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Q& A: Is a Cross-Tested Retirement Plan Right for Your Small Business?

As a small business owner, do you offer your employees a 401(k) plan with profit-sharing benefits? If so, you’re able to maintain the flexibility to make discretionary employer matching contributions to the retirement plan for yourself and your employees each year, depending on your company’s cash flow and profits.

Offering a 401(k) with profit sharing is a great way to compensate your hard-working employees for a job well done. However, a basic profit-sharing plan typically treats every employee the same – including the owner – which can make it challenging for you to stay on track for retirement. You and your employees may benefit from adopting a cross-tested profit-sharing plan.

What You Should Know

A cross-tested profit-sharing plan allows you to contribute additional funds to your employees’ retirement accounts, while also saving more for your own retirement.

Specifically, this plan provides you the flexibility to make retirement plan contributions in varying percentages for different groups of employees. In one scenario, you might create multiple employee groups based on employee compensation: you could contribute 25% of compensation to your retirement account, 15% to your highly compensated employees (HCEs) (those who own 5% interest in the business or make more than $120,000 per year), and 5% for each of your other employees. In this way, a cross-tested plan design provides additional retirement benefits to you and other targeted groups within your company, such as key employees. Other possibilities for the segmentation of your employee population might include job description, length of service, or certain goals-based criteria.

Because cross-tested plan designs are more complex than standard 401(k) profit-sharing plans, we sat down with Troy Flinn, managing partner at Alpha Wealth Advisors, to help answer some commonly asked questions. Our goal is to give insight into cross-tested retirement plans for small business owners who are interested in implementing this benefit to expand options for obtaining retirement security for themselves and their employees.

What type of business is best-suited for a cross-tested retirement plan?

Generally, cross-testing is best for small businesses with fewer than 5O-employees.

Businesses with smaller staffs benefit the most, especially when the owner wants to set aside additional savings for retirement while helping employees save more too. With a cross-tested plan design, every eligible employee must receive a contribution! However, cross-testing allows owners to increase their contributions without increasing contributions to their employees. The contributions are discretionary –   meaning, they don’t have to be made every year. Also, these plans cannot discriminate against non-highly compensated employees. As such, plans must prove nondiscrimination by testing benefits across the various groups. Cross-tested plans work better for companies with fewer employees for this reason as it’s easier to pass the testing requirements.

What are the primary benefits of a cross-tested plan?

We often see business owners use cross-tested plans in situations where they may be older than the average age of their other employees, and thus, closer to retirement. With fewer years to save, cross­ testing provides business owners the opportunity to make individual contributions at a higher percentage than their employees to achieve the same level of benefits at retirement. That said, in some cases, a cross-tested plan can be implemented even if the average age of the employees is higher than the business owner.

What’s more, contributions made by the business to the plan are tax-deductible, resulting in immediate tax savings for the business owner. For example, if the business owner makes a $10,000 contribution to a profit-sharing plan, and they’re in the 30% tax bracket, it only costs $7,000 to make that contribution –  a savings of $3,000!

Cross-testing also offers a way for business owners to reward their key employees and those who are most vital to the company’s success by making a more significant contribution to their retirement accounts.

How can a small business avoid discrimination in a cross-tested plan?

The Internal Revenue Service requires annual nondiscrimination testing to make sure that all eligible employees in 401(k) profit-sharing plans, who receive contributions, are treated fairly.

Alpha Wealth Advisors simplifies nondiscrimination testing for business owners. Our proprietary software helps ensure that the plan and the owner’s chosen contribution rates for each employee group comply with current IRS rules.

How Cross-Testing Works: A Real-Life Example

Assume for this illustration that the plan is a 401(k) with a safe harbor matching contribution that includes a cross-tested profit-sharing feature. The company has two owners and four other employees (for a total of six employees) that are eligible to receive plan contributions. The six employees are in three groups: Group 1 – owners, Group 2 – HCEs, Group 3 – other employees.

The plan is also a non-elective safe harbor plan: the employer makes a safe harbor contribution to every employee, regardless of whether the employee elects to contribute. As far as profit sharing goes, profit sharing is not equal among the groups. In this example, the owners and the non-HCE employee are the only groups to receive a profit-sharing contribution. By structuring it this way, the owners were able to maximize their contributions to plan – 71% is allocated to the owners, and the contribution is fully tax-deductible.

Compensation401(k) Deferral401(k) Safe Harbor MatchProfitSharingTotal
Group 1
Owner #1$265,710$18,500$7,971$28,529$55,000
Owner #2$114,000$18,500$3,420$15,000$36,920
Group 2
HCE #1$216,321$18,000$6,490$0$24,290
HCE #2$275,000$18,500$8,250$0$26,750
HCE #3$255,204$0$7,656$0$7,656
Group 3
Employee #1

Total Owner Contribution:$91,920
Total Owner Deferral, Match & Profit Sharing:$126,860
Owner Percentage of Total:71%

To maximize tax deductions, the best time of year for owners to adopt a cross-tested plan is at the end of the plan year – December 31 for most plans. That way, owners can make contributions during the first quarter of the initial plan year for the cross-tested plan. Besides, the contributions are tax­ deductible for the previous year in which the plan was adopted.

Cross-tested plans offer flexibility for owners seeking to reward themselves and other key employees while maximizing their retirement savings. Due to the complex nature of the rules governing these plans, you’ll need guidance from retirement plan experts who can help you develop a plan that meets regulatory requirements and who will do the calculations and testing to determine the allocations for each employee group.

The experienced professionals at Alpha Wealth Advisors can work with you to determine if a cross­ tested retirement plan is right for your company and employees. Call us to learn more about how we can help.

This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation.