The IRS recently proposed regulations that, if finalized, would make it easier for employers who maintain active, ongoing defined benefit plans to maximize contributions and benefits for their highly compensated employees.
Under the new rules, aggregated defined benefit/defined contribution plan nondiscrimination testing gateway minimums will be easier to pass than before, allowing more flexibility in plan formulas. Particularly, if you have or are considering an age- or service-based profit sharing formula in your defined contribution plan, the combined "general test" gateway minimums will be more accommodating to such designs. In addition, matching contributions of up to 3% of pay will be taken into account for the first time for purposes of the gateway minimums, allowing more of a mix of match and profit sharing in the defined contribution plan while maximizing contributions/benefits to highly compensated participants.
Plans that provide higher profit sharing contributions and/or defined benefit accruals for their highly compensated employees, as a percentage of pay, than their non-highly compensated employees, must pass an amounts-based nondiscrimination test, otherwise known as the "general test."
A popular way to pass the general test is to combine (or "aggregate") active defined benefit and defined contribution plans, testing profit sharing contributions as if they were defined benefit accruals. This is called "cross-testing." Doing so maximizes the impact of profit sharing contributions for younger, lower-paid participants when they are projected all the way to retirement age using the permissible interest rate of 8.5%.
To minimize abuse, cross-tested plans must pass a "gateway test" first, before proceeding to the general test. Currently, the gateway test requires a minimum profit sharing allocation under the defined contribution plan (or combined defined benefit plan benefit expressed as an allocation/profit sharing allocation) for each non-highly compensated participant, ranging from 1/3rd of the highly compensated employee allocations at the lower end to 7.5% of pay at the higher end (the higher the level, the more that can be provided to highly compensated participants). The minimum allocations must be the same percentage of pay for each non-highly compensated participant, limiting flexibility and discouraging age-based or service-based profit sharing formulas.
Under the new proposal, instead of each non-highly compensated participant receiving exactly the same minimum allocation, the gateway minimums can be satisfied by providing average allocation rates to non-highly compensated participants equal to the gateway minimums. Thus, younger participants and/or participants with less service can receive lower allocations than older, higher-service participants, as long as the average allocation rate for all of the non-highly compensated participants satisfies the minimums.
For the first time, cross-tested plans would be permitted to count matching contributions of up to 3% of pay towards the gateway minimums (but not for the general test itself). This allows the flexibility to provide a mix of profit sharing and matching contributions in plans that previously had focused on profit sharing contributions (or their defined benefit equivalent). As we know, more of a focus on matching contributions can encourage participants to contribute to 401(k) plans and increase non-highly compensated ADP percentages. For plans that already provide a match, a bumped-up gateway minimum could allow additional contributions/benefits for highly compensated employees.
Cross-tested profit sharing contributions generally are converted to defined benefit amounts and projected to retirement age using an interest rate of 8.5%. Under the new proposal, the gateway minimums will be waived if an interest rate of 6% is used instead. The lower 6% interest rate results in lower defined benefit projections, but the elimination of the gateway minimums may be useful for some plans.
These new proposed changes to the gateway rules would be effective with respect to the first plan year beginning on or after the date the regulations are finalized. The earliest possible effective date would be January 1, 2017, if the regulations are finalized in 2016.
It's never too soon to start analyzing your options if these changes might be helpful in aligning your plan design more closely with your business and employee benefits goals.
If you would like additional information on the topic discussed in this Compensation and Benefits Alert, please contact any member of Orrick's Compensation and Benefits Group.