Cash Balance Plan Nondiscrimination Testing: Here’s How It Works!

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We know that cash balance plans are excellent retirement plans. But how much do you know about cash balance plan nondiscrimination testing?

Cash balance plans are considered “qualified” plans. This means that they qualify for an immediate tax deferral. But only if you meet certain testing requirements.

But in some instances, passing nondiscrimination testing can be a challenge. This is why you will need to have a “TPA” or plan administrator do the work for you. You certainly don’t want to have to do the testing yourself.

Here is a brief summary and then we can discuss the specifics.

What is cash balance plan nondiscrimination testing?

  • The plan must ensure that the contributions do not benefit highly compensated employees (HCEs) compared to non-highly compensated employees (NHCEs)
  • Your plan TPA should have a checklist of testing items. This should be included in the annual administration fee.
  • If you have a solo plan then your testing procedures will be limited and many of the rules will not be required. You will still be governed by the 415 limits.
  • Failing to comply with testing standards can result in tax penalties and potentially the disqualification of the plan.

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Plan Nondiscrimination Testing Basics

Cash balance plans, like all qualified retirement plans, must comply with nondiscrimination testing requirements under the Internal Revenue Code to ensure that the plan does not disproportionately benefit highly compensated employees (HCEs) compared to non-highly compensated employees (NHCEs).

There are two main types of nondiscrimination testing that apply to cash balance plans: the coverage test and the benefit and contribution test. The coverage test ensures that the plan covers a sufficient percentage of NHCEs in proportion to the number of HCEs covered.

Cash Balance Plan Nondiscrimination Testing
Cash Balance Plan Nondiscrimination Testing

The test requires that a minimum percentage of NHCEs participate in the plan, generally based on a ratio of NHCEs to HCEs. If the plan fails the coverage test, the plan sponsor may need to make additional contributions to the plan or limit contributions for HCEs.

The benefit and contribution test compares the benefits provided to HCEs to those provided to NHCEs. The test ensures the plan does not provide disproportionately higher benefits to HCEs than NHCEs. If the plan fails the benefit and contribution test, the plan sponsor may need to reduce the benefits provided to HCEs. Alternatively, they can increase the benefits provided to NHCEs.

It is important to note that cash balance plan nondiscrimination testing can be complex and may require the assistance of a qualified retirement plan professional to ensure compliance with IRS rules. Failing to comply with the testing rules can result in significant tax penalties for the plan sponsor and HCEs, as well as the disqualification of the plan.

What is a Cash Balance Plan Administrator (“TPA”)?

A cash balance plan administrator is a person or entity responsible for overseeing the operation of a cash balance plan. The plan TPA is responsible for ensuring that the plan complies with all laws and regulations and that plan participants receive the benefits to which they are entitled.

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The plan administrator has several important responsibilities, including:

  1. Plan design: The plan administrator is responsible for designing the cash balance plan and establishing the plan’s terms and conditions.
  2. Plan document maintenance: The plan administrator is responsible for maintaining the document and ensuring that it is up-to-date. It must also comply with all laws and regulations.
  3. Participant communications: The plan administrator is responsible for communicating with plan employees and ensuring that they understand the benefits provided by the plan and the rules governing the plan.
  4. Plan funding: The plan TPA is responsible for ensuring that the plan is adequately and timely funded.
  5. Plan administration: The plan TPA is responsible for overseeing the day-to-day operation of the plan, including processing benefit claims and distributing benefits to plan participants.
  6. Compliance: The plan TPA is responsible for ensuring that the plan complies with all laws. This includes nondiscrimination testing, reporting and disclosure requirements, and IRS filings.

The TPA may be an individual or a company. The company must choose a qualified and experienced plan administrator to ensure the plan is properly managed. That plan participants receive the benefits they are entitled to.

Cash Balance Plan Rules and Background

401k plans are usually set up as safe harbor plans. An employer’s profit-sharing contributions generally range from 5% to 7.5%. The safe harbor plan shares a 3% non-elective contribution with profit-sharing, which can be subtracted from the 5% to 7.5% range.

Plan contributions will depend on compensation and age. By increasing your salary, you can maximize your contribution. This can also apply to a spouse. But remember that high wages mean higher medicare and social security taxes.

The social security wage base is limited to approximately $160,000. As a result, the 12.4% social security tax will be at most this wage. As such, a business owner can increase wages with limited employment tax increases. But before completing your salary, consider the IRS rules for reasonable compensation for your type of business, and get assistance from a CPA or a tax professional.

Can you Discriminate in a Cash Balance Plan?

Defined benefit plan schedules can be structured for 3-year vesting. As it is generally referred to, Cliff vesting requires all participants to be 100% vested after three years of plan participation. Each employee is therefore vested once they attain three years of service. In the case of a closure, before the three years are over, you would forfeit all the contributions and then use them to offset future contributions.

One year exclusionCoverage ratio
3-year vestingTop Heavy testing
At least age 21HCE & NHCE rules
Meaningful benefit ruleCompliance reporting

Plan contributions are based on actuarial calculations, which consider several subjective assumptions to determine the contribution amounts. These assumptions give room to flexible funding, resulting in overfunding in a year and lower funding levels in subsequent years.

Are Cash Balance Plans Non Qualified?

A business owner doing well in a given year can make maximum contributions. This could exceed the targeted contribution in that year. This will enable the business owner to lower that financial year’s tax liability.

IRS and the Department of Labor will always keep you on your toes regarding how you run your plan. You should, therefore, be extra careful when playing with the given rules to avoid getting in trouble with them. Otherwise, business owners can make sizable tax deductions and significant contributions by correctly structuring the plan using the above tips.

Paul Sundin

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