Ben, after many years of working for a contractor that did not sponsor a retirement plan, decided to start his own construction company. Due to his many contacts in the industry, his business grew very quickly. In order to attract and retain quality employees, Ben realized that he must offer a comprehensive benefits package that includes a 401(k) plan.
Ben is age 51 and has not had an opportunity to save a significant amount for retirement. Therefore, he would like to adopt a qualified plan for the 2004 year that allows him to achieve the following goals:
- Maximize his ability to save for retirement.
- Control the costs for his employees.
- Provide flexibility so that he is not required to make a contribution if his business experiences a downturn.
Understanding the following concepts will assist Ben in developing a retirement program that achieves his goals.
Allocation of Profit Sharing Contributions
There are three common techniques used to allocate profit sharing contributions. These techniques, known as pro-rata, permitted disparity and new comparability or cross testing, are described below.
Pro-Rata and Permitted Disparity
Under the pro-rata method, an employer’s contribution is allocated in the ratio that each participant’s compensation bears to the total compensation of all eligible participants. The permitted disparity method is very similar to the pro-rata allocation, except that generally individuals earning more than the FICA wage base will receive a contribution amount that is a higher percentage of compensation than those under the FICA wage base. These two allocation techniques are considered to be safe harbor formulas and deemed to be nondiscriminatory under the Internal Revenue Code (IRC).
New Comparability or Cross Testing
New comparability or cross testing allows a profit sharing contribution to be allocated using nondiscrimination testing requirements under Section 401(a)(4) of the IRC. IRS regulations define the methodologies used to determine if a qualified retirement plan discriminates in favor of highly compensated employees (HCEs). Generally, for the 2004 year, an HCE is an employee who earned more than $90,000 in 2003 or owned more than 5% of the plan sponsor in 2003 or 2004.
The regulations under IRC Section 401(a)(4) allow a plan to test its profit sharing allocation as though it were providing monthly benefits from a defined benefit plan. The cost of providing an annuity of $1 per year at age 65 is much greater for older employees. In order to receive the same annuity at retirement, an older participant would require a larger contribution than a younger participant. Therefore, the nondiscrimination testing rules under IRC Section 401(a)(4) allow a discretionary profit sharing plan to demonstrate that relatively large contributions for older employees are equivalent to much smaller contributions for younger employees if these contributions are used to purchase annuities at age 65.
In order to target the individual(s) who are to receive varying contribution levels, new comparability allocations create multiple allocation groups based on distinguishing characteristics, such as job title or ownership. Some plans have established a separate allocation group for each participant.
The table below shows the profit sharing contributions required to maximize Ben’s (the only HCE) contribution under the three allocation methodologies discussed above:
| Participant | 2004 Compensation | Age | Pro-Rata | Permitted Disparity | Cross Tested |
| Ben | $205,000 | 51 | $41,000 | $41,000 | $41,000 |
| Employee 1 | $80,000 | 55 | $16,000 | $13,395 | $4,000 |
| Employee 2 | $60,000 | 45 | $12,000 | $10,046 | $3,000 |
| Employee 3 | $50,000 | 35 | $10,000 | $8,372 | $2,500 |
| Employee 4 | $45,000 | 32 | $9,000 | $7,535 | $2,250 |
| Employee 5 | $35,000 | 30 | $7,000 | $5,860 | $1,750 |
| Employee 6 | $30,000 | 25 | $6,000 | $5,023 | $1,500 |
| Total | $505,000 | $101,000 | $91,231 | $56,000 |
Review of Profit Sharing Allocations
- As a result of EGTRRA (2001 tax act which became effective in 2002), the maximum contribution limits for a participant in a defined contribution plan increased to the lesser of $40,000 (previously $35,000) or 100% (previously 25%) of the participant’s compensation. As a result of cost of living increases, this limit increased to $41,000, and the compensation limit increased to $205,000 for 2004.
- EGTRRA also increased the employer tax deductible contribution limit for profit sharing plans from 15% of total participant compensation to 25% of total participant compensation. Prior to EGTRRA, Ben would not have been able to receive a maximum profit sharing allocation under the pro-rata or permitted disparity methods since that would have required a nondeductible contribution in excess of 15% of compensation.
- Cross tested plans that allocate contributions based solely on compensation are subject to minimum contribution requirements. In order to satisfy these requirements, each non-highly compensated employee (NHCE) must receive an allocation that is the lesser of (1) one-third of the highest allocation rate provided to an HCE or (2) 5% of compensation.
