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Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security, and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in Pennsylvania is representative of a common question on profit-sharing allocation formulas.
“"What are the most common contribution formulas for profit-sharing plans, and how do they compare?"”
The most common allocation formula used for profit-sharing contributions is a formula that allocates contributions based on a percentage of each participant’s compensation, known as pro rata. However, there are several formulas, including flat dollar, integrated, and cross-tested, which we will cover in the following paragraphs.
Profit-sharing plan contributions are discretionary, in most cases, and they must be made according to a nondiscriminatory allocation formula. The actual formula that a sponsor must apply will be detailed in the plan document that governs the plan.
Pro Rata: An allocation formula that provides eligible participants with a contribution based on the same percentage of compensation is known as a pro rata formula.
Flat Dollar: A plan sponsor who uses a flat dollar contribution formula in its profit-sharing plan must contribute the same dollar amount to each eligible employee, regardless of the participant’s level of pay.
Integrated: An integrated allocation formula allows a plan sponsor to provide higher contributions for eligible participants who earn amounts over a set threshold, as long as the “permitted disparity rules” of IRC Sec. 401(l) are satisfied. Integrated plans are also known as “Social Security-based” or “permitted disparity” plans. The permitted disparity rules allow plan sponsors to give eligible participants who earn compensation above the “integration level,” which is typically the Social Security Taxable Wage Base (TWB), an additional contribution. This additional contribution is equal to the lesser of either:
two times the base contribution percentage, or
the base contribution percentage plus the “permitted disparity factor.”
If the plan sponsor sets the integration level at the TWB, then the permitted disparity factor equals 5.7 percent. Note that the plan sponsor may set the integration level at an amount lower than the TWB. If this is done, however, the plan sponsor must then reduce the permitted disparity factor according to the following table.
| Integration Level | Applicable Permitted Disparity Factor |
|---|---|
| The Taxable Wage Base (TWB) | 5.7% |
| 81-99% of the TWB | 5.4% |
| 21-80% of the TWB | 4.3% |
| 0-20% of the TWB | 5.7% |
Cross-Tested: Profit-sharing plans typically satisfy general nondiscrimination rules by comparing the amount of contributions given to participants. The IRS allows plan sponsors to prove their plans are nondiscriminatory under a testing alternative known as the “cross-testing method.” Under the cross-testing method, contributions are converted to equivalent benefits payable at normal retirement age and then compared to determine whether the benefits unduly favor highly compensated employees over non-highly compensated employees. This is like defined benefit plan testing. Most cross-tested plans must satisfy a gateway requirement, commonly:
5% of compensation for non-HCEs, or
1/3 of the highest HCE allocation rate.
The most common types of cross-tested plans are "age-weighted" and "new comparability" plans.
Age-weighted plans: In these plans, the employer's contribution to the plan is allocated among employees based on factors that combine compensation with deferred annuity factors based on age. The higher the age, the larger the factor, and the larger the allocation to the participant will be.
New comparability plans: These plans permit plan sponsors to favor select groups of participants. Under the new comparability rules, plan sponsors are allowed to define and assign employees to different contribution “rate groups” within the plan. The contribution level for each rate group may vary, as long as the plan is found to be nondiscriminatory under the cross-testing method.
The table represents a hypothetical scenario for illustrative purposes only to maximize contributions for the business owners. It cannot be used for tax or legal advice.
| Employee | Age | Compensation | Discretionary Profit-Sharing Pro Rata | Discretionary Profit-Sharing Integrated TWB | Discretionary Profit-Sharing Age-Weighted | Discretionary Profit-Sharing Cross-Test |
|---|---|---|---|---|---|---|
| Owner A | 60 | $360,000 | $72,000 | $72,000 | $69,500 | $72,000 |
| Owner B | 55 | $250,000 | $62,500 | $46,784 | $54,200 | $72,000 |
| Employee C | 45 | $75,000 | $18,750 | $12,915 | $38,300 | $25,000 |
| Employee D | 25 | $50,000 | $12,500 | $8,610 | $21,750 | $14,750 |
| Total | $735,000 | $165,750 | $140,309 | $183,750 | 183,750 |
When made, profit-sharing plan contributions must be allocated according to a nondiscriminatory formula as specified in the plan document. However, as the table above illustrates, some formulas (depending on the composition of employees) can allow a greater share of the overall contribution to be allocated to owners or other more highly compensated participants.
Any information provided is for informational purposes only. It cannot be used for the purpose of avoiding penalties and taxes. Consumers should consult with their tax advisor or attorney regarding their specific situation.