Frequently Asked Questions
401(k) Profit Sharing Plans
Questions & Answers
What contributions can be made to a 401(k)/Profit Sharing Plan?
First realize that a 401(k) plan is really a profit sharing plan that may or may not utilize a profit sharing component in addition to the 401(k) salary deferrals. You might think of the plan as a double-decker bus in that you can use either tier (profit sharing or 401(k) feature), or both tiers (profit sharing and 401(k) features). Often a profit sharing plan will be implemented with both 401(k) features and profit sharing features in which case there could be three (3) sources of contributions:
• 401(k) Employee Salary Deferrals
• 401(k) Employer Match Contributions
• Employer Profit Sharing Contributions
The plan does not have to include all contribution types and can be designed to include or exclude certain contribution types. Sometimes the name of the plan is descriptive of what features the plan includes (e.g. 401(k) plan vs. 401(k)/Profit Sharing Plan), although this is not always the case and the name is not required to reflect what contribution types are allowed.
How is the EMPLOYER contribution determined and allocated ?
It depends on how the employer wants the plan designed. If the plan will allow for employee 401(k) salary deferrals (pre-tax contributions) then the employer can decide whether there will be matching contributions or not. If there is a matching contribution, it can be structured as a discretionary match with no pre-stated formula, or it can have a specific formula hard-wired into the plan as to how matching contributions will be made, for example:
100% match on the first 3% of salary deferrals plus 50% match on the next 2% of salary deferrals
If the plan allows for profit sharing contributions (either in lieu of or in addition to 401(k) deferrals/match) the contribution amounts are discretionary each year (including no contribution). The plan will specify a method to be used to allocate contributions to plan participants for those years in which the employer chooses to make a contribution. Currently, some of the more common allocation methods include:
• "Pro-rata" (based on participant’s compensation relative to total compensation).
• "Integrated" (those making more than social security wage base receive higher allocation)
• "Cross-Tested" (each participant may receive different contribution levels)
• "Age-Weighted" (older employees receive higher contribution level)
What is the maximum employee 401(k) Salary Deferral that can be made?
For 2019 it is $19,000. For 2020 it is $19,500. This amount is subject to Cost of Living Adjustments(COLA) each year.
For those employees attaining age 50 by the end of a calendar year, they can make an additional "catch-up" salary deferral for that calendar year in addition to the normal limits above. The additional contribution for 2019 is $6,000 (for 2020 it is $6,500) and is subject to (COLA).
Can an Owner/Highly Compensated Employee always make the maximum employee 401(k) Salary Deferral mentioned in the previous question?
No. Congress has tied the owners/highly compensated employees salary deferral rates to the lower-paid employees deferral rates. This is done via a discrimination test called the ADP test. In general, whatever the Average Deferral Percentage (ADP) rate is for the staff employees (e.g. 3% of pay) then the owners/highly paid employees can only defer the same overall deferral rate (percentage) plus about 2% (e.g. 5% of pay). Depending on what the rank-and-file employees defer, it may or may not be enough to allow the owners/highly paid employees to defer up to the maximum 401(k) salary thresholds mentioned in the previous question.
Is there a way around the ADP test, which ties the Owner/Highly Compensated Employee’s salary deferral amounts to the employees’ deferral amounts?
Yes. Congress, in recent years, developed a "buy-out" option from the ADP discrimination test by allowing plans to make what they call a "safe-harbor" matching contribution, or alternatively, a "safe-harbor" non-elective contribution. By making one of these "safe-harbor" contributions, the employer "buys-out" of the ADP testing and thereby "de-links" the owner/highly paid employee’s ability to defer salary, with what the rank-and-file staff is deferring.
Safe-Harbor Match: If this method is used, the employer must make a fully vested 100% match for each employee that defers salary, equal to a 100% match on the first 3% of salary deferral, plus an additional 50% match on the next 2% of each employee’s salary deferral. Therefore, the maximum match for any one employee will equate to 4% of pay (100% of 3% plus 50% of next 2%) even if the employee was to defer a significant percent (e.g. 20%) of their pay.
