Elective deferrals and associated matching contributions made to a 401(k) plan must satisfy certain non-discrimination rules known as the “actual deferral percentage” (“ADP”) and the “actual contribution percentage” (“ACP”) tests.  The ADP and ACP tests restrict the amount of elective deferral and matching contributions that highly compensated employees (“HCEs”) may receive.  However, the Internal Revenue Code of 1986, as amended, also allows a plan sponsor to “buy its way out” of the ADP and ACP tests.  This design exception to the ADP and ACP tests is known as a “safe harbor” 401(k) plan (“SH Plan”).

In a SH Plan, HCEs generally are permitted to contribute the maximum deferral amount and receive an associated match that is exempt from the restrictions normally imposed by the ADP and ACP tests.  This is permitted so long as each non-highly compensated employee (“NHCE”) receives a fully-vested employer contribution of as little as three percent of compensation if provided in the form of a non-elective profit sharing contribution (“SH PS”) or four percent of compensation if provided in the form of a matching contribution (“SH Match”).

Although the greatest burden imposed on a plan sponsor who implements a SH Plan is usually perceived to be funding the mandatory safe harbor contribution, there are many other administrative requirements that must be satisfied in order to qualify for the ADP / ACP exemption.  One such requirement relates to the plan year of a SH Plan.

In general, a SH Plan must be adopted before the beginning of the plan year and maintained throughout a full 12-month plan year.  However, for the first year that a plan or 401(k) feature is established, a SH Plan is permitted to have a no shorter than three-month plan year for purposes of the safe harbor feature.  Therefore, it generally is possible to establish a calendar year, SH Plan as late as October 1^st and still obtain the desirable exemption from the ADP and ACP tests in relation to the remainder of that same year.

In addition, effective under the Setting Every Community Up for Retirement Enhancement (“SECURE”) Act for plan years beginning after December 31, 2019, a SH Plan employing a SH PS feature can be adopted as late as 30 days prior to the end of the full plan year to which it would relate.  Also, in the alternative, if a fully vested contribution of at least four percent of compensation is allocated to each NHCE as a non-elective safe harbor contribution, a SH Plan can be established as late as the last day for distributing excess contributions in relation to such full plan year.  Generally, this means that a plan that employs a calendar year plan year will have until December 31^st of the year after the year to which the safe harbor feature relates to adopt a SH Plan so long as the amount of the non-elective safe harbor contribution is at least 4% of compensation.  However, to reiterate, the adoption timing flexibility described within this paragraph is limited to only SH Plans employing a SH PS feature, not a SH Match feature.

As described above, a SH Plan generally has to be implemented before the first day of the plan year to which it relates.  However, the exceptions to this rule described above provide significant design flexibility to plan sponsors.  This is important because, if employing a SH PS design feature, it can allow a plan sponsor to wait until the year is almost over before determining whether a SH Plan design is necessary to avoid refunds that might otherwise occur as a result of failed ADP/ ACP testing.  In addition, if the plan sponsor is willing to give a slightly larger safe harbor contribution, it can now wait until after the end of the plan year before deciding to make a safe harbor election.

As you might expect, advance preparation and planning is always necessary in order to establish a new tax-qualified plan or redesign an existing one.  The same holds true for a SH Plan.  Therefore, even with the new SH Plan establishment timing flexibility under the SECURE Act, now is the time to begin to consider whether a safe harbor feature is right for your company or your client’s plan in order to ensure that it can be fully operational in advance of the applicable deadline.  For more information about this issue please contact our marketing department at 484-483-1044 or your administrator at Legacy.

