What is new comparability profit sharing?
Companies like 401(k) profit sharing plans because they’re a great way to reward employees without increasing their taxable income. However, because of IRS requirements, most plans require that you contribute the same percentage of pay to each employee’s account to avoid discrimination, meaning business owners can’t pay more into their own accounts. That’s where new comparability plans come in.
New comparability plans are special because you can judge each employee separately, and essentially customize the profit sharing contribution for each one, so long as certain tests show that the contributions don’t discriminate against non-highly compensated employees, known as NHCEs, in the long run.
401(k) profit sharing
First, a refresher on how profit sharing plans work. In the context of retirement, profit sharing involves an employer making tax deductible contributions to employees’ 401(k) accounts. Despite the name, they don’t necessarily have to do with company profits. Think of it as a bonus deposited directly into employees’ retirement accounts. Profit sharing comes with a slew of benefits for employers and employees alike—learn about those here.
As of 2020, 401(k) profit sharing plans have a maximum annual contribution limit of $57,000. Assuming an employee defers their annual maximum of $19,500, that leaves $37,500 for employers to potentially contribute.
There are a few different ways to calculate who gets what. For example, you can give everyone the same, flat dollar amount. If you want to give high-earners a more, you can instead tie the contribution to a flat percentage of employee pay. But sometimes business owners and executives want an even bigger percentage of pay. In cases like these, neither method cuts it.
New comparability plans have a different way of calculating contributions, so you can reward these critical employees without running afoul of nondiscrimination testing.
New comparability plans work because of cross-testing. Rather than gauge whether a profit share is discriminatory on the face value of the contribution, cross-testing uses a benefit accrual rate, which projects the future value of an individual's retirement portfolio when the individual reaches retirement age. In many cases, NHCEs will have accrual rates that are similar or even higher to their high-earning peers, even if their current profit sharing allocations are significantly less.
Here’s a sample contribution setup where a small business owner is 50 years old with a high income. Using new comparability, the owner can receive a larger contribution than younger, lower income employees.
Whether or not this works depends on your company’s demographics. For example, having business owners that are the same age or earn a similar amount as other employees can throw off the results.
New comparability plans may be a great way to maximize tax and retirement savings for older, higher paid owners or employees. That’s especially true if they’re age 50 or older and eligible for “catch up” contribution limits. Between their own contributions and their employers’, qualifying participants can have up to $62,000 added to their accounts in 2019.
Going further, new comparability profit sharing can be a great option for your small business if:
- You’d like to maximize employer contributions made to owners 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)
To become eligible for new comparability profit sharing and cross-testing, a minimum gateway requirement has to be met. You’ll need to first make a minimum contribution to all NHCEs amounting to at least:
- One-third of the highest contribution rate given to any HCE, or
- 5% of the participant’s gross compensation.
To count toward this gateway, it’s best for employers to have a Safe Harbor 401(k) plan where they contribute at least 3% of pay into participants’ accounts. Safe Harbor nonelective contributions not only count toward the minimum gateway, but also have the added benefit of being exempt from nondiscrimination testing. A 401(k) plan that combines a 3% nonelective Safe Harbor contribution with a new comparability profit sharing component can help business owners maximize employer contributions to themselves (and other targeted employees) while still satisfying the rigorous compliance requirements that profit sharing plans face. Once you satisfy these requirements, you can now make individualized profit sharing contributions, based on the individual’s benefit accrual rate–potentially increasing employer contributions for certain employees.
New comparability plans offer a lot of flexibility for small businesses looking to reward owners and other HCEs. But between the rigorous testing and maintenance, setting them up can seem daunting. Don’t go it alone.
As part of Guideline’s Prime plan, our experts work with you to determine whether new comparability plans are right for your business. To learn more about how we can help, schedule a call with our retirement experts today.
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.