Huge 401 deferral makes Avg Ben Pct Test blow up?

[Guest rickw]

Every doctor client is getting excited about paying their spouse $12,000 so the spouse can defer $11,000 into a 401k. My concern is that this may make a cross-tested plan Avg Ben Percentage Test blow up.

Am I correct that the Benefit Rate % used in the Avg Ben Percentage Test will still include deferrals (unlike the benefit rate % used for the Rate Group test)? In the example above, the spouse has 95% deferral, and, based on her age, that could be a 60% benefit rate if deferrals are included.

[Mike Preston]

You are correct. Sounds like somebody (the doctor) doesn't understand his or her plan all that well. Such is life. There may be a small opportunity to save a situation that has run amok, but it is not one that is for the timid. If the spouse is a new employee, the spouse may just be a statutorily excludable employee. If so, there is a chance that you will get better results by applying the ABT separately. The problem is that the IRS hasn't come out and agreed that it is possible to have two separate ABT's, even though the regulations seem pretty clear (although convoluted) to me. In fact, the IRS has publicly stated that there is only one ABT in this particular circumstance. See Q&A #1 at the ASPA Annual Conference, 2001. However, many practitioners believe the IRS to be wrong in that particular answer. The logic that I believe applies has been previously posted by me in response to another thread recently. If I can find it, I'll post a link.

[Guest rickw]

Mike: Thanks for the reply. Fortunately, nothing has been done yet for 2002. We were momentarily as excited as the docs with the new 100% of comp limit, etc. But as soon as we tried to run some numbers, the software blew up, and we discovered the problem with the AB Pct Test. I was hoping I was wrong....

[Fred Payne]

I think your Doctors can remain excited!

In many situations, the ability for the Doctor's wife to defer $11K of a $12K salary is no problem. The Average Benefits Test--which does take into consideration salary deferrals--need only be undertaken if the cross-test fails the Ratio Percentage Test. If the spouse is in her own allocation group and gets allocated a low percentage or none at all (she is an HCE and this poses no problem), then her EBAR for the cross test could be as little as zero. Her rate group can always be made to pass the Ratio Percentage Test. Admittedly, the existence of her as an Employee may adversely impact the Ratio Percentage Test of her husband. But let's say it doesn't.

Probably the only way a Doctor's wife can defer $11K of $12K is if the 401k plan is a Safe Harbor Plan. When setting up a cross-tested plan with a 401k feature, ALWAYS use the 3% non-elective contribution to pass the Safe Harbor ADP since this 3% is a credit against the Gateway contribution. (The only downside here is that you cannot impute disparity on the 3%.) If you use the Basic Match, it's not included as part of the Gateway nor included in the cross-test, just the ABT.

If the Employer Allocation passes the Cross-test on the Ratio Percentage Test, one only needs to determine if the rules of the 401k Safe Harbor have been met. No ABT need be performed! (Remember a 401k safe harbor plan will almost always fail the ABT.)

[mwyatt]

We came to the same realization too after thinking the whole thing through (you ever try to pass the ABT with the spouse having an effective triple digit accrual rate?).

Fred, you are right about passing the Ratio Percentage Test letting you avoid the ABT. However, I haven't run across (in my limited experience) a CT plan where we had results that stopped at the Ratio Percentage Test (if you're driving this buggy, might as well push the pedal to the floor;) ).

[Guest rickw]

Fred: I have been buried in the General Test "trees" so long, I forgot about the plain-vanilla Ratio Test. We never even look at that. I guess we'll have to start!

When you refer to the "cross-test" part of the testing, I assume you are referring to the Nondiscrim/Rate Group Coverage Ratio part of the AB Test?

[Fred Payne]

Rickw:

When I refer to the "cross-test," I am referring to the Ratio Percentage Test. The Nondiscrim/Rate Group Coverage Ratio is a test one performs IF the Ratio Percentage Test fails and is a test EACH Rate Group must pass as a pre-condition to passing the ABT.