Elective deferrals and associated matching contributions made to a 401(k) plan must satisfy certain non-discrimination rules known as the actual deferral percentage (“ADP”) and the actual contribution percentage (“ACP”) tests.  The ADP and ACP tests restrict the amount of elective deferral and matching contributions that highly compensated employees (“HCEs”) may receive under a tax-qualified retirement plan.  However, the Internal Revenue code of 1986, as amended, also provides a method for a plan sponsor to “buy its way out” of the ADP and ACP tests.  This exception to the ADP and ACP tests is known as a “safe harbor” 401(k) plan and, in exchange for contributing on behalf of non-highly compensated employees as little as a fully-vested three percent of compensation profit sharing contribution or a four percent of compensation matching contribution, HCEs are generally permitted to contribute the maximum deferral amount and receive an associated match exempt from the restrictions normally imposed by the ADP and ACP tests.

Although the greatest burden imposed on a plan sponsor who elects a safe harbor 401(k) plan design feature is usually perceived to be the funding of the safe harbor contribution, there are many other administrative requirements that must be satisfied in order to qualify for the ADP / ACP exemption.  One such requirement relates to the plan year of a safe harbor 401(k) plan.

In general, a safe harbor 401(k) plan must be adopted before the beginning of the plan year and maintained throughout a full 12-month plan year.  However, in the context of the first year that the plan or 401(k) feature is established, a plan is permitted to have a no shorter than three month plan year for purposes of the safe harbor 401(k) feature.  Therefore, it is possible to establish a calendar year, safe harbor 401(k) plan as late as October 1^st and still obtain the exemption from the ADP and ACP tests in relation to the remainder of the year.

In that manner, it is possible for a new 401(k) plan to be established or for an existing profit sharing plan without a 401(k) feature to be amended to incorporate 401(k) and safe harbor features for as little as three months while still potentially allowing an HCE to contribute the maximum deferral contribution amount to such plan.  In addition, if designed correctly, the profit sharing feature associated with such plan may be effective for the full 12 month plan year allowing the maximum possible total contribution to the plan.

As you might expect, advance preparation and planning is always necessary in order to establish a new tax-qualified plan or redesign an existing one.  The same holds true for safe harbor plan design.  Therefore, now is the time to consider whether a safe harbor feature is right for your company or your client’s plan in order to ensure that it can be fully operational in advance of the October 1^st deadline.  For more information about this issue please contact our marketing department at 484-483-1044 or your administrator at Legacy.

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The design of a retirement plan drastically affects both who benefits under the plan as well as the value of the benefit received by those who do participate in the plan. If your goal is to maximize the retirement benefits provided through qualified plans sponsored by your company as well as to potentially skew benefits in favor of a specific group of employees or give disparate benefits to different groups of employees, a plan design that should be considered is to combine a 401(k)/Profit Sharing plan with a Cash Balance Plan.  Although this design results in the creation of two distinct plans that each require separate administration, testing and plan documents; it also provides an opportunity to maximize the benefits provided under both plans.

If we combine these plans, what are the advantages that can be gained?

As suggested above, the most important benefit of sponsoring both a 401(k)/Profit Sharing and Cash Balance Plans is that you can offer maximum contributions to owners and other worthy employees that exceed the limits of only sponsoring a 401(k)/Profit Sharing Plan.  If the plan is designed correctly and all testing passes, it may be possible to double or triple the benefit attributable to an owner or key employee compared to what they might receive in just a 401(k)/Profit Sharing plan.  Benefit maximization can be used to attract and retain key employees.

Another advantage to sponsoring both plans is the flexibility it provides to allocate different levels of benefits to different groups of employees.  This distinction is routinely based on job description or “highly compensated employee” status.  An example of this disparate allocation methodology could involve a law firm where senior partners receive a greater benefit percentage than junior partners.  Junior partners could then receive a higher benefit than paralegals and so on.  This flexibility is extremely helpful in meeting the benefit goals of plan sponsors who want to both maximize and target the retirement benefits they provide.

This design also can offer significant tax opportunities to a plan sponsor. In this regard, the larger plan contributions associated with this design can enable the sponsor to generate larger tax deductions.  The additional tax savings can enable plan sponsors to provide greater total retirement plan benefits to all of its employees.

Although combining plans presents powerful opportunities, remember that these are qualified retirement plans and must be designed and administered correctly in order to exploit them to their full advantage while avoiding potential compliance pitfalls.

