Pro-Rata Allocation and Gateway Test

[emmetttrudy]

401k plan ha a new comp design. But the testing doesnt really work out well. So instead they want to do a pro-rata allocation. There are 5 keys and 2 NHCEs. One of the NHCEs terminated part of the way through the year and has not met the allocation requirements (1,000 hour and last day).

Assume all 5 keys and the 1 NHCE who is still active receive 15% of compensation as a PS contiribution. The terminated NHCE receives 3% SH nonelective. Must he also receive a 2% PS contribution to get him to the Gateway? Or because they are foregoing using the new comp testing, do they not need to worry about the Gateway test and the 1 terminated NHCE can jsut receive the 3% SH?

[ETA Consulting LLC]

The problem you're having is that 100% of the HCEs receive 15% and only 50% of the NHCEs receive that rate. Therefore, that formula fails to pass 410(b) by used of the coverage ratio test on the allocation. You can attempt to cross-test the plan, but must satisfy the gateway into cross-testing before you use the cross-tested rates. Even then, the HCEs would need a signficant age advantage over the NHCEs in order to pass (but that's done with your mathematical analysis). But, to answer your question, you'd likely need the gateway since you'd likely need to cross-test the plan.

Good Luck!

[chc93]

What about the ABT for coverage. If the NHCE getting 15% is very young, it may be possible that the ABPT is >70%. And the safe harbor percentage at that point is 50%... and no cross-testing "yet", so no gateway "yet".

[ETA Consulting LLC]

What about the ABT for coverage. If the NHCE getting 15% is very young, it may be possible that the ABPT is >70%. And the safe harbor percentage at that point is 50%... and no cross-testing "yet", so no gateway "yet".

If you're not cross-testing, then why would it matter that the NHCE receiving 15% is very young? You'd need the gateway

Good Luck!

[Mike Preston]

I'm with chc93, you can run the ABT on a cross-testing basis without invoking gateway.

[Tom Poje]

at the 2009 ASPPA Conference they said (Q and A 44) the IRS response was:

"No. There is no gateway requirement for a general tested plan under Treas. Reg.

§1.410(b)-5(d)(5), unless cross-testing is used to determine the rate group testing.

The gateway rules are in §1.401(a)(4)-8(b)(1)(I)."

remember, there is one and only one avg ben pct test. you first run coverage and if your plan fails ratio %, you could pass using the avg ben test (which includes the avg ben % test)

you are not testing nondiscrimination at this point so there is no gateway.

Mike:

Saturday Feb 2 is ground hog day. That means 6 more weeks until Michigan gets the # 1 seed on selection Sunday in basketball.

[emmetttrudy]

if the term'd NHCE is receiving a SH contribution doesn't that count as benefiting for 401a? so 2 of 2 NHCEs are benefiting and coverage passes? at least thats they way our testing software is doing it (Relius)?

[ETA Consulting LLC]

unless cross-testing is used to determine the rate group testing.

But you're still cross-testing. Please show me a mathematical example of how you would test the plan using cross-tested rates without satisfying the gateway.

Good Luck!

[ETA Consulting LLC]

if the term'd NHCE is receiving a SH contribution doesn't that count as benefiting for 401a? so 2 of 2 NHCEs are benefiting and coverage passes? at least thats they way our testing software is doing it (Relius)?

Each formula must pass non-discrimination. If you merely provide a benefit to an NHCE and run a straight benefit or not benefiting, then you may design a plan to give each NHCE a contribution of $1 while giving each HCE 15%. When you impose a standard to say each formula (or rate) provided must be provided to a non-discriminatory group of employees, then that would require more testing. The software isn't going to tell you which test needs to be ran.

Good Luck!

[Tom Poje]

For a real simple example suppose I have a plan with 10 NHCEs.

Plan's formula is a straight 5% across the board.

4 of the NHCEs term, > 500 hours and receive nothing.

so for ratio % I have 60%.

I run the average benefits % test on an accrual basis and it passes 75%.

Since the plan as a whole passes avg ben pct test, and the ratio % test is 60% the IRS says no gateway is needed.

But people get worried because the avg ben pct test was run using accrual rates.

