Considerations for Retirement Plan Design

March 27, 2023

This module describes the retirement plan design process, and the options and choices plan sponsors have in establishing a plan. The content will also focus on issues such as payroll and compensation practices, which can have a direct impact on plan design, and should be considered in the design process. Most importantly, the module focuses on translating a plan sponsor’s objectives into a clear plan design strategy.

Learning Objectives

  • Become aware of the importance of developing clear goals at the commencement of the plan design process
  • Appreciate the range of choices and options available to plan sponsors
  • Understand the process in designing and establishing an effective retirement plan

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Business Analysis in Determining Organizational Objectives and Related Considerations


1. Tax Qualification

Qualified plans, such as 401(k) arrangements, are given special tax treatment if they comply with IRS and DOL rules and requirements. The special tax treatment afforded plan sponsors and participants include immediate deductibility of plan contributions, tax deferral on the earnings or growth while the benefits remain in the plan, the ability to roll over the dollars without taxation to another eligible plan, including an IRA, and, if applicable, the availability of net unrealized appreciation (NUA) on distributed employer securities.

However, if plan officials fail to operate the plan in accordance with the document and compliance rules, then a plan can lose its qualified status, which can result in loss of the favorable tax treatment, including loss of employer deductions and immediate taxability of employee benefits within the plan. Clearly, maintaining the qualified status of a plan is a key consideration for the plan officials and their advisors, consultants and service providers.

2. Employer objectives

The first step of plan design is identifying the sponsor’s goals and objectives for the plan. Once identified, a strategy for meeting those goals is through the thoughtful design of the retirement plan. Retirement plans are not all the same; there are various choices and options available. What works well for one plan sponsor may not work well for another. It is common for plan sponsors to not be aware of the various alternatives they have for designing their ideal plan.

Many plan sponsors have similar goals related to their retirement plan initiatives. Let’s look at some common plan sponsor goals. Retirement plans are an increasingly important aspect of employee retention and recruitment. Plan officials are wise to study common retirement benefit practices within their industry and locale prior to commencing the plan design process. A non-competitive plan won’t satisfy the employees nor meet the plan sponsor’s goals. Typically, plan sponsors want to provide a retirement benefit to employees (including themselves) and, at the same time, take advantage of favorable tax rules such as the ability to receive a tax deduction for contributions and tax-deferred savings. They may want to provide different contributions to different groups of employees. Many smaller plan sponsors desire to maximize the contributions for the owners and highly compensated employees (HCEs). The IRS has extensive requirements plans must meet to ensure that less highly compensated employees are treated fairly, and they receive a reasonable share of any employer contributions. Thus, an important aspect of plan design is balancing the goals of the plan sponsor while still satisfying the IRS’s nondiscrimination and compliance requirements.

Plan sponsors are, generally, cost conscious and want to minimize the expense of maintaining a retirement plan. Some plan sponsors simply want to provide a benefit that will attract or retain certain employees. Operating a retirement plan can be administratively burdensome, and plan sponsors can reduce some of the cost and administrative burden through simplifying plan design. For example, plans can have different eligibility requirements for different employee groups or various types of contributions, but variations such as these can add to the complexity and cost of the plan.

On a per participant basis—plan sponsors may desire participants attain a certain level of retirement readiness and take steps to monitor and support the participants in attaining this goal. If this is important, plan sponsors often use automatic enrollment and escalation provisions, and provide financial wellness tools and support to participants.

  • Does the plan sponsor want employees to contribute toward their own retirement? The answer to this question will help determine whether employee salary deferrals will be part of the plan.
  • Does the plan sponsor want to include or exclude as many employees as possible? The answer to this question will help determine eligibility to participate in the plan.
  • Does the employer experience high employee turnover? Compliance testing can be problematic with certain employee groups, particularly younger groups with high turnover. Perhaps safe harbor options should be considered in this situation.
  • Are employees savvy investors? The answer to this question will help determine the nature and type of investment mix the plan will have, and whether a qualified default investment (QDIA) might be appropriate.
  1. Recruitment and retention - Plans are often tools to attract and help retain employees. In many industries a competitive retirement plan is an essential and expected employee benefit.
  2. Motivation - Properly structured plans may be a key element in broader employee motivational strategies. Some employers offer employer securities as a plan investment option to motivate employees through ownership in the company.
  3. Owner specific - With smaller plan sponsors the tax and retirement income planning needs of the owners often drive plan design considerations. Typically, maximizing the owner’s contributions and containing costs are important elements in the design aspects of these plans.

