Profit-sharing plans are qualified retirement plans that give employers the opportunity to make discretionary profit-sharing contributions to the plan for the benefit of their employees. Profit-sharing contributions are typically made according to a specific formula specified in the plan document. Probably the most common formula for allocating profit-sharing is ‘pro rata’ where each employee receives a contribution at the same percentage of compensation. Plans have considerable flexibility in selecting a profit-sharing formula. The most flexible formula permits employers to allocate a different amount to each employee (plan documents may specify different groups or could put each participant into his or her own group). This flexible formula goes by many names but is most commonly referred to as a ‘new comparability’ or ‘cross-tested’ formula.
All profit-sharing contributions made to a 401(a) plan have to either 1) have a plan design and formula that doesn’t require testing or 2) pass nondiscrimination testing. A simple pro rata formula (equal percentage of compensation for all participants), for example, does not require additional testing as long as certain plan design requirements are met (e.g., the definition of compensation meets certain requirements, the plan generally allows all employees to participate in the plan, etc.). Plans with more complex formulas and plan designs generally require more complex testing.
For purposes of this article, we will refer to the profit-sharing formula where each participant could receive a different contribution as ‘new comparability’ (arguably the ‘formula’ here is the lack of a formula since each Participant could potentially receive a different amount) and the testing required for this plan design as ‘cross testing’. It’s important that the nuances of cross testing are understood in connection with the new comparability contributions since calculations for the individual allocations can be more complex and dynamic than those for traditional profit-sharing plans.
In a New Comparability plan, employers must:
- Provide at least required minimum contributions (gateway requirements), and
- Compare the projected benefits at retirement
Cross-tested plans can have contributions to the HCEs and NHCEs that look discriminatory, but which are allowed by the IRS if the plan can pass a series of strict tests.
The first hoop a New Comparability plan must jump through is the Gateway requirement. A minimum gateway contribution must be made to all NHCEs of the lesser of:
- One-third of the highest HCE/owner contribution rate, or
- 5% of the participant’s compensation
Note: A Safe Harbor 401(k) plan with a 3% non-elective contribution can apply the 3% contribution toward the minimum gateway contribution.
Cross-testing - EBARs and the General Test
Cross-testing looks at the benefit a contribution today would provide at the plan’s normal retirement age using certain actuarial assumptions known as Equivalent Benefit Accrual Rates or EBARs. An EBAR is calculated as follows:
profit-sharing contribution / compensation * actuarial factor based on age
This actuarial factor has the effect of allowing employers to make higher contributions to older employees close to retirement compared to their younger colleagues who have longer until they can retire.
The general test breaks the plan up into testing groups (rate groups) based on EBARs. Each HCE EBAR has a separate rate group. An HCE’s rate group includes all participants who have a rate equal to or greater than the HCE.
Each rate group is treated as if it were a separate plan and each must pass one of two coverage tests: the ratio percentage test or the average benefits test.
- Ratio percentage test. Once the rate groups have been determined, the percentage of the total number of NHCEs in a rate group (if 4 NHCEs are in the rate group and there are 12 total NHCEs, there are 33.33% of the NHCEs participating in that rate group) are divided by the percentage of the total number of HCEs in the group (if one HCE is in the rate group and there are 4 total HCEs, there are 25% of HCEs in the rate group). The test says that if the ratio percentage for each rate group is at least 70% (33.33/35 = 133.32%), the plan is nondiscriminatory and the second test isn’t necessary.
However, if the ratio percentage test is not passed, then it’s on to the average benefits test.
- Average benefits test. The average benefits test is much more complicated and consists of two parts: the average benefits percentage test and the non-discriminatory classification test. Both parts must be passed by the rate groups.
(Note: Guideline does not use the average benefit test, preferring instead to correct plans that fail the ratio percentage test by adjusting the allocation so they pass ratio percentage test.)
Example 1: Bruce owns a small company and has four employees, all NHCEs. Bruce has a profit-sharing plan for himself and his employees. The following table shows how Bruce’s contribution to the profit-sharing plan of $60,240 could be allocated using a Pro rata formula and a New Comparability formula.
Example 1: OLDER OWNER / YOUNGER WORKFORCE
Pro Rata 401(k) formula
Example 2: Let’s take our first example and change things around. Bruce is now a younger owner and the age of the other NHCEs that work for Bruce are also older in general. In order to make a contribution up to the 415 limit, Bruce will have to make a larger contribution to the plan overall (roughly another $30,000).
Example 2: YOUNGER OWNER / OLDER WORKFORCE
Pro Rata 401(k) formula
When are New Comparability Plans a good choice?
New Comparability profit-sharing plans are often very suitable for small businesses when:
- The plan sponsor wants to maximize contributions to him/herself
- Owners are generally older than the rest of the employees
- Owners receive higher compensation than the other employees
- The company has a small number of employees (usually fewer than 50)
New Comparability plans can be a good way to provide owners and other highly-paid employees higher contributions that they would receive under a profit-sharing plan with a pro rata formula. However, they work best for companies whose owner and other HCEs are generally older than the NHCEs since the nondiscrimination tests look at what contributions made today would be worth at retirement age.
The rules for New Comparability are very complex, so you’ll probably want help in deciding whether to offer this type of plan. Guideline can help you decide if New Comparability is a good fit for you and your business.