Safe-Harbor Non-Elective: If this method is used, the employer must make a 3% of salary contribution (non-elective) to each employee that has met the eligibility requirements, regardless of whether the employee chooses to defer any salary into the 401(k) plan. This option is sometimes used in conjunction with cross-tested profit sharing contribution formulas as it can serve triple-duty in buying out of ADP testing, usually covers top-heavy requirements, and counts towards discrimination testing under the cross-testing feature of the plan.
Why have "Cross-tested" (also known as "New Comparability") Profit Sharing Plans become so popular in recent years?
Depending on employee demographics (e.g., age, compensation, dates of hire), the cross-tested profit sharing plan, which allocates different contribution levels to different job classifications, can often leverage a larger share of the overall profit sharing contribution in favor of a target group of employee(s) such as an owner and/or management.
These plans work best where the rank-and-file employees are younger than the selected target group of employees. For example, a scenario of where the owner is age 45, and employees, on average, are age 30 makes a good candidate for a cross-tested plan. Cross testing allows a profit sharing contribution to be converted to a defined benefit-like annuity at retirement. Some fairly complex-testing goes on behind the scenes that tests discrimination of contributions projected to retirement age (instead of current ages).
This ability to test discrimination of current contributions, at each participant’s assumed retirement age, often allows for much higher current contributions for an older target group of employees (like owners). However, this type of plan is very sensitive to employee demographics (including changes in those demographics). Certain situations where demographics consist of older employees may not work well with a cross-tested plan. In that situation, another allocation approach should be used.
What types of investments are allowed under a 401(k) and/or Profit Sharing Plan?
Generally, most arms-length third party investments available to you on a personal level are also available for plan investments. For example, stocks, bonds, mutual funds, CD's, Mortgage Notes, Real Estate Investment Transactions (REITs), unimproved land, improved land, certain limited partnerships (see below), are acceptable, although certain annual appraisals would be required on these latter investments, and would possibly necessitate extra bonding requirements. The plan document must specifically allow for these types of investments, but most documents are somewhat broad in this area.
Even though you will most likely be able to invest pension money in all of the above investments, you must be careful not to use the investments for your own personal use. For example, if you purchase artwork with your pension funds, you cannot hang the art in your home, but should keep it safely stored in a vault. The same would apply to an antique car purchased with pension money. You would not be able to drive the car for your own personal use. It would need to be kept properly stored in a garage or on display where it could reasonably be expected to appreciate in value. If the plan has employees, great care must be used to determine if this type of investment is a prudent investment for all participants.
Typically, although it is not required, an employer with a 401(k) plan can allow employees to invest their own salary deferrals, as well as, the matching and profit sharing contributions into a selected group of investment funds. Most often, a group of mutual investment funds is selected with the help of an investment advisor. This group of funds usually reflects an assortment of conservative, moderate, and aggressive funds for an employee to choose from. If structured correctly, the employer may be able to avoid any liability for poor investment choices that the employee may make if thorough education is provided to the employee and if other criteria are met. The investment options presented to employees for investing are typically less broad that what a Trustee might invest in if the Trustee were investing all of the plan’s money. For example, it would be very rare to allow employees to invest in land or in a particular type of collectible, such as artwork. Although, a Trustee might elect to do so overall, as part of a broad diversified portfolio of investments for the plan.
It is critical that you do not use plan funds to invest in your business or home, or in any other investment that you will use for personal reasons.
Can I borrow money from the plan?
Yes, if you design the plan document to expressly allow for loans by adopting a loan program and subject to the limitations listed below.
The maximum loan amount is the lesser of: (a) 1/2 of your vested benefit (account balance); or (b) $50,000. A loan application is completed and signed by both the borrower and the trustee of the plan. Prior to a loan being issued, loan documents (promissory note, amortization schedule, etc) are prepared for signature by the borrower. Loan terms generally allow no longer than five (5) years for repayment. The principle and interest loan repayment terms may be scheduled per pay period, monthly or quarterly. Longer repayment term loans are available when buying a principal residence.
Which employees must be covered under the plan and does that include leased employees?
A. Generally, all common-law employees and leased employees who have met the plan's eligible requirements must be considered for plan participation, although only 70% of those meeting the eligibility requirements must be covered. Those not benefiting must be excluded from the plan by a job title or classification that is not deemed to be discriminatory.