3. Participant objectives

  1. Coverage percent - Other objectives can include the level of employee participation, which is commonly called the coverage percentage. Is a targeted employee participation rate important? If yes, certain plan design features such as liberal eligibility provisions and auto enrollment can be considered.
  2. Retirement readiness - Obviously, the success or failure of any retirement program is measured by the retirement outcomes for the participants. Did most employees attain their retirement readiness goals? What feature or options can be used to increase the likelihood of employees attaining retirement readiness goals? A plan sponsor with concerns over retirement readiness may consider an auto-escalation feature in the plan.
  3. Access to benefits - Other questions to be addressed include access to benefits prior to retirement. Does the plan sponsor want to permit plan loans, hardship distributions or access to the retirement benefits prior to retirement age through in-service distribution options?


Retirement plans are subject to complex ERISA and IRS rules known as the controlled group rules (CGR) and affiliated service group (ASG) rules. The CGR apply if two or more organizations are under common ownership or control. An ASG refers to two or more organizations that have a service relationship and, in some cases, an ownership relationship. This segment will not cover the details of the CGR/ASG rules, but provides an overall understanding of what the rules are and how they impact plan sponsors.

The CGR are intended to prevent owners from providing generous benefits to themselves and the highly compensated while providing little or no benefits to the remaining employees. The ASG rules were enacted to expand the idea of control to separate, but affiliated, entities.

The CGR apply where two or more organizations are owned or controlled by an individual, family or group.

Plan design and set-up is more complex if a controlled group exists. As an example, if ABC, Inc. and XYZ, Inc. are members of a controlled group, both organizations are taken into account for IRS plan compliance testing purposes. And, based on the nature of the employee groups, both corporations may have to offer the same or at least similar plans to all employees of both corporations.

The ASG rules may also impact plan operations. The ASG rules, similar though more subtle than the CGR, also require multiple organizations to be tested together for plan purposes. For our purposes, consider the impact of the CGR and ASG rules as essentially the same.

Examining business ownership and determining if the CGR or ASR are applicable is an essential step in plan design.


Doctors A, B and C own a clinic employing 40 staff and the clinic has no retirement plan. The doctors create a new entity, The Leasing Company (TLC), of whom they are the only employees. The doctors are no longer employees of the clinic; rather, they are employees of TLC. The doctors continue to perform services at the clinic but they do as employees of TLC. TLC then bills the clinic for the doctors’ services. The doctors establish a generous retirement plan through TLC. Under the controlled group rules, the employees of the clinic and TLC are considered employed by the same employer for compliance testing. Thus, if the doctors want a generous retirement under the TLC plan they must provide similar benefits to the employees of the clinic.


The next step is plan design is examining the employee group makeup and determining how, or if, different segments of the group can or should be treated differently under the plan. Plan sponsors may be able to exclude certain employee segments from plan participation altogether (within limits). Other employee groups or classifications can receive different contributions or benefits. If certain employee groups have high turnover and low retention perhaps they should be excluded from the plan.

Plan sponsors have great flexibility in designing a plan with different structures and rules for different employee segments. However, this flexibility comes at a cost of additional compliance testing and review.


Compensation practices and payroll capabilities are important considerations in the plan design process. Why? Each year the plan must satisfy various IRS compliance tests. Accurate compliance testing requires accurate and timely compensation and payroll data. In many cases, employees annual hours of service must be compiled or calculated and forwarded to the service provider and this information is used to determine plan and employer contribution eligibility. Different methods of compiling and calculating hours of service are available under most plans, and the plan sponsor selects the hours of service calculation method most suitable to its staffing model and payroll systems.

As the complexity of the compensation structure increases so does the complexity of the compliance testing. For example, compensation amounts such as overtime, bonuses and commissions can be excluded for plan purposes, and such exclusions increase the complexity of the plan and the testing.


If a plan sponsor acquires or merges with one or more businesses, these transactions impact the retirement plan. Entities anticipating significant merger or acquisition (M&A) activity should consider plan design decisions that streamline the impact of M&A activity on the plan operations.

