 100 percent vested in the plan.

Beneficiary of the plan

A 401(k) may have a trust as a beneficiary. A trust must meet certain requirements. The trust must be valid under state law, irrevocable at death, the beneficiaries must be reasonably identifiable and the trustee of the plan provided with a copy which has a list of all the beneficiaries and an agreement that if the trust is amended, the trustee of the plan will receive the amendments within a reasonable time.

The documentation must be provided by Oct. 31 of the year following the year of the owner’s death.

Nondiscrimination testing

Nondiscrimination testing involves setting up two distinct identifiable classes of employees.
    1. The highly compensated employee or HCE by definition is an employee who has received more than $110,000 in compensation or is a 5 percent or greater shareholder.

    2. The non-highly compensated employee or NHCE who makes less than $110,000.
Testing compares contributions or benefits between the two groups. These tests are found in 1.401(a)-4. In a defined contribution plan, the test generally is based on a percentage of contributions to a plan.

For example, each employee received 10 percent of pay to a plan. One employee received $20,000 based on his $200,000 pay; another received $2,000 based on his $20,000 pay.

In a defined benefit plan, tests are based on a percentage of pay at normal retirement age as a form of benefit. For example, one employee receives $20,000 a year for life and another $2,000 a year for life. However, the employee who is to receive $20,000 a year for life will retire in five years and the funding is significant, where the employee who is to receive $2,000 a year for life is to retire in 45 years and the funding is very small.

Cross testing is taking the funding rules of defined benefit plans and applying them to a defined contribution plan to pass nondiscrimination testing.

401(k) plan investing

Investment options are important. Today, many insurance companies and mutual fund companies have platforms that are used to invest qualified plan funds and keep required records and valuation of the funds. A person who sells financial products to a plan may be a fiduciary to a plan was PTE 84-24 may not apply and the advisor becomes an inadvertent fiduciary.

Several cases have reached the courts regarding this issue, including Reich v. Lancaster 55. F3.d 1034 (5th Cir. 1995) and Consolidated Beef Industries v. New York Life 949 F. 2d 960 (8th Cir. 1991). Generally a fiduciary is a person who has discretionary control of the plan funds or provides investment advice to the plan for a fee or has discretionary authority over the assets.

These rules are in a constant flux as to who is a fiduciary as the Department of Labor attempts to expand jurisdiction over the advisors to the plan.
Penalty for withdrawals 72(t)

If a participant removes funds out of a plan prior to age 59 ½, the participant may be subject to an additional 10 percent tax on top of the income tax. The penalty does have several exceptions, such as uniform systematic withdrawals through life expectancy, purchase of a home etc. The penalty is 25 percent if the funds come from a SIMPLE IRA. After age 59 ½ but prior to age 70 ½, funds may be withdrawn without the penalty, just ordinary income taxes.

Early distributions that are not subject to this penalty include tax free distributions from Coverdell education savings accounts, tax free scholarships, Pell grants, employer provided assistance and veteran assistance, and first time homebuyers where the maximum amount is $410,000 and the amount is used to pay acquisition cost before 120 days.

The residence must be the main house of the person, the spouse, child or grandparent. The exception to the penalty applies if the homebuyer did not own a home during a 2-year period prior to the purchase. A qualified reservist may also be exempt if called into active duty after Sept. 11, 2001 and on active duty more than 179 days. The distributions may be from a 401(k) or 403(b) plans if made from the time of active call to close of the active duty period.

401(k) plans

A plan trustee must provide a fidelity bond. On Jan. 1, 2012, new disclosure rules concerning the commissions and fees associated with the plan will go into effect. A participant is entitled to receive summary plan descriptions, individual benefit statements and a summary of material modifications to a plan.

Reporting is on a form 5500 or a 5500EZ if a one participant plan. The reporting is made through EFAST. If a plan has not filed or filed late, this may be done through the DVFCP known as the Deliquent Voluntary Filer Compliance program, usually with a $750 penalty.


Today there are over 1.168 million attorneys in the United States. The small business owner or professional could be a target of an unjust suit that can cost them everything as they near retirement age.

Cross-tested plans have been made exempt from these lawsuits by the Bankruptcy Restructuring Act of 2005. Thus, the cross-tested plan is not only a good method for saving taxes, but also a method for protecting the asset from creditor claims.

Cross testing

Cross testing is a method used to meet nondiscrimination rules. The formula for EBAR is important to know in creating a cross tested 401(k) profit-sharing plan otherwise known as a new comparability plan.

