To retain their tax-qualified status, 401(k) plans are prohibited from discriminating in favor of key owners, officers, and highly compensated employees. Some small businesses that want to help their employees save for retirement may put off offering profit sharing contributions due to the financial burden of a “pro-rata” allocation compared to what the owners might get.
For these types of small businesses, a specific profit sharing plan design may provide the solution. Called new comparability, it allows businesses to remain in compliance while making larger contributions to its older participants, typically owners and highly compensated employees.
A Different Testing Approach
Most profit sharing plans (i.e., pro rata, integrated plans), are deemed to pass nondiscrimination automatically using the safe harbor approach, while new comparability plans are required to pass the general test to prove its not discriminating against non-highly compensated employees.
New comparability allows employees to be segmented into more groups so that owners can be considered separately from, say, non-owner HCEs. In addition, testing is based on projected benefits at retirement that are derived from contributions, rather than on the contributions themselves. This “cross-testing” is a bit of a hybrid approach whereby the 401(k) (a defined contribution plan) is tested as if it were a traditional pension (i.e., defined benefit) plan.
Plans using this method are able to pass testing and be compliant because younger NHCEs have more time until retirement, and so their projected benefit based on lower contributions falls within an acceptable range of the projected benefit of older HCEs receiving a larger contribution.
Using the new comparability plan design, a plan could, for instance, make 401(k) contributions of 10% to owners and 6% to NHCEs. Or contribute 10% to one owner, 8% to another owner, and 5% to NHCEs.
Minimum “gateway requirement”
To take advantage of the new comparability profit sharing plan design, the contribution to all NHCEs must be a minimum of:
- One-third of the highest contribution rate given to any HCE; or
- 5% of the participants gross compensation
Firms Well-Suited to New Comparability
The new comparability profit sharing plan design is a good solution for companies with fewer than 50 employees that have a group of older owners and/or HCEs that are important to the success of their organization.
Companies that tend to implement this design feature include:
- Law Firms
- Medical Practices
- Accounting Firms
- Service Companies
Plan sponsors interested in this feature can include the profit sharing contribution in their plan documents as discretionary, meaning they are never obligated to make a contribution in any given year. This is helpful, too, since your employee demographics will likely change from year to year and so may your profit sharing allocation decisions.
In addition to the benefits that a retirement plan provides to employees, profit sharing plans provide real benefits to small business owners. Profit sharing contributions are tax deductible and not subject to payroll taxes (e.g. FICA).
The new comparability profit plan design gives small business owners significant flexibility to offer a 401(k) that meets the needs of their organization.