The most important consideration in M&A scenarios from a retirement plan perspective is addressing “protected benefits.” Plans may be amended or changed for many reasons and plan sponsors have much flexibility in doing so. However, a plan may not be amended in a manner that takes away protected benefits from the participants.

Often in M&A situations, one of the plans is merged into another plan. Protected benefits need to be identified and preserved to satisfy the protected benefit rules.

Generally, a plan sponsor may amend a plan so long as the change does not retroactively reduce or eliminate certain protected benefits of the participants that they already have a right to receive. In general, the anti-cutback rules of IRC § 411(d)(6) protect a plan participant’s

  • Accrued benefits, including the accrual of vesting;
  • Early retirement benefits;
  • Retirement type subsidies [not applicable to defined contribution plans]; and
  • Other forms of optional benefits.

Optional forms of benefits that are protected may include in-service distributions, payment schedules, timing of payments, commencement of benefits and medium of distribution (e.g., ability to take a distribution in cash or in kind). Plan sponsors may amend plans to prospectively eliminate optional forms of benefit, but only with respect to benefits not yet accrued.

Although commonly available in plans, the following benefits are not protected benefits under IRC § 411(d)(6) and, therefore, may be eliminated prospectively:

  • Hardship withdrawals;
  • Loans;
  • The right to make elective deferrals;
  • The right to make after-tax contributions.


Obviously, cost is always a consideration in retirement plan and other employee benefit decisions, which can result in a trade-off between simplicity and complexity. Simple plans with basic features are less costly; complex plans with unique features and options are more expensive to maintain. For example, features such as automatic enrollment, generally, increase plan costs as the additional participants usually receive matching contributions.


A challenge facing sponsors of defined contribution type plans is determining the desired retirement outcome goals and then assessing if the participants are on track to meet these goals. Fortunately, tools and resources are becoming available to assist plan officials in setting and gaging desired retirement outcome goals.

1. Replacement ratio analysis

Replacement ratio is the percent of the participant’s pre-retirement income the plan benefits will replace. The conventional wisdom states retirees should plan on a replacement ratio of 75% of their pre-retirement income. Some analysis now suggests the 75% is low, especially for younger retirees in their early retirement years. This younger retiree group may spend up to 130% of their pre-retirement income according to some analysis. That said, we will assume the 75% replacement rate is the desired outcome for our purposes. In addition, we will assume the retirement date is coincident with the individual’s Social Security full retirement age which is currently age 67.

If the desired replacement ratio is 75%, what is the source of the income? Obviously, Social Security is a significant piece of the retirement income puzzle particularly for employees in the low and mid-range compensation ranges. This analysis is further complicated by the regressive nature of Social Security the benefit, that is, the higher the income the lower the Social Security benefit as a percentage of compensation. Social Security benefits as a replacement ratio at retirement can range from more than 50% for low income participants to less than 20% for high income participants. Let’s then, for the sake of simplification, assume Social Security will replace about 35% of the pre-retirement income. That leaves 40% of the 75% retirement income replacement ratio must be made up of wages, savings, pensions and defined contributions plans like the 401(k) plan. With this in mind, plan officials should consult with their service providers and review reports and tools available in making a determination of plan design strategies that may help meet this goal. This analysis is obviously dependent on the age of the participants. Grouping the participants by age cohort (20s, 30s, 40s and 50s, etc.) and assessing each cohort makes the most sense. For example, if the 30-year-old cohort is behind the curve in terms of accumulation, plan officials and service providers can deploy communication and plan design strategies targeted at this group. For example, a design strategy could consist of automatic escalation provisions.

2. Resources, Tools and Metrics

Plan officials need not reinvent the wheel in terms of analyzing the effectiveness of their plans. Advisors, consultants and service providers have benchmarking tools and access to data to help determine how well participants are doing relative to their peer groups. Retirement outcome, obviously, is ultimately determined at retirement (if not beyond retirement age) but certain data elements are useful predictors of success and are used to evaluate the effectiveness of plan design and communication efforts.

Again, metrics, benchmarking data and analytical tools are available to the plan officials through service providers, advisors and consultants. The officials need to drive the discussion, however, to begin the process of ensuring plan participants, ultimately, achieve a reasonable level of retirement readiness.

3. Performance Evaluation Metrics

These elements can include the following:

  • Plan participation ratio,
  • Deferral rates,
  • Account balance,
  • Optimal investment selection profiles and
  • Projected income replacement ratios.