Now, in this simple example everyone received the same %, so gateway wouldn't come into play.

so lets modify it. formula is now 10%, but the 4 people in question received 3% top heavy because they were active but failed hours requirement.

using the allocation method (not accrual) you still have 60% in the rate group, which will satisfy the midpoint and the plan as a whole passes avg ben % test, so you have a plan with different allocation rates (e.g what people refer to as cross tested rates because they are different)

[ETA Consulting LLC]

So, you're saying because there is only one "rate group" (defined as each HCE percentage and everyone else at or above that percentage), then there is no gateway?

Please advise.

[ETA Consulting LLC]

Better yet, you're saying because the "rate groups were actually determined" using allocation rates as opposed to cross-tested rates would get you out of the gateway?

Please advise.

[Tom Poje]

yes, if you test dc nonelective contributions using allocation rates (even though the avg ben pct was tested using accrual rates), you have not 'cross-tested', and therefore there is no gateway, even though, conceivably you may have more than one allocation rate.

I think, what happens in many cases such plans would pass the broadly available gateway anyway, but maybe that is an overstatement.

Of course, technically, at least in a prototype plan you have to define the specific gateway, you can't pick and choose, otherwise the IRS says the formula is not definitely determinable.

[ETA Consulting LLC]

yes, if you test dc nonelective contributions using allocation rates (even though the avg ben pct was tested using accrual rates), you have not 'cross-tested', and therefore there is no gateway, even though, conceivably you may have more than one allocation rate.

I think, what happens in many cases such plans would pass the broadly available gateway anyway, but maybe that is an overstatement.

Of course, technically, at least in a prototype plan you have to define the specific gateway, you can't pick and choose, otherwise the IRS says the formula is not definitely determinable.

I'm familiar with the broadly available, primarily DB exceptions. It is new to me that if you 'define your rate groups on an allocation basis', but test on a cross-tested basis, you're exempt from the gateway requirement. I just wanted to be clear on what you're saying so I can research. Conceivably, you can design a plan with various rates without requiring a gateway. However, it wouldn't work if non of the NHCEs at least benefit (on an allocation basis) at a rate at or above the highest HCE. Would you agree?

[Mike Preston]

Agreed

[Mike Preston]

if the term'd NHCE is receiving a SH contribution doesn't that count as benefiting for 401a? so 2 of 2 NHCEs are benefiting and coverage passes? at least thats they way our testing software is doing it (Relius)?

Yes, it does. Coverage (410(b)) is not the issue. Non-discrimination (401(a)(4)) is the issue.

[ETA Consulting LLC]

(e.g what people refer to as cross tested rates because they are different)

You can rate group test on an allocation basis. I refer to cross-testing as the conversion of an allocation to a straight life annuity at Normal Retirement Age. So, I'm not concerned with the fact there are different allocation rates (i.e. you can have 10 different allocation groups where only one HCE and one NHCE is in each group, and pass on a restructured basis; when each group receives its own percentage).

But, you are saying that nonwithstanding any exceptions for broadly available rates, the fact (alone) that the rate group being tested is being defined by an allocation rate as opposed to an accrual rate, then you are exempted from the gateway (regardless of the fact that cross-testing is needed in order to pass the non-discrimination test).

I keep reiterating this because I don't want to associate one specific thing with something else (e.g. state it works this way, but have it work for an entirely different reason).

[Tom Poje]

agreed, just to make sure the terms are being used in the same way.

if I test on an allocation basis I take contr / comp so I am not converting to a straight life annuity.

it could very well be I fail the ratio % testing on an allocation basis (e.g. 60% instead of being greater than 70%) (but 60% is greater than any midpoint) and

however, it could also be true the avg ben pct test passes at 70% on an accrual basis 9e.g. converting to a straight life annuity). but the avg ben pct test does not trigger the gateway.

[ETA Consulting LLC]

agreed, just to make sure the terms are being used in the same way.

if I test on an allocation basis I take contr / comp so I am not converting to a straight life annuity.

it could very well be I fail the ratio % testing on an allocation basis (e.g. 60% instead of being greater than 70%) (but 60% is greater than any midpoint) and

however, it could also be true the avg ben pct test passes at 70% on an accrual basis 9e.g. converting to a straight life annuity). but the avg ben pct test does not trigger the gateway.