Frequently Asked Questions:

 What is a 401(k) Profit Sharing Plan?

A profit sharing plan provides the plan sponsor with the discretion to decide (within limits) how much to contribute on behalf of participants each year, if anything at all. If contributions are made, a set formula must be established in order to determine how such contributions are allocated and such contributions must also be separately accounted for in relation to each employee. Contributions to the plan can be subject to a vesting schedule (which provides that employer contributions become nonforfeitable only after a period of time). In addition, mandatory annual testing ensures that benefits for rank-and-file employees are proportional to benefits for owners/managers.

Once your company has decided to sponsor a profit sharing plan, you will have to determine certain plan features – such as which employees will participate in the plan and when. Other features of the plan are required by law. For instance, the plan document must describe how certain key functions are carried out, such as how contributions are deposited in the plan.

By adding a deferral feature to a profit sharing plan, it becomes a “401(k)” profit sharing plan.  This feature allows participants in the plan to defer an elective amount from their own paychecks.  This amount can be designated as pre-tax, Roth or after-tax, as long as the plan document allows for the appropriate type of contribution.

What is a Cash Balance Plan?

A Cash Balance Plan is a Defined Benefit Plan that looks like a Money Purchase Plan.  Like a Money Purchase Plan, fixed contributions are credited to each participant at the end of each year. In addition, participants receive interest credits that are often based on an assumed interest rate defined in the plan. Increases or decreases in the value of the plan’s investments do not directly affect the benefits promised to the participants. The investment risks and rewards are borne solely by the employer. The plan maintains a hypothetical account balance for each participant. When the participant retires, his benefit is the value of the hypothetical account. This lump sum value can also be converted to a monthly pension at retirement.

A Cash Balance plan is also known as a Hybrid Plan. This is because, although it appears to participants to operate as a Defined Contribution Plan, it is treated under the Internal Revenue Code as a Defined Benefit Plan. Regardless, participant statements look like a Defined Contribution Statement with a beginning balance, contribution credits, interest credits and an ending balance.

A Cash Balance plan can be used to skew benefits to a select group of employees.  This can make the Cash Balance design more powerful than a traditional Defined Benefit plan in certain circumstances.

How are investments in a Cash Balance plan managed?

Assets in the plan are not allocated to participant controlled accounts so participants cannot direct the investment of their retirement plan assets. Instead, a pooled account is invested by the Trustees and Investment Advisers on behalf of all participants. Gains (losses) from investments reduce (increase) the Plan Sponsor’s contribution obligations. Since interest credit guarantees cannot exceed a market rate of return, assets may be invested conservatively.

What are the other features of the Cash Balance Plan?

When a participant becomes entitled to receive benefits under a cash balance plan, the benefits are defined in terms of an account balance. For example, assume that a participant has an account balance of $100,000 when he reaches age 62. If the participant decides to retire at that time, he would have the right to an annuity based on his account balance. Such an annuity might be approximately $10,000 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his spouse) to take a lump sum benefit equal to the $100,000 account balance.

In addition to generally permitting participants to take their benefits as a lump sum benefit at retirement, cash balance plans often permit vested participants to choose (with consent from their spouses) to receive their accrued benefits in lump sums if they terminate employment prior to retirement age. Traditional defined benefit pension plans often do not offer this feature.

If a participant receives a lump sum distribution, that distribution generally can be rolled over into an Individual Retirement Account (IRA) or to another employer’s plan assuming that plan accepts rollovers. This makes Cash Balance plans portable and, as a result, more appealing to participants.

How do cash balance plans differ from traditional pension plans?

Both traditional defined benefit plans and cash balance plans are required to offer payment of an employee’s benefit in the form of a series of payments for life.  However, traditional defined benefit plans define an employee’s benefit as a series of monthly payments for life to begin at retirement while cash balance plans define the benefit in terms of a stated account balance. As a result, cash balance accounts are often referred to as “hypothetical accounts” because they do not reflect actual contributions to an account or actual gains and losses allocable to such account.