 As an example there are different ways to assess retirement preparedness. One way to gauge preparedness is the amount of retirement accumulation compared to compensation. At retirement age, as a rule of thumb for the industry, a participant should have approximately 10X current compensation to achieve reasonable retirement readiness.

Plan Establishment


The adoption of the plan must be authorized by the governing body of the plan sponsor. Usually, this authorization takes the form of a board resolution authorizing an individual or group to establish and execute (or amend) the plan document on behalf of the governing body. A copy of this resolution is maintained with the plan documents. Should the plan ever be audited or investigated by the IRS or DOL, copies of the enabling resolution will be requested.


Plan sponsors have three plan document alternatives for establishing a qualified retirement plan:

  • Prototype,
  • Volume submitter, and
  • Individually designed.

Plan sponsors will need to consider the level of design flexibility, costs of acquiring and/or preparing their documents, and maintaining ongoing compliance in order to determine which alternative is most suitable. For most plan sponsors, a prototype plan will satisfy their needs in a cost-effective manner.

The IRS responded to the complexity and cost of plan document creation by developing a pre-approved plan document program. Prototype plan documents are pre-approved by the IRS and offered through a document vendor (for example, a platform, record keeper, or financial institution). Pre-approved plans consist of a “basic plan document,” which contains all the hardwired or nonelective provisions of the plan; and an “adoption agreement,” which contains the elective provisions. The adoption agreement comes in either a “standardized” or “nonstandarized” format. Standardized means the adopting employer has fewer electives from which to choose and can generally rely on the IRS opinion letter for the document, with no additional IRS filing required. “Nonstandardized means the adopting employer has more electives from which to choose and should file for an additional IRS determination letter to ensure they may fully rely on the document.

Simplicity comes with a price, however. Under a standardized plan, eligible employees with the controlled group of businesses must be covered under the plan.


Marsha owns a dental practice with 12 employees. She also owns a fast-food franchise with 25 employees. Marsha wants to establish a 401(k) for the dental practice. If she uses a standardized adoption agreement any employees of the fast-food franchise meeting the eligibility requirements are also eligible to participate in the plan.

Nonstandardized prototype plans offer more electives than standardized plans. For example, regarding some of the most common plan sponsor plan design electives, if a plan sponsor seeks only to impose minimum age and service requirements, and exclude union and nonresident alien employees, then a standardized plan would meet the sponsor’s needs. However, if a plan sponsor wants those eligibility requirements as well as the ability to exclude classes of employees and types of compensation, and require 1,000 hours of service and presence on the last day of the plan year, then the sponsor would need to use a nonstandardized prototype plan.


There are three types of safe harbor plan designs that, when adopted, allow the plan sponsor to automatically satisfy nondiscrimination testing. The three designs include the

  • Standard design,
  • Qualified automatic contribution arrangement (QACA) and,
  • DB/(k).


1. What does the standard safe harbor plan design require?

With this plan, eligible employees can choose to participate by deferring a portion of the pay into the plan. The plan sponsor must give either a matching contribution to those participants who defer a portion of their pay into the plan or a nonelective contribution to eligible employees — regardless of whether they defer a portion of their pay or not.




The basic matching formula is a 100% match on deferrals up to 3% of compensation AND a 50% match on deferrals between 3% and 5% of compensation.

The enhanced match is a matching contribution formula that would provide a match that is at least equal to the aggregate match that would be provided under the basic match formula (e.g. 100% match on deferrals of 4% compensation).

In lieu of making a matching contribution, an employer could contribute a nonelective contribution of at least 3% of compensation to each eligible nonhighly compensated employee.

Contribution cannot be used to satisfy permitted disparity.

2. What does the QACA safe harbor design require?

A QACA is a type of automatic enrollment plan design that requires eligible employees to begin deferring at least 3% of their pay into the plan and to annually increase their deferral percentage over the next three years to a maximum of 6%. Additionally, the plan requires plan sponsors to give either a matching or nonelective contribution.

3. What does a DB/(k) safe harbor plan design require?

The DB/(k), first available in 2010, is a combination defined benefit (DB) and 401(k) plan with an automatic enrollment feature. On the DB side, there is a mandatory employer contribution for eligible employees. On the 401(k) side, employees must defer a portion of their pay into the plan and the employer must give either a matching or nonelective contribution.

