Closely-held, private companies have owners. As shareholders go, they are typically few in number with the potential to earn a large salary or draw from their companies’ revenues. But even the most successful business owner doesn’t necessarily want to receive a huge windfall in taxable income each year. Most choose to reinvest back into the business and sink as much as they can into their retirement savings plan. But contribution limits, nondiscrimination testing requirements and low participant coverage among employees often means that the amount they can contribute toward their own retirement savings is limited — at least relative to their high contribution potential.
This article will discuss the concept of combining a safe-harbor 401(k) plan with a cross-tested profit sharing plan in hopes of providing an alternative contribution and earnings platform for owners and executives of small and medium-sized businesses. The IRS’ basic premise of expanding the contributions limits in a retirement plan is a simple concept: give a little, get a lot.
A 401(k) plan is subject to seemingly innumerable tests that basically keep a plan from discriminating in favor of highly compensated employees (HCEs) by penalizing the HCEs if a plan is designed in a discriminatory fashion or is found to be discriminatory in operation. A cross-tested defined contribution plan uses an additional, permissible testing method to prove that the plan does not discriminate against non-HCEs. In 2015 (and in 2016, as the limit will not be increased), an individual is considered to be an HCE if he/she earns $120,000 in the preceding year, or is more than a 5% owner.
Typically, 401(k) or straight profit sharing plans provide a contribution allocation that is uniform to all of its participants (e.g., a contribution based on the same percentage of compensation). In such a case, the plan is not viewed to be discriminatory, because the allocation dollar amount or percentage is the same for HCEs and non-HCEs alike. A safe harbor 401(k) plan allows a plan to bypass participation testing which merely allows an HCE to contribute as much as they are allowed to contribute under the annual deferral contribution limit. Safe harbor plans do not permit HCEs to receive any contribution amount from the business that might otherwise be discriminatory; it simply allows them to contribute the same amount of their own money that the non-HCEs can contribute. In other words, the safe harbor arrangement is a first step, but hardly a complete solution for the cash-rich owner seeking to increase his or her retirement contributions.
The next step could be a cross-tested design. Cross-testing is the description for a method where an allocation in a defined contribution plan (like a 401(k) profit sharing plan) for a single year is converted to a projected benefit at retirement. To put it another way, the defined contribution plan is allowed to be tested on its defined benefit to make sure that the plan does not discriminate in favor of HCEs. If all of the projected benefits at retirement are a uniform percentage of compensation for all participants, then the plan is deemed to have “passed” and will not be considered discriminatory.
As you might expect, age of participants (or, how far away each participant is to retirement) plays a key role in allocating employer contributions in a cross-tested plan design. The obvious advantage of utilizing a cross-tested plan design is to show that all allocated contributions under the plan are not discriminatory, which, in turn, permits substantially larger contributions to be made for older participants than for younger participants. Basically, a cross-tested plan will satisfy nondiscrimination rules if the plan satisfies one of two minimum contribution requirements, called “gateway contributions.” It’s a numbers game based upon many variables including number of HCEs compared to non-HCEs, the ages of all participants and contribution goals. But in the most advantageous (for owners) situation, a plan could potentially make up to a 20% contribution for HCEs as compared to only a gateway contribution of 5% for all other employees. And this would be considered not discriminatory. As we mentioned earlier, give a little and get a lot.
An obvious disadvantage to the cross-tested route is sheer cost. First, a business has to have the right cash flow to make such expensive contributions. Even if the non-HCE allocations are relatively “low” as compared to the potential allocations available to owners, it’s still costly to provide 5-10% contributions to all of a company’s employees. However, if the goal is to maximize contributions for HCEs and minimize the cost (i.e., minimize the contributions for all other employees), cross-testing should be considered. The larger the age disparity between HCEs and non-HCES, the more money can be directed to the HCEs in a cross-tested design.
Because cross-tested designs are complex, they require careful planning and set-up time to make sure all possible methods of allocations are tested and compared. Naturally, an employer’s employee census changes annually, so what may have worked one year might produce a less-than-desirable result the next year. Working with your benefits consultant and plan’s financial advisor will ensure that you have all of your bases covered as you consider the potentially fruitful cross-tested plan design.
Whether we’re talking about a retirement plan designed to reach employees of different ages and retirement planning objectives, or helping an owner maximize their savings potential, the goal of any employer-sponsored retirement plan is to introduce creative features and hybrid approaches to design a legally compliant plan that doesn’t ignore those who can benefit from it the most. Imagine that!
For more information on cross tested retirement plan designs, contact us.
Bret works with HR professionals to ensure they have a clear understanding of the rules governing all aspects of human resources. He works with employers to maintain compliance of health and wellness benefit packages under state and federal guidelines, including rules of taxation and healthcare refo
Bret works with HR professionals to ensure they have a clear understanding of the rules governing all aspects of human resources. He works with employers to maintain compliance of health and wellness benefit packages under state and federal guidelines, including rules of taxation and healthcare reform. Bret holds a bachelor of science in economics from the University of Kentucky and a law degree from the University of Pittsburgh, School of Law.
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