Nondiscriminatory Classification Test

[austin3515]

If a plan makes haphazard profit sharing contributions to various people, relying on the "each participant is a separate allocation group" method, must it pass the ratio percentage test for coverage due to the nondiscriminatory classification test in the Average Benefits Test?

[Belgarath]

If I understand your question correctly, I'd say no. For 1.401(a)(4) rate group testing, each "group" must pass either the ratio percentage test, OR the average benefits test. The average benefits test under 401(a)(4) is a two-part test: (a) the nondiscriminatory classification test, and (b) the average benefits test. To pass the nondiscriminatory classification test, the coverage ratio must at least equal the midpoint between the applicable safe harbor percentage and the unsafe harbor percentage. The "reasonable classification test" does not apply - under 1.401(a)(4)-2(c)(3)(ii). The nondiscriminatory classification test including including the reasonable classification test is deemed satisfied if the ratio percentage test for the rate group satisfies the midpoint test. So the 410(b)-4(b) problem you mention never enters into the nondiscrimination testing, 'cause when you pass the midpoint, it is deemed satisfied. 

[austin3515]

But that's nondiscrimination testing, my question is specifically about coverage testing.

[Belgarath]

Ah, so I DID misunderstand the question. If it is for coverage testing, then yes, I think you have to pass the  ratio percentage test. The IRS position, as I understand it and unless it has changed, is that each person in their own group is tantamount to naming individual employees, and is not a reasonable classification under 1.410(b)-4(b). 

[cheersmate]

On 5/28/2025 at 7:49 AM, Belgarath said:

If I understand your question correctly, I'd say no. For 1.401(a)(4) rate group testing, each "group" must pass either the ratio percentage test, OR the average benefits test. The average benefits test under 401(a)(4) is a two-part test: (a) the nondiscriminatory classification test, and (b) the average benefits test. To pass the nondiscriminatory classification test, the coverage ratio must at least equal the midpoint between the applicable safe harbor percentage and the unsafe harbor percentage. The "reasonable classification test" does not apply - under 1.401(a)(4)-2(c)(3)(ii). The nondiscriminatory classification test including including the reasonable classification test is deemed satisfied if the ratio percentage test for the rate group satisfies the midpoint test. So the 410(b)-4(b) problem you mention never enters into the nondiscrimination testing, 'cause when you pass the midpoint, it is deemed satisfied. 

Belgarath, I am reading through a number of posts as one does on a boring Friday evening... please confirm my understanding of what you said above is correct:

1. If a cross tested plan design provides 401k, Safe Harbor and discretionary profit sharing, where each participant is defined in the the document to be in their own "rate group" for discretionary PS allocation purposes, it will pass 401(a)(4) nondiscrimination testing provided it satisfies the "Average Benefits" 2-prong test: prong 1 - nondiscriminatory classification based on the midpoint between SH and UnSH%s (deemed to pass "reasonable classification test"); and, prong 2 - average benefits test (of the plan as a whole) at 70% or more, correct?
2. Each rate group does not need to pass the 70% ratio percentage test due to each participant being in their own allocation rate group by plan definition of allocation basis, correct?  
3. The Gateway allocation requirement for NHCEs is the lesser of 5% or 1/3 of the highest HCE allocation rate, correct?

I have a plan where PS is discretionary, each participant is in their own allocation "rate group" by plan allocation provision, and there are NO allocation conditions (i.e. no min hours or last day, etc)... 2 HCEs and 21 NHCEs, NHC concentration is 91%. HCE 1 ps allocation rate for 2025 is 18%, HCE 2 is 25%; NHCEs are all at 5% (satisfies Gateway and TH; the employer could choose to increase each individually, only improving test results).

• Cross testing results: HCE1 and HCE2 Rate Groups each pass well beyond the midpoint % (23.38%) but not quite 70%; and, the Plan's ABT (as a whole) is 81%.
  • Based on this the Plan contributions pass nondiscrimination, correct? 
• All receive an allocation therefore 410b coverage is 100%
• Am I missing anything?

Thank you!

[John Feldt ERPA CPC QPA]

Yes, that passes nondiscrimination. And #1 above does not require any reasonable business classification, that requirement only applies to the coverage test and only if the coverage test needs the average benefit percentage test to pass (the simple ratio percent test is under 70%).

Just to clarify, the first requirement is to pass the coverage test. If that does not pass, you do something to make that pass.

Then you test the amounts that passed coverage for nondiscrimination. Sure, sometimes that goes hand in hand, but it’s possible to get lost in the minutiae of the nondiscrimination test sometimes to forget that we still don’t have enough NHCEs to get through the coverage test first.

In your example, you said the plan has safe harbor. If it that’s a safe harbor nonelective, and assuming there are no significant numbers of employees who are excluded from the plan by class, then you probably pass coverage under the ratio percent test as the safe harbor nonelective is provided to all the eligible NHCEs. As I’m sure you know, we don’t run extra coverage tests for each flavor of nonelective, such as “profit sharing”, we lump all of them together.

[johncerten]

Generally, yes. If a plan relies on the "each participant is a separate allocation group" approach, it still needs to satisfy the applicable coverage requirements under IRC §410(b). If the ratio percentage test isn't met, the plan typically has to satisfy the Average Benefits Test, which includes the nondiscriminatory classification test and the average benefits percentage test.

Whether a haphazard allocation pattern ultimately passes depends on the specific employee population, the allocation groups, and the demographics of highly compensated versus non-highly compensated employees. In practice, it's often a good idea to run the coverage testing before finalizing allocations to avoid unexpected compliance issues.

[cheersmate]

Hello John Feldt (and now johncerten). Sorry for the delay in seeing your reply(ies), and thank you. 

The plan I described is actually a Safe Harbor Match. There are NO exclusions on the SHM (of course) and PS contribution allocations -- if you are eligible to participate (eligibility is simply one Yr of service, no class exclusions), you share in the employer discretionary contributions. The only caveat being each participant is by plan provision in their own PS allocation rate group.  So 410b coverage is always 100% (no matter what the PS allocation rates are), therefore the requisite 70% is satisfied.

Each HCE EBAR RG passes 401a4 in far excess of the midpoint % (just not quite 70%), and, the Plan as a whole passes the ABT in excess of the 70% requirement (it's 81%).

Let me know if I have missed anything.  Thank you!

[John Feldt ERPA CPC QPA]

Without the 3% safe harbor, then 410b coverage is only 100% if an PS allocation is provided to each nonexcludable employee.