4. Are there other plan operational requirements of a safe harbor plan design of which I should be aware?

All three safe harbor plan designs require the adopting employer to satisfy certain requirements related to participant notices, elections, vesting (which pertain to when participants have a nonforfeitable right to their employer contributions) and distribution restrictions.


The stakeholders within the plan sponsor including HR, payroll and benefits groups are seminal in helping make the plan a success, and their involvement early in the plan process is encouraged. Often, plan provisions or features that sound good on paper may create administrative problems with current systems or capabilities. Before the plan is executed, each affected area needs a clear understanding of what is expected from it and the time frame for fulfillment of these expectations.


Here we will cover some of the most common plan provisions plan sponsors consider when designing a plan, including, eligibility and coverage, contributions, allocations, vesting, benefit availability, form of benefit and loans.

1. Eligibility and Coverage

An important initial question is who is eligible for the plan. The plan may impose the following eligibility requirements:

  • Maximum age requirement: Age 21
  • Maximum service requirement
    • Service of 1 year for salary deferrals and 2 years for owner contributions 1,000 hours required for year of service
    • Employed on last-day to receive employer contribution

 In addition, other employee groups can be excluded (hourly, salaried, units, divisions) and this will increase compliance testing and operational complexity.


WestCo, Inc. has 5,000 employees. 4,000 employees work at facilities in Texas. 1,000 work at a facility in Illinois. The 401(k) plan excludes the 1,000 Illinois employees.


MidCo, has 500 employees at a single facility. The 401(k) plan excludes from participation the 50 employees in the shipping division.

Different eligibility requirements can be established for different contribution types. As an example a plan can allow immediate eligibility for employee deferrals, a six month and age 21 requirement for matching and a year of service and age 21 requirements for employer discretionary contributions. This approach is not uncommon but adds to the complexity of the plan’s administration.

2. Automatic Enrollment

Traditionally, employees have been required to make some type of affirmative action (such as completing an enrollment form) to participate in a 401(k) plan. The employer then withholds and remits the deferred amount to the 401(k) plan. Requiring some type of affirmative employee action often reduces the number of employees participating in the plan. Recently, the automatic enrollment model (also sometimes referred to as an “auto deferral” or “negative election” plan) has gained popularity with plan sponsors. In this model, if an employee does nothing he or she automatically participates in the plan at a specified level of deferral. The plan sponsor must give each eligible participant a notice that explains the automatic deferral arrangement, his or her right to elect not to have deferrals automatically made to the plan, and how the person may alter the amount of contributions, if desired. Following receipt of the notice, the plan sponsor must give each eligible employee a reasonable period of time to make a deferral election, and, ongoing, opportunity to change his or her election. Including an automatic enrollment feature has been an effective way for many employers to increase participation in their 401(k) plans.

a. Automatic Enrollment Safe Harbor

Automatic enrollment safe harbors are available for 401(k) plans that would allow plans to automatically satisfy the 401(k) nondiscrimination and top-heavy requirements. Such arrangements require the following:

  • Automatic deferral contributions up to 10%, and must be at least 3% during the initial plan year, 4% during the second plan year, 5% during the third plan year, and 6% during any subsequent plan years;
  • An owner-provided contribution in the form of a matching or nonelective contribution;
  • Two-year cliff vesting of employer contributions;
  • Owner contributions are subject to the withdrawal rules applicable to elective contributions;
  • Required notice to each eligible employee explaining the employee’s rights and obligations.

b. Automatic escalation

In addition to an automatic enrollment feature, another design strategy in a 401(k) plan is the scheduling of automatic deferral increases, usually to coincide with pay increases. This design feature is referred to as automatic escalation, or auto deferral increase. In this model, participants commit in advance to increasing their deferral percentage at specified times.

Typically, the increase is for a set amount (for example, one or two percent of pay up to a set cap). The effect of automatic escalation is to increase participant savings levels.

3. Contributions

The plan sponsor can elect various contribution types be permitted in the plan. Choices may include



Traditional employee deferrals

Withdrawn from pay on a pre-tax basis

Designated Roth

Withdrawn from pay on an after-tax basis

Employer matching

Contingent on employee deferrals; Can be mandatory or optional, with the matching formula specified in the plan, or the plan sponsor deciding annually on the matching amount

Employee after-tax

Other than designated Roth; usually limited to help satisfy IRS testing requirements

Employer contributions

Usually, discretionary in terms of amount of annual contributions. Plan sponsors can select the conditions required for participants to receive employer contributions. Conditions such as completing 1,000 hours of service and/or being employed on the last day of the plan year are common requirements.