Okay, Poje. We have two out of three. Let's go for 3 out of 3.

1) We agree that allocations testing is not converting to straight life annuity (hence no cross-testing).

2) We agree that the rate group (defined by the allocation rate) passes the midpoint.

3) The average benefits test may be done on an allocations basis or utilizing cross-tested rates. I've never said anything to imply avg. ben means gateway. What I am saying is the usage of the cross-tested rates as opposed to the allocation rates is what imposes the gateway requirement.

Mike is saying that ship as sailed, because you're beyond the definition of the rate group (which was already done on an allocation basis) and that any cross-testing does not need the gateway because the rate groups have already been defined.

I have alway held that "any cross-testing" in the absent of established exceptions for broadly available or primarly DB, etc... would require the gateway. I understand Mike's argument and going to research that point. Is that also your understanding?

[Mike Preston]

Tom is real good at citations. :-)

But the fact is that this issue has long been put to bed.

Not thrilled with your tenses ("rate groups already been defined"). I don't think you start with the rate groups. You could just as easily start with the ABPT, note that it passes and then do a rate group analysis dependent upon the mid-point. All tests must pass and the order of performing them shouldn't cause concern.

[emmetttrudy]

if the term'd NHCE is receiving a SH contribution doesn't that count as benefiting for 401a? so 2 of 2 NHCEs are benefiting and coverage passes? at least thats they way our testing software is doing it (Relius)?

Yes, it does. Coverage (410(b)) is not the issue. Non-discrimination (401(a)(4)) is the issue.

OK. But I was responding to ERISATookKits response that this scenario would NOT pass coverage. And I'm still confused by his comments about cross testing. If I am allocating a profit sharing contribution pro-rata, what's the issue with 401(a)(4)? There are seven employees. Five of them key. Two of them NHCE. All five key employees and one NHCE receive 15% profit sharing contribution. The terminated NHCE, who did not meet either the last day requirement or 1,000 hour requirement, receives the 3% SH and $0 profit sharing because he did not meet the eligibility criteria. Pro-rata allocation of profit sharing. No cross testing. Passes 410(b), passes 401(a)(4).

[ETA Consulting LLC]

It is not my intent to thrill or trigger any emotional state of any member on this board. What I am attempting to do is understand a position (without the introduction of other issues not pertaining to what we are addressing). I think I have articulated my questions in an attempt to understand how you get to cross testing without the gateway.

[emmetttrudy]

if the term'd NHCE is receiving a SH contribution doesn't that count as benefiting for 401a? so 2 of 2 NHCEs are benefiting and coverage passes? at least thats they way our testing software is doing it (Relius)?

Yes, it does. Coverage (410(b)) is not the issue. Non-discrimination (401(a)(4)) is the issue.

OK. But I was responding to ERISATookKits response that this scenario would NOT pass coverage. And I'm still confused by his comments about cross testing. If I am allocating a profit sharing contribution pro-rata, what's the issue with 401(a)(4)? There are seven employees. Five of them key. Two of them NHCE. All five key employees and one NHCE receive 15% profit sharing contribution. The terminated NHCE, who did not meet either the last day requirement or 1,000 hour requirement, receives the 3% SH and $0 profit sharing because he did not meet the eligibility criteria. Pro-rata allocation of profit sharing. No cross testing. Passes 410(b), passes 401(a)(4).

did not meet the "allocation" criteria...not eligibility criteria, that was a typo.

[emmetttrudy]

It is not my intent to thrill or trigger any emotional state of any member on this board. What I am attempting to do is understand a position (without the introduction of other issues not pertaining to what we are addressing). I think I have articulated my questions in an attempt to understand how you get to cross testing without the gateway.

i understand that but who is trying to get to cross testing without the gateway? that's what i'm confused about. the original question was if you do a pro rata allocation (no cross testing), does the terminated NHCE need the Gateway contribution, and I believe the answer to that is no. i'm not sure how the performing cross testing and not having to worry about gateway conversation started, but it wasnt realyl related to the original post.

