401(k) Profit Sharing Plans
More and more employees perceive 401(k) plans as a valuable benefit which have made them the most popular retirement plans today. Employees can benefit from a 401(k) plan even if the employer makes no contribution. Employees voluntarily elect to make pre-tax contributions through payroll deductions up to an annual maximum limit (click here for current limits).
The plan may also permit employees age 50 and older to make additional "catch-up contributions" up to an annual maximum limit (click here for current limits).
The employer will often match some portion of the amount deferred by the employee to encourage greater employee participation, i.e., 25% match on the first 4% deferred by the employee. Since a 401(k) plan is a type of profit sharing plan, profit sharing contributions may be made in addition to or instead of matching contributions. Many employers offer employees the opportunity to take hardship withdrawals or borrow from the plan.
Employee and employer matching contributions are subject to special nondiscrimination tests which limit how much the group of employees referred to as "Highly Compensated Employees" can defer based on the amounts deferred by the "Non-Highly Compensated Employees." In general, employees who fall into the following two categories are considered to be Highly Compensated Employees:
An employee who owns more than 5% of the employer at any time during the current plan year or preceding plan year (stock attribution rules apply which treat an individual as owning stock owned by his spouse, children, grandchildren or parents); or
An employee who received compensation in excess of the indexed limit in the preceding plan year (indexed limit is $125,000 for 2019 and $130,000 for 2020). The employer may elect that this group be limited to the top 20% of employees based on compensation.
401(k) Safe Harbor Plans: The plan may be designed to satisfy "401(k) Safe Harbor" requirements which can eliminate some nondiscrimination testing. The Safe Harbor requirements include certain minimum employer contributions and 100% vesting of employer contributions that are used to satisfy the Safe Harbor requirements. The benefit of eliminating the testing is that Highly Compensated Employees can defer up to the annual limit ($19,000 in 2019 and $19,500 in 2020) without concern for what the Non-Highly Compensated Employees defer.
The profit sharing contribution is generally the most flexible contribution type in this kind of qualified plan. Company contributions to a profit sharing plan are usually made on a discretionary basis. Each year the employer decides the amount, if any, to be contributed to the plan. For tax deduction purposes, the company contribution cannot exceed 25% of the total compensation of all eligible employees. The maximum eligible compensation that can be considered for any single employee is $280,000 in 2019 ($285,000 in 2020).
The profit sharing contribution can be allocated a number of different ways. They may be allocated to employees in proportion to compensation, integrated with Social Security, or better yet a cross-tested approach can be utilized. Cross-tested allocation methods are usually the preferred way of calculating profit sharing contributions. That is because business owners and other targeted employees can receive larger contributions than the rest of the eligible employees.