Understanding Cross-Testing Profit-Sharing Plans: Why Allocation Percentages Differ Among Employees

Qualified retirement plans like 401(k), profit-sharing, and safe harbor plans are valuable tools for business owners seeking to retain talent and reduce tax liability. One advanced design strategy used in these plans is cross-testing, which results in differing profit-sharing percentages for employees. This article explains how cross-testing works and why it benefits your company.

What Is Cross-Testing?

Cross-testing is a method used by profit-sharing plans to demonstrate that differing contribution rates are nondiscriminatory by considering an employee’s compensation and age to project their benefit at retirement, rather than strictly a percentage of current-year compensation. This approach allows employers to direct a larger share of the employer contributions to older or higher-compensated employees, within IRS limits.

Rather than allocating the same percentage to everyone, cross-testing converts current-year contributions into an equivalent benefit at retirement, typically using actuarial assumptions. The IRS allows differing allocation rates as long as the plan passes nondiscrimination testing.

Why Do Contribution Percentages Vary?

Because of how cross-testing works, younger or lower-paid employees may receive a smaller percentage of profit-sharing contributions than older or higher-paid employees. This is not favoritism; it’s a function of how the amount of time affects projected benefits at normal retirement age.

Example (conceptual only):

• Employee A is 60 years old and earns $150,000.

• Employee B is 30 years old and earns $50,000.

  
  

To provide each with the same retirement benefit at age 65, Employee A may need a 15% contribution now, while Employee B may only need 5%, since their contribution has 35 years to grow.

In Summary:

Cross-testing is a strategic, IRS-approved method to tailor profit-sharing contributions in a way that allows an employer to focus its contribution on a key individual or group while providing minimum benefits to other eligible employees. Differences in contribution percentages are not unfair. They are actuarially grounded and legally compliant. This design can help your business attract and retain top talent while optimizing the plan’s financial efficiency.

Ready to Optimize Your Profit-Sharing Plan?

Understanding cross-testing is key to maximizing the benefits of your retirement plan while staying IRS compliant. If you want guidance on designing or reviewing your profit-sharing plan, schedule a consultation with CRI TPA Services today.