A “new comparability” plan is a flexible type of profit sharing retirement plan that can either stand alone, or be part of a 401(k) plan. Small business owners find these plans attractive for their flexibility in dividing employees into different groups, and assigning these groups different profit sharing contribution rates. Often, business owners will be able to maximize the contribution rate for the group they belong to, so long as the other groups receive an adequate minimum allocation.
How is this possible? Unlike some other profit sharing allocation methods (such as the “comp-to-comp” or “permitted disparity” methods), which are automatically deemed not to discriminate in favor of Highly Compensated Employees (HCEs), the allocations in new comparability plans must pass “cross-testing” to prove nondiscrimination. Cross-tested plans will pass the nondiscrimination test if they can demonstrate that the “benefit accrual rates” of Non-Highly Compensated Employees (NHCEs) are equal or similar to the benefit accrual rates of the HCEs.
What does this mean in plain English? In cross-testing, profit sharing allocations are recalculated into projected benefits at each participant’s normal retirement age under the plan. Instead of comparing each participant’s allocation as a percentage of pay, a cross-tested plan compares these projected retirement benefits. Cross-testing often finds that NHCEs will have benefit accrual rates that are at or above the benefit accrual rates of the HCEs, even if their profit sharing allocations are significantly less. Such an outcome would still pass the nondiscrimination test.
It’s important to keep in mind that cross-testing results will depend on your company demographics. For example, having business owners that are the same age, or make the same amount, as their other employees will often mean that cross-testing won’t work as intended. And, the fewer the number of employees, the more sensitive the calculations will be to each individual’s age and salary.
All that being said, a new comparability plan may be a great way to maximize your tax and retirement savings as an older owner or employee. Qualifying participants can have up to $62,000 added to their accounts in 2019, instead of just the $19,000 ($25,000 if age 50 or over) employee deferral limit found in the most basic 401(k) plans.
Profit sharing plans can allow you to save thousands for retirement, while also saving in taxes each year. We’ll walk you through how new comparability profit sharing works to see if this makes sense for your business.
How do profit sharing plans work?
401(k) profit sharing plans have a maximum annual allocation limit of $56,000 in 2019. Assuming an employee defers the maximum $19,000 of their own pay into the account, that leaves $37,000 more for an employer to contribute toward the employee’s retirement. If you are age 50 or over, you’re also able to defer an additional $6,000 of your pay, for a total limit of $62,000. For 2019, a 401(k) plan with no employer contributions will limit an eligible employee to an allocation of just their own deferrals, up to $19,000 (plus $6,000 catch-up if eligible).
How do you ensure new comparability profit sharing plans are fair and pass IRS tests?
First, it’s important to have a Safe Harbor 401(k) plan that uses at least the 3% nonelective contribution. “Safe Harbor” plans require employers to contribute to their employees’ 401(k) in order to be exempt from certain non-discrimination tests. We recommend making a nonelective 401(k) Safe Harbor contribution that is from 3-5% of their compensation, which will also help to satisfy the “gateway” minimum contribution needed for cross-tested plans such as new comparability plans.
To use cross-testing, a new comparability plan must satisfy one of two minimum gateway requirements. The gateway minimum contribution must be made to all NHCEs before cross-testing can be performed and is equal to the lesser of:
- One-third of the highest contribution rate given to any HCE, or
- 5% of the participant’s gross compensation.
Note that using a Safe Harbor nonelective contribution will serve two purposes:
- Exempts the plan from ADP/ACP nondiscrimination testing, so that business owners don’t have to worry about refunding their contributions for the year, and
- Counts toward the minimum gateway contribution needed to do new comparability profit sharing.
In contrast, a Safe Harbor matching contribution will give an exemption to nondiscrimination testing but will not count toward the minimum gateway contribution, so it is not recommended.
After securing your Safe Harbor contribution, the next step is to make differing profit sharing contributions to each NHCE in such a way that the future benefit at normal retirement age is equivalent, on the whole, to each HCE’s future benefit.
Here’s a sample contribution scheme where the small business owner is 50 years old with a high income. Using new comparability, the owner can receive a larger contribution than the younger, lower income employees.
As you can see, this type of structure enables older owners to save more aggressively for retirement, while also ensuring younger employees gain significant retirement benefits through additional employer contributions.
(It’s important to note that changes in your employees can affect your projected contributions. So, specific results may change each year and can’t be guaranteed.)
Who is a good fit for new comparability profit sharing?
A 401(k) plan that combines a 3% nonelective Safe Harbor contribution with a new comparability profit sharing component may permit business owners to maximize employer contributions to themselves (and other targeted employees) far beyond any other profit sharing plan design, while still satisfying the rigorous compliance challenges these plans face.
New Comparability profit sharing can be a great option for your small business if:
- You’d like to maximize employer contributions made to owners and/or executives
- Owners are generally older than non-owner employees
- Owners have a higher salary than non-owner employees
- You have a small number of employees (typically fewer than 50)
Does Guideline support new comparability profit sharing plans?
Yes, we will help you analyze whether a new comparability plan is right for your business.
Due to the rigorous testing and maintenance to set up the plans, many 401(k) providers charge more for new comparability profit sharing. However, at Guideline we include it in our Prime plan offering, which is a simple flat fee of $99 base plus $8 per employee per month.
The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.