Ben, after many years of
working for a contractor that did not sponsor a retirement plan, decided
to start his own construction company. Due to his many contacts in the
industry, his business grew very quickly. In order to attract and retain
quality employees, Ben realized that he must offer a comprehensive
benefits package that includes a 401(k) plan.
Ben is age 51 and has not had an opportunity to save a significant
amount for retirement. Therefore, he would like to adopt a qualified plan
for the 2004 year that allows him to achieve the following goals:
- Maximize his ability to save for retirement.
- Control the costs for his employees.
- Provide flexibility so that he is not required to make a
contribution if his business experiences a downturn.
Understanding the following concepts will assist Ben in developing a
retirement program that achieves his goals.
Allocation of Profit Sharing Contributions
There are three common techniques used to allocate profit sharing
contributions. These techniques, known as pro-rata, permitted disparity
and new comparability or cross testing, are described below.
Pro-Rata and Permitted Disparity
Under the pro-rata method, an employer's contribution is allocated in
the ratio that each participant's compensation bears to the total
compensation of all eligible participants. The permitted disparity method
is very similar to the pro-rata allocation, except that generally
individuals earning more than the FICA wage base will receive a
contribution amount that is a higher percentage of compensation than those
under the FICA wage base. These two allocation techniques are considered
to be safe harbor formulas and deemed to be nondiscriminatory under the
Internal Revenue Code (IRC).
New Comparability or Cross Testing
New comparability or cross testing allows a profit sharing contribution
to be allocated using nondiscrimination testing requirements under Section
401(a)(4) of the IRC. IRS regulations define the methodologies used to
determine if a qualified retirement plan discriminates in favor of highly
compensated employees (HCEs). Generally, for the 2004 year, an HCE is an
employee who earned more than $90,000 in 2003 or owned more than 5% of the
plan sponsor in 2003 or 2004.
The regulations under IRC Section 401(a)(4) allow a plan to test its
profit sharing allocation as though it were providing monthly benefits
from a defined benefit plan. The cost of providing an annuity of $1 per
year at age 65 is much greater for older employees. In order to receive
the same annuity at retirement, an older participant would require a
larger contribution than a younger participant. Therefore, the
nondiscrimination testing rules under IRC Section 401(a)(4) allow a
discretionary profit sharing plan to demonstrate that relatively large
contributions for older employees are equivalent to much smaller
contributions for younger employees if these contributions are used to
purchase annuities at age 65.
In order to target the individual(s) who are to receive varying
contribution levels, new comparability allocations create multiple
allocation groups based on distinguishing characteristics, such as job
title or ownership. Some plans have established a separate allocation
group for each participant.
The table below shows the profit sharing contributions required to
maximize Ben's (the only HCE) contribution under the three allocation
methodologies discussed above:
| Participant |
2004
Compensation |
Age |
Pro-Rata |
Permitted
Disparity |
Cross
Tested |
| Ben |
$205,000 |
51 |
$41,000 |
$41,000 |
$41,000 |
| Employee 1 |
$80,000 |
55 |
$16,000 |
$13,395 |
$4,000 |
| Employee 2 |
$60,000 |
45 |
$12,000 |
$10,046 |
$3,000 |
| Employee 3 |
$50,000 |
35 |
$10,000 |
$8,372 |
$2,500 |
| Employee 4 |
$45,000 |
32 |
$9,000 |
$7,535 |
$2,250 |
| Employee 5 |
$35,000 |
30 |
$7,000 |
$5,860 |
$1,750 |
| Employee 6 |
$30,000 |
25 |
$6,000 |
$5,023 |
$1,500 |
| Total |
$505,000 |
|
$101,000 |
$91,231 |
$56,000 |
Review of Profit Sharing Allocations
- As a result of EGTRRA (2001 tax act which became effective in 2002),
the maximum contribution limits for a participant in a defined
contribution plan increased to the lesser of $40,000 (previously
$35,000) or 100% (previously 25%) of the participant's compensation. As
a result of cost of living increases, this limit increased to $41,000,
and the compensation limit increased to $205,000 for 2004.
- EGTRRA also increased the employer tax deductible contribution limit
for profit sharing plans from 15% of total participant compensation to
25% of total participant compensation. Prior to EGTRRA, Ben would not
have been able to receive a maximum profit sharing allocation under the
pro-rata or permitted disparity methods since that would have required a
nondeductible contribution in excess of 15% of compensation.
- Cross tested plans that allocate contributions based solely on
compensation are subject to minimum contribution requirements. In order
to satisfy these requirements, each non-highly compensated employee
(NHCE) must receive an allocation that is the lesser of (1) one-third of
the highest allocation rate provided to an HCE or (2) 5% of
compensation.
- In order to take advantage of the new comparability or cross tested
allocation technique, it is not necessary for all of the NHCEs to be
younger than the HCEs. The number of younger employees required to pass
the nondiscrimination testing is a function of the percentage of NHCEs
in the entire eligible group.
Adding a 401(k) Feature
Prior to EGTRRA, there were two significant issues that could make it
difficult to add a 401(k) feature to a cross tested profit sharing plan.
The first issue was that the maximum employer tax deduction limit was 15%
of total participant compensation. Included as employer contributions in
applying this limit were the employer profit sharing contributions as well
as the participant salary deferrals. Therefore, if the employer made a
profit sharing contribution that approached 15% of total compensation, it
was not possible to add a tax deductible 401(k) feature.