B. In very small companies, excluding an employee by job classification may not be possible if such exclusion causes the coverage of eligible employees to fall below 70%. For example, a company with only 3 employees could not exclude even one (1) employee and pass the 70% coverage requirement (2/3 = 66%).
Can employer contribution amounts change each year and are they required?
Yes. Employer contributions, under a profit sharing plan, are discretionary from year-to-year. Although, ongoing contributions may be required from time-to-time to demonstrate that the plan is a viable profit sharing plan. If no employer contributions are ever to be made, the plan should probably be a frozen money purchase plan, which would not have any contribution requirements. Ask your administrator for details.
When does the required employer contribution have to be made?
The employer contribution must be made by the due date of your tax return that reflects the tax deduction (including any extension).
When can I begin to withdraw money from the plan?
A. A "distributable event" is the typical justification for distribution. Distributable events include: attainment of normal retirement age, termination of employment, death, disability or plan termination.
B. Participant loans may be available (see Question 8 - Can I borrow money from the plan?).
C. Some 401(k)/Profit Sharing plans may also allow for hardship distributions for specific reasons, in-service distributions upon attainment of a certain age, or completion of a specified number of years of service. Note: The taxation of such distributions may not receive favorable tax treatment and could be subject to early distribution penalties.
Are the benefits under the plan guaranteed?
No. Only certain Defined Benefit Plans have guaranteed benefits.
Can I terminate the retirement plan, and if so, when can I do it ?
A. Generally, a pension plan should be kept long enough for the IRS to consider the plan to have been intended to be a permanent retirement program. There is no required number of years, but we feel that keeping the plan for 3 - 5 years should satisfy this requirement. Terminating the plan before this time may still be acceptable to the IRS if retirement occurs; or if the business is sold, closed down or has other extenuating circumstances.
B. The plan termination is done through a series of steps that include:
a. Preparation of Agreement to Terminate, Action of the Board of Directors, and a Notice advising participants of proposed termination date b. Calculation and preparation of benefit statements for all participants;
c. Preparation of Election Forms and distribution instructions;
d. Forms 1099R and 945 are prepared in January or February of the year following the plan termination.
e. IRS approval on the plan termination is available, but not required.
f. A Form 5500 Annual Report is required for each year or partial year that the plan has assets remaining in the trust.
What are the available vesting schedules?
The following are the two slowest and most common vesting schedules allowed for top-heavy plans (you can always customize a vesting schedule to be MORE generous than these shown):
"2-20" Schedule "3-Year Cliff Schedule"
0-1 Year = 0% 0-2 Years = 0%
2 Years = 20% 3 + Years = 100%
3 Years = 40%
4 Years = 60%
5 Years = 80%
6 Years = 100%
Note: An employee is always 100% vested in their own 401(k) salary deferrals.
What is the longest eligibility-waiting period you can use?
For 401(k) features, one (1) Year of Service is the maximum eligibility-waiting period. If you want to use one of the above vesting schedules then one (1) Year of Service is the longest eligibility-waiting period. A Year of Service is generally defined as a twelve month period in which the employee works 1000 hours (equates to about 20 hrs. per week) so that even some part-time employees will qualify for the plan if they work 1000 hours per year.
One alternative with profit sharing features, but not 401(k) features, is the use of a two (2) year eligibility-waiting period but ONLY if the employee becomes 100% vested IMMEDIATELY upon entry into the plan (i.e. you can’t use a vesting schedule).
Do I have to be incorporated to sponsor a retirement plan and claim deductions for contributions?
No. A plan can be sponsored by any type of business entity (including most non-profit organizations) whether or not incorporated. This may include Sole Proprietorships, Partnerships, Limited Liability Company, S-corporations, C-Corporations, and professional corporations.
Under any of these types of entities, the contribution that is calculated within IRS prescribed limitations is 100% deductible. An unincorporated entity with employees would generally split the deduction by taking the deduction on their business return for their employees contributions (e.g. Schedule C) and the remainder on their personal return (i.e. Form 1040) for their own personal contributions.