Amounts accumulated by a participant in other retirement plans and rolled over to a new employer’s plan by the participant


Amounts accumulated by a participant in other retirement plans and transferred to a new employer’s plan by the employer

Qualified nonelective or qualified matching

Fully vested contributions that are used to satisfy IRS testing requirements

In addition, within limits, the terms of the plan document can specify contribution rates will vary among different employee groups.


The Big Time Trucking Company 401(k) plan provides 100% matching for truckers and 50% matching for administrative staff.

4. Compensation

The plan may define what employee remuneration is considered compensation for plan allocation purposes. For example, overtime, bonuses and/or commissions could be excluded for plan purposes.


Lori participates in the LMN, Inc., 401(k) plan. Her compensation consists of $85,000 of salary and a $15,000 bonus. The plan excludes bonus compensation for plan purposes. Thus, if the employer makes a 5% contribution, Lori’s contribution is calculated as follows:

$85,000 X .05 = $4,250

However, excluding compensation requires additional IRS testing to ensure the exclusions don’t adversely impact the nonhighly compensated employees.

5. Allocations

The plan sponsor can determine how employer contributions are allocated to eligible participants. Common choices include, but are not limited to, flat dollar, pro-rata, integrated, cross-tested, age-weighted and new comparability.

Employer contributions are discretionary (optional) in most cases, but if made, they must be made according to a nondiscriminatory allocation formula. The most common formula used is a formula that allocates contributions based on a percentage of each participant’s compensation, but there are several others, as described in the following paragraphs. The actual formula that must be used will be selected in the plan document that governs the profit sharing plan.

a. Flat Dollar

A plan sponsor who uses a flat dollar contribution formula in its profit sharing plan must contribute the same dollar amount to each eligible employee.

b. Pro Rata

An allocation formula that provides eligible participants with a contribution based on the same percentage of compensation is known as a pro rata formula.

c. Integrated

An integrated allocation formula allows a plan sponsor to provide higher contributions for eligible participants who earn amounts over a set threshold, as long as the “permitted disparity rules” of IRC Sec. 401(1) are satisfied. Integrated plans are also known as “Social Security-based” or “permitted disparity” plans. The permitted disparity rules allow plan sponsors to give eligible participants who earn compensation above the “integration level,” which is typically the Social Security Taxable Wage Base, an additional contribution. This additional contribution is equal to the lesser of

  • two times the base contribution percentage, or
  • the base contribution percentage plus the “permitted disparity factor.”

If the plan sponsor sets the integration level at the Social Security Taxable Wage Base, then the permitted disparity factor equals 5.7%. Note that the plan sponsor may set the integration level at an amount lower than the Social Security Taxable Wage Base. If this is done, however, the plan sponsor must then reduce the permitted dis- parity factor according to the following table.



The Taxable Wage Base (TWB)


81–99% of the TWB


21–80% of the TWB


0-20% of the TWB



Integrated Systems, Inc., maintains an integrated profit sharing plan for its employees. The integration level is the taxable wage base (i.e., $142,000 for 2021). For 2021, Integrated Systems will make a 6% contribution (i.e., the base contribution) up to the taxable wage base for all eligible participants. For those participants with compensation above the taxable wage base, Integrated Systems will make an 11.7% contribution (which is the lesser of twice the base contribution (12%) or the base contribution plus 5.7% (11.7%)).

d. “Cross-Tested” Plans

Profit sharing plans typically satisfy general nondiscrimination rules by comparing the amount of contributions given to participants. The IRS allows plan sponsors to prove their plans are nondiscriminatory under a testing alternative known as the “cross-testing method.” Under the cross-testing method, contributions are converted to equivalent benefits payable at normal retirement age, and then compared to determine whether or not the benefits unduly favor highly compensated employees over nonhighly compensated employees. This is similar to defined benefit plan testing. A complete discussion of the cross-testing method is beyond the scope of this writing.

Common businesses that use cross-tested plans are those that want to provide more favorable benefits for certain segments of employees. Typically, these are professional businesses such as chiropractors, doctors, and lawyers. The most common types of cross-tested plans are age-weighted and new comparability plans.

