Profit Sharing Allocation Formulas
By Ethan Branum, CIP
My client currently has a deferral-only 401(k) plan and is looking to add a discretionary profit sharing feature to maximize his total contributions. What are the basic allocation formula options?
Employers have many options to choose from to determine what is best for the owners and employees. The Internal Revenue Code (IRC) provides three different formulas that are considered “safe harbor” formulas deemed to satisfy the nondiscriminatory requirements.
The first is a pro rata allocation formula, under which your contribution must be the same percentage of compensation for all participants eligible to receive an allocation (e.g., 5% of compensation). The second option is a flat dollar formula where all participants eligible to receive a contribution receive the same dollar amount (e.g., $500).
The third safe harbor formula is a Social Security integration formula. Employers pay a percentage of each employee’s pay into Social Security every pay period. The wages subject to this Social Security tax are limited to a specified amount, called the “taxable wage base,” which is adjusted periodically for cost-of-living increases. The Social Security integration formula results in eligible participants with wages above the taxable wage base receiving a contribution that is slightly higher as a percentage of compensation than participants with compensation below the taxable wage base. The higher contribution percentage theoretically makes up for Social Security contributions based on a smaller percentage of wages compared to participants with wages below the taxable wage base.
What options does a business owner have if his goal is to maximize his own contribution and minimize contributions to his employees?
There are two common allocation formulas that aren’t considered safe harbor and must, therefore, pass one or more tests to prove they don’t discriminate. These are the age-weighted allocation formula and the new comparability formula.
The age-weighted formula takes into consideration both the age of participants and their compensation to determine their contributions. This formula generally favors older participants.
The new comparability formula is a popular option for employers because of its flexibility. It allows an employer to define “allocation groups” and contribute a different amount to each of the groups. These groups can be created based on a wide variety of criteria, including ownership status, age or years of service, department, etc. In addition, each participant can be in a separate allocation group. The employer contributes to each group and allocates the contributions either on a pro-rata or flat dollar basis among participants within each group.
Are there any required contributions with the new comparability formula?
If in any given plan year an employer decides to make a discretionary profit sharing contribution that is allocated using a new comparability allocation formula, the employer is required to either make a minimum contribution called a “gateway” contribution or make sure that each allocation rate is available to a nondiscriminatory group of employees. These requirements are beyond the scope of this QRP Focus.
How do I know which allocation formula is best for my client?
What is best for your client depends on the client’s objectives and can vary depending on many facts and circumstances, including demographics, cash flow, etc. The employer must consider the many factors involved and is advised to work with a competent professional to make a decision on which formula is best.