[ETA Consulting LLC]

The answer was no. However, your formula provided a coverage ratio percentage of 100% since everyone in the plan received a nonelective contribution. However, that alone does not satisfy nondiscrimination. This is why we started on crosstesting, because there is clearly a need for additional testing. You cannot have a formula providing 3% to NHCEs and 3.5% to HCEs and think that is okay merely because everyone has received a contribution. Additional testing would be necessary.

[emmetttrudy]

But the HCEs are not receiving a different amount of profit sharing than the NHCEs are. A pro-rata allocation is a safe harbor allocation, it doesn't require additional testing, right? The only reason ONE of the NHCEs is not receiving 15% profit sharing is because he failed to meet the allocation conditions (he was not employed on the last day of the year and he did not work 1,000 hours). The other NHCE is receiving 15% profit sharing because he did meet both of the allocation criteria. Same as the 5 HCEs, 15%. So why is there clearly a need for additional testing?

[Mike Preston]

Because we all fell into the trap of thinking that the plan was designed to provide for different percentages for each employee.

This disucssion got off on the wrong foot because not enough detail about the plan was known and the first few questions didn't fill in the right gaps.

In the case you are describing in #26, that is the first I've heard of it being a safe-harbor allocation formula in the plan (not to be confused with a 401(k) 3% SH, which is a totally different animal.

In fact, you started out by saying the plan was a new comp design. Can't really blame anybody for being confused.

So, let's start over.

There are two cases here, one is terribly esoteric and the other is blatantly obvious. Both end up needing the same tests.

First, let's assume the plan document calls for a 401(a)(4) safe-harbor formula (which is different from a 3% SH one finds in a 401(k) plan), you can allocate a pro-rata contribution of 12% to the 5 HCE's who satisfy the allocation conditions of the plan and 12% to the one NHCE who satisfies the allocation conditions of the plan. In addition, all 7 receive the 3% SH allocation. Hence, 6 end up with 15% and one NHCE ends up with 3%. All 7 are benefitting so the plan easily passes coverage. And most people think the plan automatically passes 401(a)(4), but it doesn't. In this case you have two separate allocation requirements. 6 people satisfy one, 7 satisfy the other. This means, unfortunately, that the plan, as a whole, is not eligible for 401(a)(4) safe-harbor treatment and must be general tested. There is an exception to this rule if the 7th person is getting an allocation of the top-heavy minimum only (like a person employed throughout the year who works only 100 hours and is given 3% of pay to satisfy the top-heavy rules). But there is no exception to this rule if the 7th person gets an allocation due to the 401(k) SH provisions. I know we argued a lot with the IRS and asked for another exception in the 401(a)(4) rules but if memory serves they didn't acquiesce. One way around this is to have the plan's top-heavy provisions match the plan's 401(k) SH provisions (that is, everybody gets 3% whether employed at EOY or not). Most plans don't even have that as an option. So, as far as I know, this problem can't typically be "cured" with a document provision unless you go individually designed (or treat the modification as not serious enough to bounce it out of pre-approved status).

In any event, you should read 1.401(a)(4)-3(b)(6)(xi) for more information on this esoteric situation.

Now, most of the time, when you have a 401(k) SH you don't have such skewed demographics, so it just isn't usually an issue.

But the result is the same as if the plan were designed as a new comp plan to begin with. That is, if the allocation is pro-rata (and you are not cross-testing for anything but the ABPT - which I've already said doesn't count as cross-testing for purposes of determining whether a gateway contribution is required), the way you demonstrate that you have satisfied 401(a)(4) is that you restructure the plan into two plans. One plan gives everybody in it 12% (in this case everybody is 6 people). And the other plan gives everybody in it 3% (in this case everybody is 7 people). EDIT: I mis-used the term "restructure". I meant to use another word like "break" because "restructure" is a defined term that only allows a given participant to be in one of the "restructured" plan. I'm not talking about that sort of restructuring. I'm talking about "breaking" the plan into pieces to demonstrate how it would fail the "multiple formulas" section of the 401(a)(4) regulations. END OF EDIT

Everybody agrees that the 7 person "plan" satisfies coverage and 401(a)(4).