An age-weighted or age-based plan takes into consideration both the age of the plan participant and his/her compensation in determining the contribution amount. Consequently, age-weighted formulas favor older participants. Age-weighted allocation formulas are particularly well suited for small businesses and professional practices where the owners are markedly older than the rank-and-file employees.

New comparability plans permit plan sponsors to favor select groups of participants. Under the new comparability rules, plan sponsors are allowed to define and assign employees to different contribution “rate groups” within the plan. The contribution level for each rate group may vary, as long as the plan proves nondiscriminatory under the cross-testing method.

As the following comparison chart for 2021 illustrates, cross-tested allocation formulas can allow substantially higher contribution amounts for owners and key employees.

Plan Allocation Formula Comparison






Pro Rate



New Comparability

Owner 1







Owner 2







Employee 1







Employee 2







Employee 3







Employee 4







Employee 5













For illustrative purposes only

6. Contribution Limits

In addition to contributions being limited by the terms of the plan document, there are also statutory limits that apply to profit sharing plan contributions. These limits include the compensation cap, the IRC Sec. 415 limit, and the employer’s IRC Sec. 404 limit for deductibility of plan contributions. A brief discussion of each of these limits follows.

a. Compensation Cap

The maximum amount of compensation that can be considered when calculating a plan participant’s contribution is determined under IRC Sec. 401(a)(17) and IRC Sec. 404(l). The limit under these sections for 2022 is $305,000. This amount may be indexed periodically based on cost-of-living adjustments.


Janet Green, a participant in the ACE profit sharing plan, has annual compensation of $305,000. For 2022, Janet’s employer decides to make a 10% pro rata profit sharing contribution to the plan. Her contribution is $30,500 ($305,000 X 10%)

7. Deduction Limits

In designing a 401(k) plan, the plan sponsor will also focus on the deductibility rules for plan contributions. Generally, deductibility issues are not of concern to larger plans but small 401(k) plans can run afoul of the deductibility limits if the plan is not properly designed.

Under IRC Sec. 404, a plan sponsor may only receive a tax deduction for contributions to a 401(k) plan of up to 25% of eligible payroll for the taxable year (i.e., the total compensation paid to all eligible participants in the plan). Employee salary deferrals are not treated as employer contributions for purposes of determining the maximum deductible contribution limit. Therefore, elective contributions are always fully deductible by the employer.

8. Vesting

For participants who cease employment prior to retirement age, the plan will determine the amount of employer contributions in the plan they are entitled to receive based on their “vested” percentages. Employee contributions and rollovers are always 100% vested. Generally, for defined contribution plans, vesting schedules up to six years may be utilized. Vesting is calculated based on the participant’s years of service. The following is a common vesting schedule:













 9. Benefit availability

The plan sponsor determines when benefits are available (payable) to the participants. Different contribution types have different distribution availability rules. In most plans, distributions are available when participants attain the plan’s retirement age even if they are still employed.

A plan participant must have a “triggering event” to be eligible to receive a distribution from a retirement plan. The most common triggering events include

  • attainment of a normal retirement age or early retirement age,
  • severance of employment,
  • plan termination,
  • disability,
  • divorce, or
  • death

The terms of the plan document will define the distribution triggering events that allow participants to take distribution of some or all of their plan balances. Some contribution types such as rollovers, after-tax and certain employer contributions may be distributed at any time, unless the plan sponsor elects a more restrictive distribution requirement.

a. In-Service

In-service distributions of salary deferrals in a 401(k) plan are more restricted than in-service distributions of other types of plan assets. In general, employee salary deferrals may not be distributed prior to severance from employment, death, disability, plan termination, attainment of age 59½, or hardship (IRC Sec. 401(k)(2)(B)(i)).

b. Hardship distributions

Hardship distributions of employee salary deferrals are limited to the lesser of the amount needed to cover the hardship, or “the maximum distributable amount.” For 2018, the maximum distributable amount is the participant’s employee salary deferrals (minus amounts previously distributed on account of hardship), plus the following pre-1989 amounts if the plan so permits: earnings on deferrals, qualified nonelective contributions (QNECs) plus earnings, and qualified matching contributions (QMACs) plus earnings.

Effective for the 2019 and later plan years, participants will be able to distribute other types of contributions beyond employee salary deferrals and grandfathered, pre-1989 amounts as part of a hardship distribution, including qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), safe harbor contributions, and earnings from all eligible sources (including post 1988 earnings on elective deferrals).

