One of the strongest features of a well-designed 401(k) plan is the ability of participants with higher levels of compensation to make significant contributions to a qualified retirement plan (up to $56,000 annually plus an additional “catch-up” deferral of $6,000 for those over the age of 50). This provides both meaningful tax benefits and allows the investment returns on these contributions to cumulate tax-free while they remain in the plan. The result is annual tax savings and significantly larger balances for employees at retirement.
One of the strategic ways where highly compensated employees can reach these maximum thresholds is through a discretionary profit sharing feature. The IRS rules allow employers to decide both whether a contribution will be made for a given year up and the amount, allowing them flexibility year to year based on their business results.
Profit Sharing Contributions: The Basics
401(k) profit sharing contributions, in addition to being discretionary, are considered a type of “non-elective” employer contributions. This means that employees who may not be deferring into the plan are still eligible to receive contributions made to profit sharing. Profit sharing contributions also have added flexibility for the employer as they can be made subject to a vesting schedule – up to a 3-year cliff or 6-year graded. For organizations which may have short-tenured employees, this can involve forfeiture of these benefits upon termination, further lowering the overall cost to owners for utilizing a profit sharing feature.
When to Choose Profit Sharing
Because of the discretionary nature of profit sharing contributions, they can be a great choice for startups, companies with erratic profitability or those who frequently make corporate acquisitions.For professional organizations such as medical practices and certain law firms with stable or increasing cash flows, profit sharing contributions can be pivotal in achieving certain plan goals, including the following:
- Allowing certain HCE’s to increase total annual contributions up to the legal limits (described above).
- Giving your lower paid staff and administrative employees (whose loyalty greatly benefits the organization) a base retirement benefit.
- Attracting and recruiting top employee talent through a generous retirement benefit.
To be clear, profit sharing contributions are not always good choice for every 401(k) plan. Matching contributions may be a more effective way to go for those plans whose primary goal is to incentivize a high percentage of employees to participate in salary deferrals.
Further, not all employers will qualify for the most flexible allocation methods due to IRS nondiscrimination testing limits and the demographic makeup of its workforce. But for many professional service firms, profit sharing contributions can be an extremely valuable tool to achieve plan goals.
Profit Sharing Allocation Methods
For professional firms such as legal and medical practices, achieving these upper limits of participant contributions for the highly compensated employees (HCE’s) of the practice without unfairly discriminating against those designated by ERISA as non-highly compensated (NHCE’s) involves choosing among a variety of methods by which to allocate the total annual profit sharing contribution. By comparing the resulting impact of each method and then combining it with other 401(k) features such as matching contributions, an overall plan design can be customized to best achieve plan goals.
When employers choose to “turn-on” the profit sharing feature of their plan, they can allocate these contributions using one of the following methods:
Option #1: Pro-Rata or Salary Proportional
This formula is the most basic and serves as the default allocation for many 401(k) plans. With pro-rata allocation, each participant receives an allocation equal to a uniform percentage of his or her compensation. This salary proportional method is a good choice given that the employer wishes to provide an easy to understand retirement floor for employees. It’s obvious drawback is that it may be significantly more expensive formula for those companies which want their highly compensated partners to max-out their retirement contributions.
Option #2: Permitted Disparity / Social Security Integrated
Unlike easier to understand methods such as pro-rata, permitted disparity allocation formulas are a bit more complex. This option is also referred to as Social Security Integration in that it recognizes that Social Security retirement benefits are provided only up to compensation at or below the Social Security Wage Base ($132,900 for 2019; $137,700 for 2020). This formula specifically allows additional plan contributions for employees whose annual compensation may exceed that level (termed “Excess Compensation”).
There are two steps to determining the contribution using Permitted Disparity or Social Security Integration:
- Step 1 – A uniform percentage of total base pay, referred to as the “base percentage”, is allocated to all eligible participants. This would include those eligible but not actively deferring a portion of their own wages into the plan.
- Step 2 – A uniform percentage of Excess Compensation is allocated to those eligible participants whose compensation exceeds the Social Security Taxable Wage Base (SSTWB) in effect for that year. This excess percentage cannot exceed the lesser of the base percentage or 5.7%.
