Understanding Integration Level in the Context of Permitted Disparity Rules

Employer-provided retirement plans, such as 401(k) and profit-sharing plans, are often set up as cross-tested plans. Yet, there are circumstances where a cross-tested plan might need to revert to being an integrated plan, primarily for conformity with nondiscrimination rules. This transition is closely associated with the concept of 'integration level' and 'permitted disparity.'

To further clarify, let’s define the critical terms in context:

1. A 'uniform allocation' profit-sharing plan allows employers to contribute a uniform dollar amount or the same percentage of compensation to each eligible employee. This allocation can be a flat dollar amount, say $2,000 for every participant, or a percentage, such as 10% of compensation for all participants.
2. An 'integrated' profit-sharing plan, on the other hand, allows a slightly higher percentage of pay to employees whose compensation exceeds a particular threshold, often the Social Security Taxable Wage Base. The term 'integrated' was historically used because these plans would integrate with Social Security contributions or benefits. The regulations today refer to it as 'permitted disparity.' For example, in an integrated plan, employees that earn more than the integration level could receive a 13% share, compared to a 10% share for those below the threshold.
3. A 'cross-tested plan,' gives the employer discretion over the allocation of profit-sharing contributions for each employee, as long as a nondiscrimination test and certain other requirements are met. The plan doesn’t necessarily need to use cross-testing every year. It is essentially a tool to ensure non-discrimination in annual contribution allocations.

Understanding when cross-testing may no longer be optimal and reverting back to an integrated plan is essential to the proper management of a 401(k) plan. For example, let’s consider a hypothetical situation where the employee demographic landscape of a company has shifted, resulting in a failure of the nondiscrimination test at a 5% profit-sharing contribution. To meet the test, they may have to distribute a much larger share, say 16% to employees. This situation implies that the non-highly compensated employees are receiving a higher percentage than the highly compensated employees. In such scenarios, switching from a cross-tested plan to an integrated model would be beneficial.

The concept of 'integration level' occurs when an 'integrated' profit sharing plan allows a slightly higher percentage of pay to those whose compensation exceeds a certain threshold. According to a discussion forum post on Benefitslink, it seems mandatory to use the full taxable wage base as the integration level for permitted disparity.

However, it is crucial to remember that plan sponsors have flexibility in their plan design, allowing them to balance their business objectives while conforming to IRS nondiscrimination and compliance rules. As such, the integration level and permitted disparity settings should be decided in a way that optimally fits the company's and employees' needs.

Finally, while this article provides a brief overview of the topic, the specifics of your situation may require buying advice from a professional to ensure compliance with legal and tax requirements.