- In order to take advantage of the new comparability or cross tested allocation technique, it is not necessary for all of the NHCEs to be younger than the HCEs. The number of younger employees required to pass the nondiscrimination testing is a function of the percentage of NHCEs in the entire eligible group.
Adding a 401(k) Feature
Prior to EGTRRA, there were two significant issues that could make it difficult to add a 401(k) feature to a cross tested profit sharing plan. The first issue was that the maximum employer tax deduction limit was 15% of total participant compensation. Included as employer contributions in applying this limit were the employer profit sharing contributions as well as the participant salary deferrals. Therefore, if the employer made a profit sharing contribution that approached 15% of total compensation, it was not possible to add a tax deductible 401(k) feature.
EGTRRA provided two solutions to this problem. As mentioned above, the employer tax deductible limit for defined contribution plans was increased to 25% of participant compensation. In addition, participant salary deferrals are no longer included in applying the 25% limit.
The second issue that impacted the addition of a 401(k) feature to a profit sharing plan was the individual maximum contribution limit. Prior to EGTRRA, contributions from all sources (employer and salary deferrals) were limited to the lesser of $35,000 or 25% of a participant’s compensation. If the HCE was earning far less than the compensation limit (i.e. $100,000), the cross tested profit sharing allocation may have used the entire 25% of compensation limit, leaving no room for a salary deferral contribution.
EGTRRA solved this problem as well. As mentioned above, the maximum contribution limit increased to the lesser of $40,000 ($41,000 in 2004) or 100% of a participant’s compensation. Therefore, if an HCE’s profit sharing allocation does not approach the $41,000 limit, the 100% of compensation limit will not prohibit the addition of a 401(k) feature.
EGTRRA also permits individuals who are 50 years of age or older during a calendar year to make additional salary deferrals called catch up contributions. The catch up contribution limit for 2004 is $3,000. Catch up contributions are not included in applying the $41,000 contribution limit for 2004. Therefore, a 50-year-old participant can potentially receive total contributions of $44,000 during 2004. Without a 401(k) feature, that same participant would be limited to total contributions of $41,000.
Let’s look at what Ben’s plan will look like with a salary deferral feature in addition to the cross tested profit sharing contribution.
| Participant | 2004 Compensation | Age | Salary Deferral |
Cross Tested |
Total Allocation |
| Ben | $205,000 | 51 | $16,000 | $28,000 | $44,000 |
| Employee 1 | $80,000 | 55 | $8,000 | $3,642 | $11,642 |
| Employee 2 | $60,000 | 45 | $3,000 | $2,732 | $5,732 |
| Employee 3 | $50,000 | 35 | $2,000 | $2,276 | $4,276 |
| Employee 4 | $45,000 | 32 | $0 | $2,049 | $2,049 |
| Employee 5 | $35,000 | 30 | $0 | $1,593 | $1,593 |
| Employee 6 | $30,000 | 25 | $0 | $1,366 | $1,366 |
| Total | $505,000 | $29,000 | $41,658 | $70,658 |
Review of 401(k) and Profit Sharing Allocations
- Since Ben deferred the maximum salary deferral ($13,000 deferral limit plus $3,000 catch up contribution) for 2004, a profit sharing contribution of only $28,000 was required to achieve a maximum allocation. The $28,000 contribution was 13.66% of Ben’s compensation. The resulting minimum contribution that must be provided to the NHCEs is one-third of Ben’s (the only HCE) allocation rate or 4.55%. The addition of a 401(k) feature allowed Ben to make the $3,000 catch up contribution and decreased his contribution requirement to the employees.
- Salary deferral contributions made to 401(k) plans are subject to annual discrimination testing. The salary deferrals above would fail the required test. However, Ben could have established the plan as a safe harbor 401(k) plan that is exempt from annual 401(k) discrimination testing. If the plan meets certain notice requirements and withdrawal restrictions, a cross tested plan can use part of its profit sharing contribution to meet the safe harbor 401(k) contribution requirements. These requirements can be met if a fully vested contribution of 3% of compensation is made annually.
In addition to fully vesting some or all of the profit sharing contribution, there is an additional hurdle to implementing a safe harbor 401(k) feature. The plan cannot impose a conditional requirement in order for participants to receive a contribution. Common features such as requiring a participant to work 1,000 hours during a year or be employed on the last day of a year in order to receive a contribution cannot be imposed on a safe harbor 401(k) plan contribution. Any participant eligible to make salary deferrals must receive the fully vested 3% of compensation contribution.