When performing a test for nondiscrimination, the elective deferrals are not considered, as they represent employee contributions. The test is measured on the employer contributions.

A defined contribution plan such as a 401(k) profit-sharing plan uses employee benefit accrual rates as opposed to employee normal accrual rates and most valuable accrual rates which are used in a defined benefit plan. Hence the name EBAR.

John, age 60, has his employer contribute $10,000 into an annuity that will give him 5 percent for five years. Sue, age 25, has her employer contribute $2,000 one time into an annuity at 5 percent for 40 years. The plan has a normal retirement age of 65.

After five years, John will have a balance of $12,763 and Sue will have a balance of $14,080. Sue came out ahead as she had a longer time to invest the funds even though her contribution is lower. Sue is a HNCE and John is a HCE. The formula to test a plan is basically:

Amount invested * (1+ i)^

i= interest rate

^= amount of years.

Two ways to test a DC plan
    1. On an allocation basis: Regs. 1.401(a)-(4)-2

    2. On a benefits basis: Regs. 1.401(a)-(4)-8(b).
Testing on an allocation basis is simple, but in testing on a benefits basis there are two rules that must be complied with:
    1. The gateway rule under Reg. 1.401(a) (4)-(8) (b) (1). In effect Jan. 1, 2002 this can start at 5 percent of pay to a maximum of 7.5 percent of pay.

    2. The equivalent accrual rule found in reg. 1.401(a) (4)-(8) (b) (2).
There also is a special rule for target benefits found in Reg. 1.401(a) (4)-(8) (b) (3).

Future value or lump sum

The first step is to calculate the future value or what the lump sum will be in a plan where a series of deposits will be made into a plan. These series of deposits with an assumed interest rate will determine a lump sum amount. Treasury regulation 1.401(a) (4)-(B) (2) (II) (b) refers to this as normalization.

Normalization is a lumps sum amount at retirement.

The second step is to convert the lump sum into a lifetime income. The math is easy: divide the lump sum amount by the annuity purchase rate. In English, how much of a lifetime income will this sump sum give me?

Annuity purchase rates

What is an annuity purchase rate? If I give you $1 million, what will you give me as income for life at age 65 where if I die you will keep the lump sum? Two factors come into play, the interest rate assumption and the mortality assumption. The lifetime income can be:
    A. $100,000

    B. $80,000

    C. $60,000
The APR is found in regulation 1.401(a) (4)-12. If you use a standard mortality table, the annuity rate is usually expressed as an amount that would be received monthly. For example, if you give me $1,000, I will give you $6 per month. This amount will need to be multiplied by 12 to annualize the rate for testing purposes: 6x12=72 or a 7.2 percent return.

The third step is to take the benefit and divide it by the individual 414s compensation to arrive at an EBAR. Some actuaries have called this the equivalent benefit accrual rate, but the regulations never use the term EBAR. Each employee in a plan will have an EBAR and each employee in a plan is either a HCE or a NHCE.

John, age 60, makes $230,000 a year. The plan contributes $46,000 a year to John or 20 percent of pay. Sue makes $20,000 a year. The plan contributes $1,000 a year or 5 percent of pay.

It appears impossible to pass nondiscrimination testing on the basis of allocation as John receives $46,000 to Sue’s $1,000. It looks bad; a percentage of pay 20 percent as opposed to 5 percent. How do you pass nondiscrimination testing?

Look at equivalent benefits.

First, calculate John’s EBAR. The APR is 115.39 based on the 1983 IAF table of 8.5 percent (46,000* 1.085^5) *12/115.39/230,000=3.128.

John has an EBAR of 3.128.

Second, calculate Sue’s EBAR. (1,000*1.085^22)/115.39/20,000=3.129.

Sue has an EBAR of 3.129.

The HCE and NHCE are placed into a rate group. John has a lower EBAR of 3.128 then Sue’s 3.129 and the plan is deemed nondiscriminatory. Fill out your schedule Q demo 5-6 and wait for the IRS to give you a favorable opinion letter.

John received $46,000 and Sue received $1,000 and the plan is nondiscriminatory as to benefits. Why is this possible? First, the age of the participants; John is 17 years older than Sue.

Second, the compensation is different: $230,000 a year as opposed to $20,000. The maximum considered compensation for testing purposes today is $245,000. Finally the interest rate assumption used of 8.5 percent. If you used a rate of 7.5 percent a different result would take place.