To satisfy the regulations relating to a hardship, an in-service distribution of salary deferral amounts must be for the purpose of covering an immediate and heavy financial need (i.e., the “events test”), and must not exceed the amount that is necessary to satisfy the financial need (the “needs test”). However, the amount required to satisfy the financial need may include any amounts necessary to pay any taxes or penalties that are expected to result from the distribution. The regulations pro- vide two different standards for determining whether the events and needs tests for a hardship are satisfied: the general standard (also called the facts-and-circumstances standard) and the safe harbor standard. Most plan documents incorporate the safe harbor standard.

Plan sponsor considering hardship distributions consider the advantages of early access to the retirement benefits contrasted with the disadvantages of poor retirement outcomes if retirement assets are diverted for other purposes.

c. Plan Loans

The plan may permit a participant to borrow up to half their vested benefit (up to $50,000) for up to five years (longer time frames are permitted if the loan is for a primary mortgage on a principle residence). A plan may permit participants to have multiple outstanding loans. Loans are popular, but failure to make required loan payments can subject the participant to serious income and penalty tax consequences. And, plan loans, represent one of the most common areas plans fail to administer correctly.

Review of the plan design process

  • Review and determine the objectives of the plan sponsor.
  • Pass a resolution authorizing the establishment of the plan.
  • Review and select plan provisions consistent with the employer’s objectives.
  • Review plan provisions with stakeholders, including payroll, benefit and HR departments or providers.
  • Finalize and execute the plan document.
  • Select vendors, appoint plan committee(s) if applicable.
  • Prepare and distribute employee communications

Frequently Asked Questions

  1. ABC, Inc., DEF, Inc., and GHI Inc., are part of a controlled group. The board wants to offer a 401(k) to the employees of DEF only and they want to keep the plan as simple as possible. Can a standardized plan be used? No. Use of a standardized plan requires all eligible employees in the controlled group be able to participate. Use of a standardized plan would require DEF’s plan to cover the employees of ABC and GHI, as well.
  1. Which contribution types are always 100% vested? Traditional employee salary deferrals, designated Roth contributions, after-tax contributions, rollovers and safe-harbor contributions.
  1. Can different eligibility rules be used with different contribution types? Yes. A plan may require different eligibility requirements for different contribution types as long as they are nondiscriminatory.
  1. If a participant is still employed, under what circumstances may they receive a distribution of employee salary deferrals? Attainment of age 59½ or hardship (if the plan permits)
  1. What is the maximum plan loan? The maximum plan loan is ½ the participant’s vested balance or $50,000, which ever is less.
  1. Who must authorize the establishment of a plan? The governing body of the plan sponsor, usually the board.
  1. Can certain compensation amounts be excluded for plan purposes? Yes, if additional IRS testing is satisfied.
  1. Must all participants receive the same employer contribution? Yes, if the plan uses a flat dollar allocation formula; no if the plan allocates employer contributions using a pro rata, permitted disparity or cross-tested/age-weighted formula.
  1. Must participants always complete enrollment paperwork before becoming eligible to participate in the plan? Not always. If the plan has an automatic enrollment feature, eligible employee need not take any steps; they will be automatically enrolled in the plan. They can affirmatively opt out in that case.
  1. Can the plan give different contribution amounts to different employee groups? Yes, if the plan document permits and the contributions satisfy additional IRS testing.
  1. What are triggering events? A triggering event must occur before participants are eligible to receive distributions of some or all of their plan benefits. Common triggers include attainment of a normal retirement age or early retirement age, severance of employment, plan termination, disability, divorce, or death. Other triggers may be specified in the plan document.

At Diversified Financial Advisors, we believe with the right plan design, we can create successful retirement outcomes for your business and employees.

We are happy to help, if you have any questions or would like additional insight, please feel free to reach out to me at or 800.307.0376.

Disclosure: This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. Investment Advice and 3(38) Investment Fiduciary services offered through Diversified Financial Advisors, LLC, a Registered Investment Advisor. 3(16) Administrative Fiduciary Services provided by PISTL Service Corporation. Discretionary Trustee services provided by Printing Industries 401k Trustees. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material. 

This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Readers should consult with their tax advisor or attorney regarding their specific situation. The information provided has been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed

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