Top Heavy Contributions
Since new comparability or cross tested plans are successful in providing considerable contributions to owners and officers, they are likely to become “top heavy.” A plan is top heavy if more than 60% of plan assets are allocated to certain owners and officers. Top heavy plans are subject to minimum contribution requirements and more rapid vesting.
The top heavy minimum contribution is the lesser of 3% of compensation or the highest allocation rate for any HCE. These minimum contributions can be used in performing the nondiscrimination testing required of new comparability. In fact, a new comparability profit sharing allocation can perform triple duty: (1) meet nondiscrimination testing requirement under IRC Section 401(a)(4); (2) meet safe harbor 401(k) contribution requirement; and (3) meet top heavy minimum contribution requirement.
Ben can control his costs by waiting until he receives his year end bonus to make a 401(k) salary deferral contribution. If at year end he realizes that lack of profits or cash flow will make it difficult to make a top heavy minimum contribution, he can forego making any salary deferral. If he does not make any salary deferral or receive a profit sharing contribution, he will not have any contributions allocated to his account, which will preclude the need to make a top heavy minimum contribution for his employees.
Conclusion
The expanded employer tax deductible and individual contribution limits enacted by EGTRRA have provided greater planning opportunities for new comparability plans. In fact, EGTRRA’s addition of catch up contributions has made the addition of a 401(k) profit sharing feature to a new comparability plan even more appealing.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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Spring will arrive soon, promising new growth and a fresh beginning. It could also be the perfect time to do some spring cleaning for your plan. Let’s look at some areas that you might consider reviewing to ensure your retirement plan is operating efficiently.
Document your processes and procedures to make certain that plan tasks can be handled in case of any absences during an enrollment or pay period. Having a backup in place can prevent errors and delays that could lead to penalties.
Make sure to have a process in place to notify all new enrollments of their eligibility, regardless of whether the plan has automatic enrollment. Depending on the timing for plan entry, including the plan enrollment paperwork with the new hire paperwork could make entry easier for you. Please reach out with any questions regarding when an employee enters the plan.
Deposits of employee deferrals and loan repayments must be submitted to the plan as soon as possible to avoid penalties and corrections. For plans with less than 100 participants, a safe harbor rule allows deposits to be made within seven business days. For larger plans, the expectation is that the money will be deposited more quickly. Depositing these funds on the pay date will avoid the possibility of being late.
Monitoring deferral contribution limits during the calendar year will avoid refunds after year end. Make sure that your payroll is set up to stop deferrals once the limit is reached, including any catch-up contributions for those who have reached age 50.
To keep the plan in compliance, employer contributions must be deposited timely. Due dates are impacted by the type of contributions, required status and tax deductibility. If you have questions on when to deposit your employer contribution or even whether to make an employer contribution, please contact us.
Most plans must be covered by a fidelity bond. The minimum coverage is 10% of plan assets (rounded up to the next $1,000) and the maximum coverage is $500,000. Additional requirements apply to plans with employer securities or non-publicly traded assets. If your fidelity bond is insufficient, now is the time to raise the coverage. Inflation clauses that increase the bond amount as the plan assets increase can ensure that your bond coverage is always adequate. Contact us or your insurance provider if you don’t have a fidelity bond.
Another area to review is communication with participants. Helping your employees understand and trust the plan can increase their contributions. Be sure that your procedures include distributing any plan-related communications—including required participant notices.
Distributions also involve communication, including some of the aforementioned notices. Discussing distribution options with terminated participants, possibly as part of an exit interview, can help to reduce risk of lost participants. We’ll provide instruction on distributions for force-out distributions for small balances, testing corrections and required minimum distributions.
Your plan document is the legal source on how the plan should be administered; operating within its parameters is critical. It’s always worth taking time to review the plan document to ensure that you fully understand and are following its provisions. We’ll cover more details about the plan document later in this newsletter. We’re here to support you in keeping your plan in compliance. Please feel free to reach out with any questions.
Addressing the Challenge of Uncashed Distribution Checks
Uncashed distribution checks present a persistent and often overlooked challenge for retirement plan sponsors. Despite the best efforts of plan administrators, some participants fail to cash their distribution checks, leading to administrative burdens, fiduciary concerns and potential compliance issues. A recent publication by Retirement Management Services (RMS) sheds light on this issue and offers practical guidance for employers seeking to manage and mitigate the risks associated with uncashed checks.