But the 6 person "plan" has a challenge to overcome when it comes to determining whether it satisfies coverage. There is only one rate group and the coverage percentage of that rate group is only 50% so the only way to satisfy coverage is for the plan as a whole to satisfy the ABPT. Running the numbers on the ABPT without using cross-testing we find that the HCE's average 15% and the NHCE's average 9%. That doesn't satisfy the ABPT because 70% of 15% is 10.5%, so it fails. You didn't give us enough information to determine whether running the ABPT by imputing permitted disparity would result in the ABPT passing (if it does, then everything works out fine). But let's assume that running the ABPT with imputed disparity still fails. The next step is to run the ABPT on a cross-tested basis and see if it passes. The bottom line is that you have to satisfy the ABPT to satisfy the 401(a)(4) non-discrimination rules in this case.

General comments: 1) very few people are aware of this requirement 2) I think even the IRS thinks that if they were to re-draft the section of the 401(a)(4) regs cited earlier they would carve out an exception not only for TH but also for 401(k) SH.

It is even possible that the IRS has gone on record saying that the addition of a 401(k) SH provision can't cause a plan to fail to satisfy the 401(a)(4) safe-harbor design test if it would otherwise do so. I'd love to see it if that is the case.

I haven't paid attention to this issue in years since none of my plans have the skewed demographics that your plan has; but as I said, if the IRS has extended the safe-harbor rules to cover this situation, I'd be happy.

WIth all that said, the above is based on a 401(a)(4) safe-harbor formula.

You don't start a message with the words "new comp" and expect anybody to stick to an analysis which is focused on the document formula being a 401(a)(4) safe harbor design.

[emmetttrudy]

I understand what you are saying but I still think there is some confusion. The actual plan design is a 3% safe harbor nonelective with a discretionary profit sharing contribution and each participant is in his own classification (new comp). However, the plan document allows for a pro-rata allocation, which in this case we are trying to rely on because given the demographics and disparity between HCEs and NHCEs the new comp testing does not work out well. HCEs are excluded from receiving the 3% safe harbor contribution. So each of the 5 HCEs are getting a 15% profit sharing contribution. One of the NHCEs is getting a 3% SH contribution, and a 15% profit sharing contribution. The other NHCE (who terminated and did not meet allocation conditions) is getting a 3% SH contribution, which satisfies his need for the top heavy minimum, and 0% profit sharing.

[emmetttrudy]

I understand what you are saying but I still think there is some confusion. The actual plan design is a 3% safe harbor nonelective with a discretionary profit sharing contribution and each participant is in his own classification (new comp). However, the plan document allows for a pro-rata allocation, which in this case we are trying to rely on because given the demographics and disparity between HCEs and NHCEs the new comp testing does not work out well. HCEs are excluded from receiving the 3% safe harbor contribution. So each of the 5 HCEs are getting a 15% profit sharing contribution. One of the NHCEs is getting a 3% SH contribution, and a 15% profit sharing contribution. The other NHCE (who terminated and did not meet allocation conditions) is getting a 3% SH contribution, which satisfies his need for the top heavy minimum, and 0% profit sharing.

disregard the TH minimum comment since he's obviously terminated and doesnt need one. but the rest of the other details are accurate.

[Mike Preston]

I understand what you are saying but I still think there is some confusion. The actual plan design is a 3% safe harbor nonelective with a discretionary profit sharing contribution and each participant is in his own classification (new comp). However, the plan document allows for a pro-rata allocation, which in this case we are trying to rely on because given the demographics and disparity between HCEs and NHCEs the new comp testing does not work out well. HCEs are excluded from receiving the 3% safe harbor contribution. So each of the 5 HCEs are getting a 15% profit sharing contribution. One of the NHCEs is getting a 3% SH contribution, and a 15% profit sharing contribution. The other NHCE (who terminated and did not meet allocation conditions) is getting a 3% SH contribution, which satisfies his need for the top heavy minimum, and 0% profit sharing.

OK, so we are back to new comp. Note that it is fundamentally impossible to have a plan satisfy 401(a)(4) as a 401(a)(4) safe-harbor formula (for example: comp to comp) when the plan's terms allow each participant a different amount. Even if the employer ends up allocating the same percentage to each participant it must be general tested.

