Small business owners want to maximize their own contributions to retirement accounts while saving the most money. While standard 401K plans offer options, they are limited. The new comparability profit sharing contribution plan; however, favors older business owners that want to aggressively invest in their own retirement plan.
This 401K profit sharing plan differs from the standard profit sharing plan because it allows employers to divvy employees into different groups, including themselves. Obviously, business owners place themselves in the largest contribution group for the greatest return for the best results. For this reason, they can act a little like cash balance plans.
It probably seems strange amongst the numerous laws surrounding 401K plans, ensuring the lack of discrimination amongst employees; however, new comparability contributions must undergo extensive IRS tests called ‘cross-testing.’ Passing these tests ensures that there isn’t any discrimination occurring within the 401K distributions.
Keep reading to learn more about the new compatibility profit sharing plan.
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Who Benefits from the New Comparability Plan?
All candidates for the new comparability plan must pass the general test. You pass the nondiscrimination test by comparing benefit rates at retirement rather than as a participant contribution rate. The contribution rate drops for younger employees and increases for older employees or those closer to retirement.
In other words, a 55-year old will have a higher percentage than a 30-year old, but will have the same outcome for testing purposes. As employees age, their percentage will increase. As a business owner, your percentages may change on an annual basis, if you have a high employee turnover rate.
Typically, older business owners benefit the most with this plan. When business owners are at least 10 years older than a majority of the employees, the spread is large enough for business owners to get the most out of their own contributions. Business owners can contribute the maximum contributions to themselves while providing employees with the required minim, based on their age. You pass the IRS guidelines while still maximizing your own retirement benefits.
Under the new comparability plan, qualifying participants can contribute up to $62,000 to their account. This is much higher than the current limit of $19,000 or $25,000 for those age 50 and older.
Understanding Profit Sharing
401K profit sharing plans work a little differently than standard 401K plans. With a standard 401K, employees may defer up to $19,000 of his or her income into a 401K account. Employers may or may not contribute, based on how they set up the plan. Employers can opt to ‘match’ an employee’s contributions up to a specific percentage if they desire. The employer-matched contributions aren’t the same as profit sharing – you must match the amount promised upon opening the account.
With 401K profit sharing plans, employers can choose to share some of their profits with employees or not share at all, based on the profits that year. 401K profit sharing plans have a contribution limit of $56,000 overall. This takes into consideration the maximum employee contribution of $19,000, leaving employers with $37,000 in contributions, should they decide to contribute that much. Any employees ages 50 and over can also contribute an extra $6,000 per year for catch-up.
Passing IRS Tests
One of the best ways to ensure that you pass the IRS tests is to have a Safe Harbor 401K with at least a 3% non-elective contribution. This means every employee in the 401K plan receives 3% – 5% of his or her salary as an employer contribution. This satisfies the IRS’s gateway minimum contribution requirement. Again, this contribution is separate from the profit sharing contribution.
If you don’t use the Safe Harbor 401K safety measure, then you must provide a gateway minimum contribution of either 1/3 of the highest contribution rate provided to employees or 5% of each employee’s gross income, whichever is less. It’s much safer and easier to offer the 3% – 5% non-elective contribution.
Please note, if you offer a Safe Harbor matching contribution, this doesn’t satisfy the minimum gateway contribution requirement, subjecting you to further IRS testing.
Once you pass the minimum gateway contribution requirements, you must set the profit sharing contributions so that they are equivalent at each employee’s retirement age. In other words, older employees can have larger profit sharing contributions than younger employees.
Older business owners can receive larger contributions than younger employees that make less money. This allows older business owners to aggressively invest in his or her retirement while still following the IRS rules.
Who Benefits from New Compatibility Profit Sharing?
We’ve established that business owners that provide at least a 3% non-elective Safe Harbor contribution are good candidates for the new compatibility profit sharing plan, but you should consider a few other factors.
If your business meets the following, you may benefit:
- Has less than 50 employees
- Has younger employees (at least younger than the owner)
- Pays the owner a high salary that is much higher than the employees
The more employees you have, the more complicated the testing gets. Many business owners lose the benefits of maximizing their own contributions with too many employees. The same is true if your staff is mostly older, as they’ll be privy to higher contribution rates.
The new comparability profit sharing plan has its benefits, but it’s also much more complicated. You must pass a series of IRS tests and always make sure you are compliant. Some 401K providers do charge more for the service because of the complexity of it. Make sure you understand the fees involved as well as the regulations to ensure that you are compliant and that the investments make sense for your bottom line.