Companies value 401(k) profit sharing plans as an attractive employee benefit, allowing them to reward their workforce without immediate taxable income implications. Traditional profit sharing plans, however, often require uniform contribution percentages across all employees to meet IRS non-discrimination rules. This can limit the ability of business owners and highly compensated employees to maximize their own retirement savings within these plans. This is where the concept of New Comparability Profit Sharing emerges as a strategic solution.
New comparability plans offer a unique approach to profit sharing contributions. Instead of treating all employees as a single group, these plans allow for individual assessment of each employee. This flexibility enables businesses to customize profit sharing contributions, potentially allocating larger percentages to key personnel, including owners and executives. The crucial aspect is adhering to specific IRS tests that ensure these contribution structures do not disproportionately favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs) in the long run. This method hinges on a concept known as cross-testing, which we will explore further.
Understanding 401(k) Profit Sharing Basics
Let’s first revisit the fundamentals of 401(k) profit sharing plans. In essence, profit sharing within a retirement context involves employers making tax-deductible contributions directly into employees’ 401(k) accounts. It’s important to note that despite the term “profit sharing,” these contributions are not strictly tied to company profitability. Think of them more as performance-based bonuses or general retirement contributions made by the employer. Profit sharing plans offer significant advantages for both employers and employees, creating a win-win scenario for retirement savings and workforce motivation.
Various methods exist for calculating and distributing profit sharing contributions. A straightforward approach is to allocate a fixed dollar amount to each employee. Alternatively, to provide proportionally larger benefits to higher earners under traditional plans, contributions can be tied to a uniform percentage of each employee’s salary. However, these standard methods may fall short when business owners or key executives aim for substantially higher contribution percentages for themselves compared to other employees. This is the precise scenario where new comparability plans become invaluable. They offer an alternative calculation method designed to potentially deliver greater rewards to these critical employees while still adhering to IRS guidelines.
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Delving into Cross-Testing and New Comparability
The mechanism that underpins new comparability plans is cross-testing. This method departs from the traditional approach of directly evaluating the contribution percentage to determine if a profit sharing plan is discriminatory. Instead, cross-testing assesses discrimination based on the benefit accrual rate. This rate projects the future value of an employee’s retirement account at their anticipated retirement age, taking into account current contributions and estimated investment growth over time.
Crucially, cross-testing often reveals that NHCEs can achieve benefit accrual rates comparable to, or even exceeding, those of their higher-earning counterparts. This can occur even when their current profit sharing allocations are numerically smaller. The reason for this lies in factors like age and time horizon until retirement. Younger employees have a longer time horizon for their retirement savings to grow, potentially offsetting lower current contribution percentages when projected to retirement age.
Consider this illustrative example of a small business owner, aged 50 and with a higher income, utilizing a new comparability plan:
| Participant | Age | Salary | Contribution % | Profit Sharing $ |
|---|---|---|---|---|
| Owner | 50 | $200,000 | 10.0% | $20,000 |
| Alice | 25 | $40,000 | 3.33% | $1,340 |
| Bob | 30 | $60,000 | 3.33% | $2,000 |
| Carrie | 35 | $80,000 | 3.33% | $2,670 |
The table depicted is illustrative. It is not representative of any client account.
The effectiveness of new comparability plans is contingent on your company’s specific demographics. Factors such as business owners being of similar age or income level to other employees can influence the outcomes of cross-testing and may not yield the desired results. However, for businesses where owners and key employees are generally older and higher-paid than the broader workforce, new comparability plans can be an excellent strategy to maximize tax-advantaged retirement savings. This is particularly relevant for those aged 50 or older who are eligible for “catch-up” contributions, allowing for even greater annual retirement contributions.
New comparability profit sharing can be particularly advantageous for your small business if these conditions align with your situation:
- You aim to maximize employer contributions for owners and executives.
- Business owners are generally older than non-owner employees.
- Owners consistently earn higher salaries compared to non-owner employees.
- Your company has a relatively small workforce (typically under 50 employees).
Navigating Gateway Requirements for New Comparability
To qualify for new comparability profit sharing and cross-testing, certain minimum gateway requirements must be satisfied. These requirements are in place to ensure a baseline level of benefit for NHCEs. Specifically, you must make a minimum contribution to all NHCEs that is at least:
- One-third of the highest contribution rate provided to any HCE, or
- 5% of the NHCE participant’s gross compensation.
Leveraging a Safe Harbor 401(k) plan is often the most efficient way to meet these gateway requirements. Safe Harbor plans, where employers contribute at least 3% of pay into eligible participants’ accounts as a non-elective contribution, not only satisfy the minimum gateway but also offer the added benefit of exempting the plan from certain annual non-discrimination tests.
Combining a 3% non-elective Safe Harbor contribution with a new comparability profit sharing component can be a powerful strategy. It allows business owners to optimize their own (and other targeted employees’) employer contributions while concurrently meeting the necessary minimum gateway requirements for most NHCEs. It’s important to note that depending on the specific demographics and compensation structure of your workforce, some NHCEs might necessitate contributions exceeding the minimum gateway to successfully pass the Average Benefits Test and/or coverage testing, which are also mandatory for plan compliance.
Once these gateway and non-discrimination requirements are met, you gain the flexibility to implement individualized profit sharing contributions based on each employee’s benefit accrual rate. This unlocks the potential to significantly increase employer contributions for strategically chosen employees, such as owners and key executives, while maintaining a qualified and compliant retirement plan.
New comparability plans offer substantial flexibility for small businesses seeking to strategically reward owners and other HCEs within their retirement plan framework. However, the complexities of rigorous testing, ongoing maintenance, and plan setup can appear daunting. Seeking expert guidance is highly recommended to navigate these intricacies effectively and ensure your plan is both compliant and optimized for your specific business objectives.
Give your employees a roadmap to retirement
With Guideline, you can provide an impactful work benefit while minimizing paper work and fees