That is your major confusion.

Now you mention that notwithstanding the fact that everybody is in their own allocation group the "document allows for a pro-rata allocation". Sorry to say it, but this means absolutely nothing. In order to be a 401(a)(4) safe-harbor formula it would need to mandate a pro-rata allocation, not merely allow for it.

So, we are back to general testing the plan and you want to general test the plan on an allocations basis. Fair enough. If you pass your general test on an allocations basis you have no need to ever consider a gateway contribution. In the process of running your general test you might need to pass the ABPT (in this case "might" is "definitely" because your coverage percentage of the rate group where HCE's receive 15% of pay is less than 70%). You can run your ABPT any way you want (impute permitted disparity, cross-test, change the definition of 414(s) compensation used, etc.) and it will have no effect on whether a gateway contribution is required. If you fail to pass the ABPT no matter how hard you try, now you will need to cross-test in your general test and, if you pass, the only increase required would be the gateway. If you still failed, however, then you would need to save the plan by way of a 1.401(a)(4)-11(g) amendment. There are a myriad of ways that such an amendment might be structured, some of which would invoke gateway others of which would not (for example, one way to "fix" the broken test would be to give more money to the NHCE who is already receiving 15%. If you did that and the plan now passed the ABPT it would allow the plan to say that it passed the general test on an allocations basis and no gateway would be required).

[chc93]

So, we are back to general testing the plan and you want to general test the plan on an allocations basis. Fair enough. If you pass your general test on an allocations basis you have no need to ever consider a gateway contribution. In the process of running your general test you might need to pass the ABPT (in this case "might" is "definitely" because your coverage percentage of the rate group where HCE's receive 15% of pay is less than 70%). You can run your ABPT any way you want (impute permitted disparity, cross-test, change the definition of 414(s) compensation used, etc.) and it will have no effect on whether a gateway contribution is required. If you fail to pass the ABPT no matter how hard you try, now you will need to cross-test in your general test and, if you pass, the only increase required would be the gateway. If you still failed, however, then you would need to save the plan by way of a 1.401(a)(4)-11(g) amendment. There are a myriad of ways that such an amendment might be structured, some of which would invoke gateway others of which would not (for example, one way to "fix" the broken test would be to give more money to the NHCE who is already receiving 15%. If you did that and the plan now passed the ABPT it would allow the plan to say that it passed the general test on an allocations basis and no gateway would be required).

Mike... I'm confused by the bolded part above (or at least, not understanding). In order to cross-test in the general test, don't you need to pass the APBT at >=70% first?

[Mike Preston]

So, we are back to general testing the plan and you want to general test the plan on an allocations basis. Fair enough. If you pass your general test on an allocations basis you have no need to ever consider a gateway contribution. In the process of running your general test you might need to pass the ABPT (in this case "might" is "definitely" because your coverage percentage of the rate group where HCE's receive 15% of pay is less than 70%). You can run your ABPT any way you want (impute permitted disparity, cross-test, change the definition of 414(s) compensation used, etc.) and it will have no effect on whether a gateway contribution is required. If you fail to pass the ABPT no matter how hard you try, now you will need to cross-test in your general test and, if you pass, the only increase required would be the gateway. If you still failed, however, then you would need to save the plan by way of a 1.401(a)(4)-11(g) amendment. There are a myriad of ways that such an amendment might be structured, some of which would invoke gateway others of which would not (for example, one way to "fix" the broken test would be to give more money to the NHCE who is already receiving 15%. If you did that and the plan now passed the ABPT it would allow the plan to say that it passed the general test on an allocations basis and no gateway would be required).

Mike... I'm confused by the bolded part above (or at least, not understanding). In order to cross-test in the general test, don't you need to pass the APBT at >=70% first?

Not at all; there is no tie between the two. The consequences of not passing the ABPT is that each rate group must satisfy a 70% threshold. You can reach that 70% threshold by testing on contributions or benefits. If you do happen to pass the ABPT then each rate group merely has to satisfy the mid-point of the safe and un-safe harbors.

[chc93]

Got it... thanks, Mike.