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An in-depth look at the requirements, testing, and rules involved with the new comparability profit sharing formula.
Updated over a week ago Table of contentsProfit sharing in a 401(k) plan is a discretionary pre-tax contribution employers can make to their employees’ retirement accounts after the end of the year. Guideline offers several types of profit sharing formulas (pro-rata, flat-dollar, and new comparability), which give plan sponsors considerable flexibility in how these contributions are allocated to participants.
The most dynamic formula is new comparability, sometimes referred to as the cross-tested formula. With this formula, employers can allocate a different contribution amount to each employee. Plan documents may specify different groups or could put each participant into their own group.
While new comparability can be complex, here’s a detailed overview of how to determine if this profit sharing formula might make sense for your business.
In a new comparability plan, employers must:
Provide at least required minimum contributions (gateway requirements), and Compare the projected benefits at retirementNew comparability plans can give profit sharing contributions to the highly compensated employees (HCEs) that appear to favor HCEs, but which are allowed by the IRS if the allocation can pass a series of strict tests. Note that Guideline takes all testing into account when determining the allocation amounts. Any allocation amounts provided by Guideline will pass these tests.
New comparability plans must first satisfy the gateway contribution requirement, which is where a minimum gateway contribution must be made to all non-highly compensated employees (NHCEs).
This contribution must be the lesser of:
Note: Safe harbor 401(k) plans that make a non-elective contribution can use the non-elective contribution to offset the minimum gateway contribution.
The second test that applies to all profit sharing allocation formulas is used to confirm that the formula is not discriminatory. For new comparability formulas, we use the general test to make this determination.
In the general test, the participants are broken up into groups based on their profit sharing contribution rate. The difference with new comparability formulas is that we will use the participants’ equivalent benefit accrual rate (EBAR) instead of their actual allocation. Each HCE will be put in their own allocation group and each group will then be tested individually. The allocation must pass either the Ratio Percentage Test (RPT) or the Average Benefits Test (ABT), or the plan as a whole fails. Since the RPT is easier to perform, it is typically run first, and the ABT is only run when the RPT fails.
The first step is to determine each participant’s equivalent benefit accrual rate (EBAR) as this will be used instead of just their profit sharing contribution rate when running the RPT and the ABT.
When calculating a participant’s EBAR, a formula is used that includes an anticipated rate of return on investments along with an actuarial factor based on age to estimate what the profit sharing contribution will be worth at an assumed retirement age. Because the EBAR essentially measures the expected investment benefits of an allocation between the time of contribution and the time of retirement, employers can often make higher contributions to older employees who are closer to retirement compared to their younger colleagues who have longer until they reach the assumed retirement age.
Once the EBARs are determined, the next step is to break participants up into groups based on their EBARs (the general test) with each group consisting of an HCE and any participants (HCE or NHCE) with an EBAR equal to or greater than the HCE. This is referred to as a “rate group” and the number of rate groups will depend on how many HCEs are in the plan and if any of the HCEs have the same EBAR. These rate groups will be used for the remainder of the testing. Each rate group will then be tested individually and the plan must pass either the RPT or the ABT. This testing is complex and below is a very high level explanation.
Under the RPT, the ratio of NHCEs benefiting in that rate group is compared with the ratio of HCEs benefiting. The RPT is satisfied if the plan’s “ratio percentage” is greater than 70%.
The average benefits test is much more complicated and consists of two parts: the average benefits percentage test and the nondiscriminatory classification test. Both parts must be passed by the rate group.
Note that in the below examples, the numbers provided for the new comparability formula meet the testing requirements as stated above and are designed to give the smallest total profit sharing possible while maximizing the owner.
Example 1: Bruce owns a small company and has 4 employees, all NHCEs. Bruce has a profit-sharing plan for himself and his employees. In this first example, Bruce is the oldest employee of the company with the majority of other employees who are eligible to participate in the plan being significantly younger than him.
The following table shows how the company’s contribution of $60,240 to the profit-sharing plan could be allocated using a pro-rata formula versus a new comparability formula.
Example 1: OLDER OWNER / YOUNGER WORKFORCE
Pro rata 401(k) formula vs. new comparability 401(k) formula
Example 2: Marco is a younger owner and the age of the NHCEs who work for Marco are older in general. However, the compensation earned is the same. In order to make a contribution up to the annual additions limit (415 limit) using the new comparability allocation formula, the company will have to make a larger contribution to the plan overall (roughly another $30,000) than the company in the first example. In this example, if the goal is to maximize the contribution to Marco while keeping the overall contribution as low as possible, the company may choose to use the pro-rata allocation formula instead of new comparability.
Example 2: YOUNGER OWNER / OLDER WORKFORCE
Pro rata 401(k) formula vs. new comparability 401(k) formula
The rules for new comparability are complex, so we can help you decide whether this formula might make sense for your plan.
Interested in new comparability profit sharing? Contact our sponsor support team for more information or to find out if it may be a good fit for your business.
New comparability profit sharing is included in Guideline 401(k) plans within our Enterprise tier and available for an additional fee for our Core plans. See our Form ADV 2A Brochure for more information regarding Guideline's fees.