EGTRRA provided two solutions to this problem. As mentioned above, the
employer tax deductible limit for defined contribution plans was increased
to 25% of participant compensation. In addition, participant salary
deferrals are no longer included in applying the 25% limit.
The second issue that impacted the addition of a 401(k) feature to a
profit sharing plan was the individual maximum contribution limit. Prior
to EGTRRA, contributions from all sources (employer and salary deferrals)
were limited to the lesser of $35,000 or 25% of a participant's
compensation. If the HCE was earning far less than the compensation limit
(i.e. $100,000), the cross tested profit sharing allocation may have used
the entire 25% of compensation limit, leaving no room for a salary
deferral contribution.
EGTRRA solved this problem as well. As mentioned above, the maximum
contribution limit increased to the lesser of $40,000 ($41,000 in 2004) or
100% of a participant's compensation. Therefore, if an HCE's profit
sharing allocation does not approach the $41,000 limit, the 100% of
compensation limit will not prohibit the addition of a 401(k) feature.
EGTRRA also permits individuals who are 50 years of age or older during
a calendar year to make additional salary deferrals called catch up
contributions. The catch up contribution limit for 2004 is $3,000. Catch
up contributions are not included in applying the $41,000 contribution
limit for 2004. Therefore, a 50-year-old participant can potentially
receive total contributions of $44,000 during 2004. Without a 401(k)
feature, that same participant would be limited to total contributions of
$41,000.
Let's look at what Ben's plan will look like with a salary deferral
feature in addition to the cross tested profit sharing contribution.
| Participant |
2004
Compensation |
Age |
Salary
Deferral |
Cross
Tested |
Total
Allocation |
| Ben |
$205,000 |
51 |
$16,000 |
$28,000 |
$44,000 |
| Employee 1 |
$80,000 |
55 |
$8,000 |
$3,642 |
$11,642 |
| Employee 2 |
$60,000 |
45 |
$3,000 |
$2,732 |
$5,732 |
| Employee 3 |
$50,000 |
35 |
$2,000 |
$2,276 |
$4,276 |
| Employee 4 |
$45,000 |
32 |
$0 |
$2,049 |
$2,049 |
| Employee 5 |
$35,000 |
30 |
$0 |
$1,593 |
$1,593 |
| Employee 6 |
$30,000 |
25 |
$0 |
$1,366 |
$1,366 |
| Total |
$505,000 |
|
$29,000 |
$41,658 |
$70,658 |
Review of 401(k) and Profit Sharing
Allocations
- Since Ben deferred the maximum salary deferral ($13,000 deferral
limit plus $3,000 catch up contribution) for 2004, a profit sharing
contribution of only $28,000 was required to achieve a maximum
allocation. The $28,000 contribution was 13.66% of Ben's compensation.
The resulting minimum contribution that must be provided to the NHCEs is
one-third of Ben's (the only HCE) allocation rate or 4.55%. The addition
of a 401(k) feature allowed Ben to make the $3,000 catch up contribution
and decreased his contribution requirement to the employees.
- Salary deferral contributions made to 401(k) plans are subject to
annual discrimination testing. The salary deferrals above would fail the
required test. However, Ben could have established the plan as a safe
harbor 401(k) plan that is exempt from annual 401(k) discrimination
testing. If the plan meets certain notice requirements and withdrawal
restrictions, a cross tested plan can use part of its profit sharing
contribution to meet the safe harbor 401(k) contribution requirements.
These requirements can be met if a fully vested contribution of 3% of
compensation is made annually.
In addition to fully vesting some or all of the profit sharing
contribution, there is an additional hurdle to implementing a safe
harbor 401(k) feature. The plan cannot impose a conditional requirement
in order for participants to receive a contribution. Common features
such as requiring a participant to work 1,000 hours during a year or be
employed on the last day of a year in order to receive a contribution
cannot be imposed on a safe harbor 401(k) plan contribution. Any
participant eligible to make salary deferrals must receive the fully
vested 3% of compensation contribution.
Top Heavy Contributions
Since new comparability or cross tested plans are successful in
providing considerable contributions to owners and officers, they are
likely to become "top heavy." A plan is top heavy if more than 60% of plan
assets are allocated to certain owners and officers. Top heavy plans are
subject to minimum contribution requirements and more rapid vesting.
The top heavy minimum contribution is the lesser of 3% of compensation
or the highest allocation rate for any HCE. These minimum contributions
can be used in performing the nondiscrimination testing required of new
comparability. In fact, a new comparability profit sharing allocation can
perform triple duty: (1) meet nondiscrimination testing requirement under
IRC Section 401(a)(4); (2) meet safe harbor 401(k) contribution
requirement; and (3) meet top heavy minimum contribution requirement.
Ben can control his costs by waiting until he receives his year end
bonus to make a 401(k) salary deferral contribution. If at year end he
realizes that lack of profits or cash flow will make it difficult to make
a top heavy minimum contribution, he can forego making any salary
deferral. If he does not make any salary deferral or receive a profit
sharing contribution, he will not have any contributions allocated to his
account, which will preclude the need to make a top heavy minimum
contribution for his employees.
Conclusion
The expanded employer tax deductible and individual contribution limits
enacted by EGTRRA have provided greater planning opportunities for new
comparability plans. In fact, EGTRRA's addition of catch up contributions
has made the addition of a 401(k) profit sharing feature to a new
comparability plan even more appealing.
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