One of the most powerful retirement plan structures is a combination of a profit-sharing 401(k) and a cash balance plan. However, when these plans are combined, they must meet strict IRS compliance tests. One of the most important of these is the gateway test.
The gateway test serves as the entry point for determining whether different contribution levels between owners and employees are acceptable under IRS rules. It ensures that non-highly compensated employees, or NHCEs, receive a minimum level of benefits before the plan can demonstrate overall fairness through actuarial testing.
In this article, we will discuss how the test works and offer a few tips on passing it. Let’s jump in!
Understanding Cross Testing in Retirement Plans
Cross testing allows employers to show that their retirement plan is nondiscriminatory based on benefits at retirement age rather than contributions today. This testing method is especially useful in plans that provide different contribution rates for different employee groups, such as owners versus staff. By converting current contributions into future retirement benefits using actuarial assumptions, the plan can demonstrate fairness across groups.
Many small businesses use cross testing to create flexible and efficient benefit structures. It allows older, highly compensated employees to receive larger contributions without violating nondiscrimination rules. However, before a plan can use cross testing, it must first pass the gateway test. The gateway test ensures that lower-paid employees receive a minimum benefit level that is significant enough to justify cross testing for the group as a whole.
The IRS established the gateway test to prevent plans from heavily favoring owners or senior staff. By setting minimum benefit thresholds, it ensures that all employees share fairly in employer contributions, even when contribution formulas differ.
The Purpose of the Gateway Test
The primary goal of the gateway test is to ensure that retirement plans using cross testing provide equitable benefits to all participants. It prevents employers from allocating excessively high contributions to owners while giving very little to other employees. In simple terms, the gateway test sets a floor for employee benefits before allowing a plan to use actuarial cross testing to prove nondiscrimination.
The test works by comparing the percentage of compensation contributed for highly compensated employees (HCEs) against that of non-highly compensated employees (NHCEs). If the NHCEs receive at least a certain minimum percentage, the plan is considered eligible for cross testing. The two main gateway formulas are the five percent rule and the one-third rule.
If the plan passes one of these two standards, it can then proceed to cross testing, which evaluates benefits on a projected retirement basis. This process ensures that the overall plan is balanced and fair under IRS guidelines.
How the Gateway Test Works
To qualify for cross testing, the plan must first satisfy one of two gateway thresholds. These are simple percentage-based rules designed to ensure fair treatment of all participants. The first is known as the five percent rule, and the second is the one-third rule.
Under the five percent rule, all non-highly compensated employees must receive employer contributions of at least five percent of compensation. This threshold ensures that every eligible employee receives a meaningful level of benefit before cross testing begins. The second option, the one-third rule, compares the contribution rates between groups. It requires that each NHCE receive at least one-third of the highest contribution rate given to any HCE.
The plan must meet at least one of these requirements. Once the gateway test is satisfied, the employer may perform cross testing by converting all contributions into equivalent benefits at normal retirement age, typically age 65. This step determines whether the benefits are nondiscriminatory across employee groups.
The table below summarizes the two gateway options and how they apply in different scenarios.
| Gateway Rule | Requirement | Purpose |
|---|---|---|
| Five Percent Rule | Each NHCE must receive at least 5% of pay in employer contributions. | Ensures a minimum level of benefit for all non-highly compensated employees. |
| One-Third Rule | Each NHCE must receive at least one-third of the highest HCE contribution rate. | Balances contributions relative to owners or highly compensated employees. |
These formulas provide flexibility depending on company goals and employee demographics. Employers may choose the option that best aligns with their funding objectives while maintaining compliance.
Use EMPARION PLANS on
*Emparion is not affiliated with, endorsed by, or sponsored by these institutions.*
Gateway Testing with a Cash Balance and 401(k) Plan
When a cash balance plan is combined with a 401(k) plan, the gateway test becomes especially important. Each plan has its own contribution structure, but the IRS views them together when testing for nondiscrimination. The 401(k) portion often includes a profit-sharing or Safe Harbor contribution, while the cash balance plan provides a defined benefit. The combined value of both must meet the gateway threshold for NHCEs.
For example, a Safe Harbor contribution of three percent and a profit-sharing contribution of two percent together satisfy the five percent rule. This allows the plan to proceed with cross testing using both plan types. Once the gateway is met, the employer can make larger contributions for owners through the cash balance plan without violating IRS rules. This combination maximizes deductions and retirement savings while maintaining fairness for staff.
