New Comparability 401(k) Plans - Are They Right for Your Small Business?
One of the most common goals for a small business 401(k) plan is maximizing owner contributions up to the legal limit - $64,500 for 2021 (assuming employee catch-up contributions). Often, the cheapest way to meet this goal is using a new comparability profit sharing contribution. Unlike other types of 401(k) profit sharing, these contributions permit an employer to allocate multiple contribution rates to different employee groups – making larger contribution rates to business owners possible.
However, like most 401(k) plan design options, new comparability contributions are not for everybody. While other profit sharing contributions (e.g., pro rata or permitted disparity) are automatically deemed to not discriminate in favor of business owners (and other Highly-Compensated Employees (HCEs)), new comparability contributions must pass a special IRS “general test” to prove nondiscrimination. This test can be impossible for some companies to pass when business owners are favored due to the demographics of their workforce.
Because of their special – not to mention, complicated - testing, 401(k) providers often charge additional fees for new comparability plan designs. However, these fees can be offset easily by the thousands of dollars a business can save annually in employer contributions versus other 401(k) plan designs. If you’re a high-paid business owner looking to maximize your 401(k) plan contributions, you owe it to yourself to find out more about new comparability contributions – they can save you big bucks on your 401(k) plan!
Who is the ideal candidate for a new comparability 401(k) plan?
To be a candidate for new comparability contributions at all, a 401(k) plan must be able to pass the general test. Most new comparability 401(k) plans pass this nondiscrimination test by converting participant contribution rates to a benefit rate at retirement - typically, age 65. This “cross-testing” can make a 15% contribution to a 55-year-old (with 10 years to retirement) as valuable as a 5% contribution to a 30-year-old (with 35 years to retirement) for testing purposes.
Due to “cross-testing,” companies with older business owners are typically the best candidates for new comparability contributions. A spread of 10+ years often does the trick, allowing the plan sponsor to maximize owner contribution while allocating just the “gateway minimum” contribution to non-HCEs.
What is a gateway minimum contribution?
Before a 401(k) plan can cross-test a new comparability contribution, it must first allocate a gateway minimum contribution to all non-HCEs. This contribution prevents an employer from passing the general test by giving large contributions (as a % of compensation) to young, low-wage workers while giving miniscule contributions to other non-HCEs.
The gateway minimum contribution made to all plan non-HCEs must equal the lesser of:
- one-third the highest contribution rate given to any HCE (based on the plan’s definition of compensation)
- 5% of the participant’s gross compensation
Generally, only non-HCEs eligible for the new comparability contribution must receive the gateway minimum contribution. However, any non-HCE that receives a safe harbor 3% non-elective or top heavy minimum contribution must also receive a gateway minimum contribution. This exception is noteworthy because small business 401k plans frequently combine new comparability and safe harbor 3% non-elective contributions to pass ADP/ACP and top heavy testing.
What are the consequences for failing the general test?
To retain their tax-qualified status, 401(k) plans must not discriminate in favor of HCEs. If a plan’s new comparability contribution fails the general test, The IRS can disqualify the whole plan. 401(k) plan disqualification is no joke! When it happens, participant accounts become taxable and past employer deductions are disallowed.
However, new comparability contributions rarely “fail” the general test. Instead, non-HCE contribution rates are increased until the test passes – the worst-case scenario being either a pro rata contribution to all profit sharing eligible participants or no contribution at all.
How can I make it easier to pass the general test?
There are several tricks a 401k plan sponsor can use to make the general test easier to pass with lower non-HCE contribution rates, including:
- Liberalizing restrictive plan eligibility or allocation requirements to make it easier for young non-HCEs to receive a new comparability contribution and help testing.
- Excluding HCEs from a safe harbor 3% nonelective contribution.
- A new comparability contribution can always be made to offset the missed safe harbor contribution.
- This exclusion is particularly useful when a company employs the children of business owners (or other young HCEs). These employees can easily blow up a general test when they receive any nonelective contribution (safe harbor or new comparability) at all.
- Defining multiple employee groups in the plan document to improve contribution rate flexibility.
Unfortunately, these tricks don’t work in all cases – in fact, they can sometimes backfire. That said, a skilled plan design expert can help you pick the right new comparability terms for your plan.
Shortcutting the 401(k) plan design process can be a costly mistake!
If you are a business owner, you most likely want to spend as little time as possible when setting up your 401(k) plan. My advice? Don’t shortcut the plan design process – a well-designed 401(k) plan can save your business tens of thousands of dollars annually in plan contributions while still meeting your company goals.
Small businesses interested in maximizing the 401(k) plan contributions of business owners should ask their 401k provider about new comparability contributions. These contributions are often the cheapest way to maximize owner contributions. The key is passing the general test.
About Eric Droblyen
Eric Droblyen began his career as an ERISA compliance specialist with Charles Schwab in the mid-1990s. His keen grasp on 401k plan administration and compliance matters has made Eric a sought after speaker. He has delivered presentations at a number of events, including the American Society of Pension Professionals and Actuaries (ASPPA) Annual Conference. As President and CEO of Employee Fiduciary, Eric is responsible for all aspects of the company’s operations and service delivery.