I misspoke in my first reply. The Doc's spouse will NEVER have an EBAR of 0 since the Safe Harbor 3% non-elective is an allocation that is included in the cross-test. But with a 3% allocation, the wife's Rate Group almost always passes the Ratio Percentage Test.

We have run across a few cross-tests that stop at the Ratio Percentage Test. Since it's all a matter of census, Mwyatt's experience won't be uncommon. Employing the Safe Harbor 401k can help lower the HCEs' EBARs and will sometimes allow the Ratio Percentage Test to pass. If it doesn't, the Safe Harbor 401k will complicate passage of the ABT, forcing either a lower allocation to the HCE or a higher allocation to one or more NHCs.

It's important to get the NHCs to defer. THeir participation makes a huge difference in the ability for the plan to pass the ABT (when passage is necessary.)

[Guest rickw]

Fred: So we are probably still in a pickle with a small doctor's office.

Please confirm my understanding: If EACH Rate Group can't pass the 70% Ratio Pct Test, then the entire plan has to rely on ABT. It does no real good for just one Rate Group to pass Ratio Pct Test. (In fact, as part of the ABT, each Rate group can pass either the Ratio Test OR the NonDiscrim/Concentration Test, but the WHOLE plan has to pass the Avg Ben Pct Test, and that's where the HCE deferrals cause the problem.)

As you said, the best approach is to try to get the NHCE deferrals up -- just like the old days!

[Fred Payne]

You are correct, if EACH Rate Group cannot pass the Ratio Percentage test, then the Plan is subject to the ABT.

I don't know about the either-or aspect, but I always operate on the premise that every Rate Group must pass the NonDiscrim/Concentration Test if any one group fails the Ratio Percentage Test. (That begs the questions as to whether a Rate Group that can pass its Ratio Percentage Test would fail the NonDiscrim/Concentration Test. I would bet not.)

I occasionally lose sight of what the primary benefit of cross-testing is, that is to lower the cost of funding the NHCs contributions. In almost every instance, a cross-tested plan will result in a lower funding cost than a straight DC plan. However, we've seen instances where there's a better plan design than the cross-tested plan.

If the demographics of the Plan is such that there will be lousy 401k participation causing problems for the cross-test to pass the ABT, we then opt for a 401k with both a Basic Match and Discretionary Match plus an integrated PS contribution. That design can for some groups beat a cross-test.

[mwyatt]

Sounds like your situation is similiar to one we just reviewed (small doctor's office with wife "working"). What we discovered was that her deferrals really put the ABT completely out of whack on a forecasting basis, to the extent that her $11,000 deferral was going to cost twice that much in extra contribution to rank and file discretionary PS cbn in order to pass.

My recommendation if your client is really keen on idea is to

1) See what discretionary contributions are required in order to pass General Test by stopping at Ratio Percentage Test (i.e., all your HCE rate groups' ratio percentages are 70% or over);

2) Figure out your "optimal" solution assuming no deferral by spouse of doctor; and

3) Figure out what you need to contribute to get your doctor back to desired level assuming spouse does make maximum deferral.

From here you can see what economic impact is of her deferral

Two opportunity costs involved:

Cost of stopping at Ratio Percentage Test (contrast 1 and 2) in either lost contributions for doctor and/or increased costs to NHCE

Cost of deferral (contrast 2 and 3) will show how much extra needs to be contributed to NHCE group in order to allow spousal deferral.

Now you have real dollars to see if it makes sense for her to defer.

Hope this is of help.

[Blinky the 3-eyed Fish]

One thing to note: In a safe-harbor 401(k) plan an HCE does not need to receive the 3% non-elective contribution. Therefore, in this example the doctor's wives (assuming the doctors are > 5% owners of the company) can have an EBAR of 0.

[Fred Payne]

Blinky: Never knew that, and if I did, it was long forgotten!

[Guest rickw]

Still no special "doctor rules" huh?