Profit 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:

New 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) that are receiving nonelective contributions ​

In order to pass the minimum gateway contribution test, the allocation for each eligible NHCE must be the lesser of:

Note: For Safe harbor 401(k) plans that make a nonelective contribution, the nonelective contribution can offset all or part of 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. The EBAR predicts what that contribution will be worth when the participant reaches retirement age, allowing the plan to take into account future earnings when determining if HCEs are receiving a significantly larger benefit than NHCEs.

Each HCE will be put in their own allocation group and each group will then be tested individually. The allocation must pass either the Rate Group Test (RGT) or the Average Benefits Percentage Test (ABPT) and coverage test, or the allocation is not compliant with IRS regulations. Guideline will always use the most beneficial testing method for each allocation calculated.

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 RGT and the ABPT.

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 more years 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 RGT or the ABPT and coverage testing. This testing is complex and below is a very high level explanation.

For the rate group test, the ratio of NHCEs benefiting in each rate group versus the total number of NHCEs in the plan must be 70% or more of the ratio of HCEs in the group versus the total HCEs. Each rate group must pass coverage for the allocation to be compliant.

Often, the average benefits percentage test can be a less expensive option. The ABPT compares the average of the EBARs for all HCEs to the average of the EBARs for all NHCEs. If the NHCEs’ average is equal to or exceeds 70% of the HCEs’ average, the allocation passes. As a result, the rate group coverage percentage is decreased to 50% or less, depending on the number of HCEs and NHCEs in the plan.​

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 allocations for rank-and-file employees while maximizing the owner’s allocation.

​Example 1: Amy and her son Paul are the owners of a small company that has 11 employees – one HCE and 10 NHCEs. Their plan has a safe harbor matching formula. The owners are contemplating a pro rata profit sharing of $50,000, but would like to see what a new comparability formula giving both owners the maximum would look like.

Example 2: Steven and Laura are the owners of a company with 10 employees, all NHCEs. They have a plan with a 3% SHNEC. The owners would like to receive the maximum contributions possible.

The rules for new comparability are complex, so we can help you decide whether this formula might make sense for your plan.

​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 Pricing Page for more information regarding Guideline's fees.