Proper coordination between both plans is critical. The employer must ensure that the total benefit provided to each employee meets the gateway threshold based on combined contributions from both plans.
Why the Gateway Test Matters
The gateway test provides a safeguard that keeps retirement plans equitable and compliant. Without it, plans could heavily favor owners or senior employees, creating significant disparities. It ensures that rank-and-file workers receive meaningful benefits even when the plan uses a tiered or age-weighted allocation.
Passing the gateway test also reduces the risk of IRS penalties or plan disqualification. Failing to meet the requirement can invalidate the cross testing process, forcing the employer to make corrective contributions or redesign the plan. For professional practices such as dental or medical offices, where owners often want to contribute much more than staff, the gateway test provides a clear path to doing so legally and fairly.
Ultimately, the gateway test creates balance between cost efficiency and compliance. It allows employers to reward owners appropriately while protecting employees’ access to meaningful retirement benefits.
Advantage of Using a 3% Non-Elective Contribution to Pass Gateway
Here is a great tip. By adopting a 3% non-elective Safe Harbor contribution, employers automatically satisfy a large portion of the gateway requirement without having to make additional profit-sharing allocations.
Is a Cash Balance or Defined Benefit Plan Right For You?
The 3% non-elective Safe Harbor contribution applies to the 5% minimum employer contribution required under the gateway test. Non-highly compensated employees automatically receive 3%, so only a 2% profit-sharing contribution is needed to meet the gateway threshold. This reduces costs, ensures compliance, and simplifies plan design.
In addition to satisfying the gateway test, the Safe Harbor contribution eliminates the need for annual ADP and ACP testing for employee deferrals. This allows highly compensated employees to defer the maximum 401(k) contribution without limitation. The combination of the Safe Harbor 3% contribution and the cash balance plan creates a compliant, efficient structure that maximizes deductions for owners while providing predictable benefits to employees.
Key Factors to Consider When Applying the Gateway Test
Employers designing plans that rely on cross testing must consider several factors when determining how to satisfy the gateway test. These factors influence both cost and compliance outcomes. The goal is to achieve an optimal balance between owner contributions and employee benefits.
Key considerations include:
- The demographics of employees, including age and compensation levels
- The contribution rates for highly compensated and non-highly compensated employees
- Whether the company uses a Safe Harbor contribution that can count toward the gateway requirement
- The presence of a cash balance plan that adds to total benefits for employees
- The cost of additional contributions required to meet the 5% or one-third threshold
- The long-term funding goals of the owners or partners
- The ability to maintain consistent contributions year after year
By reviewing these elements, employers can ensure that the combined plan design remains compliant while meeting the financial objectives of the business.
Practical Example of the Gateway Test
Consider a professional practice that combines a cash balance plan with a 401(k) profit-sharing plan. The owners receive contributions equal to 15% of compensation. Under the one-third rule, non-highly compensated employees must receive at least 5% of pay. This can be achieved by combining a three percent Safe Harbor contribution with a two percent profit-sharing allocation.
In another example, if the owners receive 9% of pay, the non-highly compensated employees must receive at least 3% to meet the one-third rule. If the employer instead provides all NHCEs with a flat 5% contribution, the plan satisfies the gateway requirement under the five percent rule. After passing this initial test, the plan can perform cross testing to confirm that overall benefits are nondiscriminatory.
These examples demonstrate how the gateway test allows flexibility while enforcing fairness. Employers can structure contributions to meet their goals without compromising compliance.
Final Thoughts
The gateway test is an essential step in ensuring that cross-tested retirement plans remain fair and compliant under IRS regulations. It serves as a threshold that guarantees employees receive a meaningful level of benefit before the plan can apply actuarial testing. By requiring either a five percent contribution or one-third of the highest rate given to owners, the gateway test balances flexibility with fairness.
When combined with a 401(k) and cash balance plan, the gateway test allows employers to design highly efficient, tax-advantaged structures that reward both owners and staff. Meeting this requirement not only supports compliance but also builds trust among employees who see tangible contributions to their future security. With thoughtful planning and the right professional guidance, employers can use the gateway test to achieve both financial efficiency and long-term retirement success.