Uncashed checks can arise for various reasons. Participants may have moved without updating their contact information, may not recognize the check as legitimate or may simply forget to deposit it. Regardless of the cause, the responsibility for addressing these uncashed funds ultimately falls on the plan sponsor. This creates a fiduciary obligation to act in the best interest of the participant while ensuring compliance with IRS and Department of Labor (DOL) regulations.
Sponsors are encouraged to maintain up-to-date contact information for all plan participants and to follow up promptly when checks remain uncashed. This may involve sending reminder letters, making phone calls or using certified mail to confirm receipt. In some cases, plan sponsors may also consider using electronic payment methods to reduce the likelihood of checks going uncashed in the first place.
The IRS and DOL have issued guidance on how to handle these situations, including the use of forfeiture accounts and escheatment to state unclaimed property programs. However, these options come with their own set of rules and potential pitfalls. For example, using a forfeiture account may require the plan document to explicitly allow for such treatment. Escheatment laws, which allow the government to assume control of unclaimed property, vary by state. As such, plan sponsors must carefully evaluate their options and consult with legal or compliance experts as needed.
Another important consideration is the documentation of all the efforts made to contact participants and resolve uncashed checks. Maintaining a clear audit trail can help demonstrate fiduciary prudence and protect the plan sponsor in the event of an audit or legal challenge. It is extremely important to have a written policy in place that outlines the steps to be taken when a check remains uncashed beyond a certain period.
By taking a proactive, well-documented and compliant approach, employers can fulfill their fiduciary duties, reduce administrative burdens and ensure that participants receive the benefits they are entitled to.
Source: Retirement Management Services – “Uncashed Distribution Checks” https://www.consultrms.com/Resources/59/Plan-Sponsor-Tips-and-Help/212/Uncashed-Distribution-Checks
Divorce and the Retirement Plan
When a participant in a qualified retirement plan undergoes a divorce, the participant’s account balance may be an asset that is split with the former spouse. As the plan exists for the exclusive benefit of its participants, a court order is required to transfer the participant’s benefits to the ex-spouse. Once approved by the plan administrator, this court order is called a Qualified Domestic Relations Order (QDRO).
The QDRO is a judgment, decree or order that must be issued by a state authority (usually a court). It can be part of the divorce settlement or it may be a separate document. Because of the serious nature of separating the participant’s account balance, the QDRO is more than just an agreement made by both parties — it must also be signed by a judge.
A QDRO will describe how to divide the participant’s account balance between the participant and the ex-spouse, referred to as the alternate payee. In some cases, a set dollar amount will be allocated; in others, a percentage of the account may be designated. In the latter case, the amount assigned to the alternate payee represents the given percentage of the participant’s total vested account balance as of a specified valuation date. This percentage will apply to all sources — such as deferrals, matching or profit sharing — unless specified by the QDRO. Any interest and investment gains/losses that accrue between this valuation date and the date the funds are separated into an account for the alternate payee are often factored into this final calculation. If the participant has outstanding loans, the QDRO will usually indicate how the loans are handled.
Contributions such as deferrals and employer matching made after the valuation date are credited to the participant’s account. Earnings and losses are applied to the account balances. Once the division is complete, the alternate payee’s portion (either dollars or shares) is transferred to an account in the alternate payee’s name.
If the plan allows, the alternate payee may be paid out in a cash or rollover distribution. Not all plan documents allow the alternate payee to receive a distribution before reaching normal retirement age, so it’s important to follow the terms of the plan. In addition, the QDRO cannot violate the provisions of the plan document by requiring a plan to provide an alternate payee or participant with any type or form of benefit not otherwise provided under the plan.
Although the most common situation for a QDRO is a divorce, it can be issued in other situations, such as to a dependent in the case of child support. If the alternate payee is a minor child or legally incompetent, the order can also require payment to the individual with legal responsibility for the alternate payee. If a participant or their attorney provides you with a copy of a divorce decree that references the plan or a QDRO, please contact us immediately, and we will work with you to ensure it meets the requirements of the plan.
Important note for defined benefit plans: For 2025 plan years, PBGC premiums are due one month earlier than usual, specifically on the 15th day of the ninth month after the beginning of the plan year. For calendar year plans, this means the premium is due on September 15, 2025, instead of the usual October 15. This accelerated deadline is due to a provision in the Bipartisan Budget Act of 2015.
Upcoming Compliance Deadlines for Calendar-Year Plans
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