Broker Check
Part I - New Comparability Plan

Part I - New Comparability Plan

November 22, 2019

What is it?

In general

A new comparability plan is a qualified profit-sharing plan that can have more substantial contributions for favored employees (usually higher-paid workers and key employees). With this type of plan, contributions are not allocated strictly as a percentage of compensation. Instead, by dividing up plan participants into two or more classes and having different contribution rates for each class, this type of plan allows businesses to maximize plan contributions for certain employees and minimize allocations to other employees. A new comparability plan satisfies nondiscrimination requirements by requiring minimum contributions and then having the plan pass a series of tests to show that the projected benefits for each class meet the coverage requirements.

In general, a new comparability plan is a type of profit-sharing plan that is similar to an age-weighted plan in that both types of plans allow a business to maximize the plan contributions to the older, higher-paid owners and key employees while minimizing allocations to the accounts of younger employees. New comparability plans, however, take this one step further than age-weighted plans by also putting employees into different groups or categories (rather than strictly using age) and each category may have a different contribution formula.

As an employer with a new comparability plan, you may be able to provide yourself and other highly compensated employees a higher percentage of the plan contribution than you could under a traditional profit-sharing plan or even an age-weighted plan. You might also decide to receive the same dollar amount of a contribution as under a traditional profit-sharing plan but reduce the overall contribution amount for other employees.

You can maximize your contributions for yourself and other highly compensated employees


With a new comparability plan, the percentage of the plan contribution going to your account and other highly compensated employees can be much higher, while the cost of providing benefits to other employees can be extremely low. Keep in mind, however, that like all profit-sharing plans, the maximum deductible employer contribution you can make is limited to 25% of the total compensation of all plan participants (compensation for each employee is limited for this purpose to $280,000 in 2019, up from $275,000 in 2018).

Example(s): Lou, the 55-year-old owner of the Café, earns $150,000 per year. He is the company's only highly compensated employee. He employs four non-highly compensated employees: Susan, age 50; Donald, age 35; Ann Marie, age 28; and Joseph, age 25. Susan earns $40,000 per year, Donald earns $25,000, Ann Marie earns $20,000, and Joseph earns $20,000. Lou would like a profit-sharing plan with as much as possible allocated to his account and with as little as possible allocated to Susan's, Donald's, Ann Marie's, and Joseph's accounts. The following table shows how the Café's contribution of $46,250 (a little over 18% of eligible pay) could be allocated within a traditional profit-sharing, age-weighted plan and a new comparability plan:

*May require minimum 3% contribution if top-heavy

Example(s): While all three plans are nondiscriminatory under the law, the new comparability plan gives Lou a much bigger share of the annual plan contribution. Under the new comparability plan, Lou has almost 89% of the plan's contributions allocated to his own account ($41,000 for him out of a total of $46,250 in contributions), while under the age-weighted plan, he has 81% allocated to his account and only 59% allocated under the traditional profit-sharing plan. In addition, under the new comparability plan, Lou will receive $13,794 more than under the traditional plan while the cost of providing benefits for his employees will be $13,794 less.


Test to see if benefits are nondiscriminatory

With this type of plan, once minimum contributions levels are satisfied, it is the equivalent benefits, not the actual contributions, that are tested ("cross-tested") each year to demonstrate that the plan is not discriminatory in favor of highly compensated employees. There are several steps to this process. The employees are divided into separate groups usually with highly compensated employees (HCEs) and other key employees in one group and everyone else (non-highly compensated employees, known as NHCEs) in another group. 

Then, the projected retirement benefits are expressed as a percentage of compensation (the "equivalent benefit accrual rate," or EBAR); EBARs for all participants are compared and assigned to testing groups (called "rate groups"), and then each rate group is tested under the coverage requirements.

Note: With age-weighted plans, the EBARs are the same for all participants. That's not the case with new comparability plans. The regulations prescribe additional rules for testing defined contribution plans that are aggregated with defined benefit plans for purposes of Sections 401(a)(4) and 410(b).

Tip: State and local government plans are exempt from discrimination testing.

Why new comparability plans can be nondiscriminatory

You might be concerned as to whether a new comparability plan violates the nondiscrimination principles that prohibit highly paid employees from benefitting more from a qualified plan than lesser-paid employees. Note that contributions aren't the only way to make a comparison for nondiscrimination purposes — the IRS regulations permit benefits to be compared, too.

Technical Note: IRC Section 401(a)(4) provides that for a plan to be qualified, the "contributions or benefits provided under the plan [must] not discriminate in favor of highly compensated employees." The IRS has issued detailed regulations describing how qualified employer plans can prove they are nondiscriminatory. Two basic approaches are permitted by these regulations — either a plan can be designed to meet a safe harbor (thereby trading design flexibility for nondiscrimination certainty), or a plan can have a non-safe harbor design, requiring regular testing ("rate group testing") under the "general nondiscrimination rules." The general nondiscrimination rules allow defined contribution plans to be tested either by examining the current dollar contribution made to employees each year, or by converting those contributions into equivalent benefits, essentially looking at the benefit a particular dollar contribution today would provide at the plan's normal retirement age using certain actuarial assumptions. This latter approach is referred to as "cross-testing." That is, contributions are converted to equivalent benefit accrual rates (EBARs), which are then tested for nondiscrimination in a manner similar to the testing of defined benefit plans. Additional final regulations issued in 2001 provided specific guidance for plans using the cross-testing approach and require that new noncomparability plans provide a minimum allocation to non-highly compensated employees (the "gateway" test) as a prerequisite for using cross-testing.