John (46,000*1.075^5)*12/115.39/230,000=2.986

Sue (1,000* 1.075^22)*12/115.39/20,000=2.553

The plan fails testing.

John’s EBAR is now greater than Sue and you fail testing. But what happens if John was born in the latter half of the year and is really close to age 61 with four years to retire? If you use the age nearest birthday in testing, the EBAR is lower. Is deference given to the administrator today under Conkright v. Frommett for plan testing?

Lower EBAR: (46,000*1.085^4)*12/115.39/230,000=2.883 results when a shorter time frame is used for retirement.

The general test

Employer contributions are considered nondiscriminatory in a defined contribution plan by following a “uniform allocation method” or the “general test,” which I found in defined benefit plans. Regs. 1.401(a) (4)-2. Hence the name cross testing, since you are using the DB rules to pass testing in a DC plan.
The employer provided benefits under a defined benefit plan are considered nondiscriminatory if each rate group under a plan satisfies 410(b). A rate group consists of each HCE and all other employees who have a normal accrual rate greater than the HCE and also a most valuable accrual rate greater than the HCE.

The example found in Reg. 1.401(a) (4)-3(c)-4 provides a demonstration of rate group testing. A company has 1,100 employees. Employees 1-1,000 are considered non-highly compensated employees and employees 1-100 are considered highly compensated employees. There are 100 rate groups as there are 100 highly compensated employees.

A calculation is performed to determine the normal accrual rate and the most valuable accrual rate for each group.

Assuming Rate Groups are as follows:

NHCE 1-100 has an NAR of 1.0 and a MVAR of 1.40,

NHCE101-500 has a NAR of 1.5 and a MVAR of 3.0

NHCE 501-750 has a NAR of 2.0 and MVAR of 2.65 and

NHCE 750-1000 has a NAR of 2.3 and a MVAR of 2.80.

Next the highly compensated employees:

H1-50 has a NAR of 1.5 and a MVAR of 2.0.

HCE 51-100 have an NAR of 2.0 and MVAR of 2.65.

Rate group H1-H50 satisfies the ratio percentage test as 90 percent of the NHCWEs have a higher NAR and MVAR than H1-50. Only N1-100 has a lower rate and we needed 70 percent to pass.

But what about H51-100? H51-100 is lower than all NHCE groups except N501-750 and N750-100. H51 passes the ratio percentage test. Why?

H51-100 represents 50 percent of the HCEs and N501-1000 represents 50 percent of the NHCEs: 50/50=100 percent and we need 70 percent to pass.

Example two provides the same facts except H96 has an MVAR of 3.6 percent. No other employee that is an NHCE has this high rate. The plan would pass by treating H96 as not benefitting as this group constitutes less than 5 percent of the HCEs. The commissioner may determine the plan is nondiscriminatory based on these facts and circumstances.

Hated example 2 gives a 5 percent fudge factor along with discretion to the commissioner. Actuaries hate facts and circumstances test since this test cannot be quantified.

Normal accrual rate

What is a normal accrual rate? In the regulations it is the increase in the employee’s accrued benefit during the measurement period divided by the employees testing service expressed as a dollar amount or average annual compensation — basically an EBAR.

Most valuable accrual rate

What is MVAR? It has the same definition except it is the increase in the most valuable optional form of payment. The optional form of payment is determined by calculating the normalized QJSA associated with the accrued benefit. If the plan provides a QSUP, the MVAR must also take into account the QSUPP in conjunction with the QJSA.

In cross testing a profit sharing plan, there usually is no QSUPP or QJSA to take into account and hence no MVAR. MVAR in defined benefit plans includes early retirement subsidies, early retirement benefits, etc. The measurement period can be the current plan year, the current plan year and all prior years or the current plan year and all prior and future plan years.
Secret formula
    Step 1: Lump sum at NRA or contribution* (1+i) ^

    Step 2. (Lump sum/APR)*12=annual benefit.

    Step 3. Benefit /compensation=EBAR

Cross- tested plan designs takes into account calculating EBARs, passing the gateway and general test.

Data submitted by Dr. Smith: Retirement through a cross tested plan.
Smith medical census

Results for Dr. Smith
Smith medical custom carve-out plan.


Cross tested plans simply determine contributions on a benefits basis as opposed to a contribution basis. As the population of baby boomers need to fund more for retirement, a cross tested plan can be an ideal solution as they are generally older and more highly compensated and will achieve larger contributions on a benefits basis. In addition, the assets are protected from lawsuits and creditor claims.
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