For example, Curtis is a partner of ABC Law and earns $200,000 in 2019. Curtis would have excess compensation of $67,100 in that year ($200,000 – $132,900). If the base percentage set for the plan were 10%, Curtis would receive a profit sharing contribution of $23,825based on the formula as follows:
Total Compensation X 10% ($200,000 X .10) = $20,000
+Excess Comp X 5.7% ($67,100 X .057)= $3,825
Total Contribution $23,825
It should be noted that it is also possible to integrate the allocation at a level below the SSTWB. Doing so, however, would result in a reduction of the maximum excess contribution percentage.
This permitted disparity allocation formula should be considered for plans wishing to increase contributions for high income employees while insuring that the plan will also pass IRS nondiscrimination testing.
Option #3: New Comparability
The new comparability method uses the time value of money as a basis to allocate larger contributions to older participants who are closer to retirement. It is also the most flexible type of profit sharing allocation formula in that it allows employers to allocate contributions at multiple rates to different employee groups. This added flexibility allows employers to allocate larger contributions to business owners or other highly compensated employees (HCE’s).
The first step for determining the allocation for a given year involves dividing eligible participants into employee groups referred to as “allocation groups”. Participants are placed into various groups to maximize flexibility and employers are permitted to determine the amount of the total profit sharing contribution to allocate to each group.
NHCE’s are required to receive a minimum “gateway” contribution that is the lesser of the following:
- 5% of compensation
- One third of the highest percentage allocated to any HCE
The next step is to project these contributions as a benefit at the plan’s normal retirement age (usually age 65) and cross-tested to confirm that the future benefits to be received by HCE’s is not disproportionately higher than the future benefits to be received by the NHCE’s on a percentage basis. This cross-testing can make a 15% contribution to a 55 year old employee with 10 years to retirement as relatively valuable as a 5% contribution to a 30 year old with 35 years to retirement. If the HCE benefits fall outside of the acceptable range, the company can correct by increasing the contributions for NHCE’s, reduce the contributions for HCE’s, or a combination of both.
Importantly, the effectiveness of new comparability is highly sensitive to the demographic composition of a company’s workforce. However, if one of your primary plan goals is maximizing business owner contributions at the lowest total cost, a new comparability formula may be a great option.
Due to the “cross-testing” required for determining new comparability allocations, companies with older business owners are often the best candidates for new comparability. A spread of 10 years between owners and NHCE’s often allows these employers to maximize owner contributions while limiting NHCE contributions to the “gateway minimum”. Often the annual tax saving to owners utilizing this method exceeds the additional non-elective contributions made on behalf of lower paid staff.
Changing Methods: What You Need to Know
Allocation formulas may be changed from year to year based on changing company demographics or profitability. However, it is important that the plan document specify the allocation method to be used for any particular plan year. The general guideline for making an allocation change is by the end of the year for which the contribution will be made. If you are considering making a profit sharing contribution this year, you should have SRP run an illustration of how the various methods would work for you and amend your plan document accordingly prior to December 31, 2019 (or the last day of your current plan year). Amending your plan’s profit sharing method will in not commit you to electing profit sharing contribution for the current year.
Call Us for a Customized Illustration
Profit sharing contributions are flexible and allow plan sponsors meet a variety of plan goals. You should understand your options in order to decide whether to implement them for your plan. Give us a call and we can provide you with an illustration tailored to your company.
Brian C. Rall
President- Strategic Retirement Partners, LLC
Strategic Retirement Partners is an independent, boutique investment advisory and consulting firm providing plan design, vendor search, investment selection, fiduciary guidance and participant education for company sponsored retirement plans.
Strategic Retirement Partners, LLC is a registered investment advisor in the State of Washington. The investment advisor may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Any information contained herein or on SRP’s website is provided for educational purposes only and is not intended to make an offer or solicitation for the sale of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated are not guaranteed. SRP does not provide legal or tax advice and clients should consult their attorneys and CPA for any strategy discussed herein or on this website.