In sum, a new comparability plan can be nondiscriminatory because it provides at least required minimum contributions and it is viewed and evaluated for nondiscrimination purposes by comparing the projected retirement benefit at retirement, not at the current contribution level.


Participants are divided into classes

With new comparability plans, employees in a profit-sharing plan are grouped into two or more categories and each category may have a different contribution formula. The purpose of adopting a new comparability plan is to provide more for certain groups than others. Typically, substantial contributions are made for a favored and, on average, older group, with lower contributions for the other employees. Groups could be, for example, highly compensated employees, professional staff, clerical staff, officers, employees under age 50 (or some other age) and employees over age 50 (or some other age).


The gateway test

Under the final regulations, a defined contribution plan can test on a benefits basis if it:

  1. Provides broadly available allocation rates, or
  2. Provides age-based allocations, or
  3. Passes a "gateway" requiring allocation rates for all non-highly compensated employees to be at least 5% of pay or at least one-third of the highest allocation rate for highly compensated employees

A new comparability plan must satisfy number 3, the gateway test, to be eligible to show, through cross-testing, that the EBARs of plan participants are nondiscriminatory. 

A plan satisfies the gateway test if each NHCE (non-highly compensated employee) has an allocation rate [determined using IRS Section 414(s) compensation] that's at least 1/3 of the highest allocation rate of any HCE (highly compensated employee) participating in the plan (the "1/3 test").

Alternatively, a plan is deemed to satisfy the gateway test if each NHCE receives an allocation of at least 5% of the employee's IRC Section 415 compensation (the "5%" test). Therefore, a plan that's designed to provide a minimum allocation to NHCEs of at least 5% will always be eligible to use cross-testing to establish nondiscrimination.


Example(s): The highest allocation rate for any HCE participating in the XYZ Profit-Sharing Plan is 21%. The Plan can satisfy the gateway test, and use cross-testing to establish nondiscrimination, if each NHCE receives an allocation of at least 1/3 of 21% (7%) of Section 414(s) compensation. Alternatively, the gateway test is satisfied if each NHCE receives an allocation of at least 5% of IRC Section 415 compensation.


Caution: There are different definitions of compensation for each part of the 5% or one-third gateway test. For the one-third test, the plan's definition of compensation must satisfy IRC Section 414(s). For the 5% test, IRC Section 415(c)(3) compensation, a broader compensation definition, is used. This means that a new comparability plan must use the top-heavy definition of compensation [IRC Section 415(c)(3)] to determine whether that plan satisfies the 5% minimum allocation gateway and may not use the IRC Section 414(s) compensation definition that is usually required to test for nondiscrimination under the IRC Section 401(a)(4) nondiscrimination rules. The net effect of this is to increase the required employer contribution for eligible NHCEs participating in new comparability plans using the 5% gateway test.

Calculating equivalent benefit accrual ratios (EBARs)

Once a new comparability plan has satisfied the 5% or one-third gateway test, the next step is to calculate the EBARs of each participant. To calculate an EBAR, each participant's annual allocation is converted into a projected retirement benefit in a process called "normalizing the benefit." That is, the participant's current contribution is converted to an annual benefit payable as a single life annuity at the plan's normal retirement age (typically age 65) using actuarial factors. This projected retirement benefit is divided by the participant's compensation to determine the participant's EBAR. It is these EBARs, not the actual current dollar contributions, of participants that are compared (cross-tested) to determine whether a plan is nondiscriminatory.

Identifying the rate groups

Once EBARs have been calculated for each participant, the next step is to establish the testing groups ("rate groups"). The non-highly compensated employees (NHCEs) with an EBAR equal to or greater than the EBAR for a particular highly compensated employee (HCE) are grouped together as rate groups.

Meeting the coverage requirements

After the rate groups are determined, each rate group must satisfy the coverage requirements of IRC 410(b) by passing either (1) the ratio percentage test or (2) the average benefits test.

  • The ratio percentage test: To pass this test, the employees in a rate group must have a coverage ratio of at least 70%. The number of NHCEs in a rate group is divided by the total number of NHCEs (including those not covered by the rate group) to determine the NHCE ratio. Then, the number of HCEs in a rate group is divided by the total number of HCEs (including those not covered by the rate group) to determine the HCE ratio. The NHCE ratio is divided by the HCE ratio — if the coverage ratio is at least 70%, the rate group passes the ratio percentage test.

  • The average benefits test: If any group fails the ratio percentage test, then the rate group is tested under the more complicated average benefits test which consists of a nondiscriminatory classification test and an average benefit ratio test.

The information in this newsletter is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented, nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Broadridge Advisor Solutions. © 2019 Broadridge Investor Communication Solutions, Inc. CRN202110-255702