For many small businesses comprised of one or several highly compensated employees and a few non-highly compensated employees, the Safe Harbor 401k plan may be the best option if maximizing contributions is a primary objective. Safe harbor plans effectively remove the barriers of discrimination testing that limits the amount that can be contributed for highly compensated employees. However, what if the objective is to be able to contribute the maximum amount allowable under the tax code? That’s where a combination safe harbor/profit sharing plan can be the ultimate solution for maximizing the retirement savings opportunities for business owners and their highly compensated employees.
How Does a Safe Harbor-Profit Sharing Plan Work?
A Safe Harbor 401k plan is a 401k plan alternative for smaller businesses that seeks to weigh their contributions more heavily to the owners and/or highly compensated employees. Essentially, the plan requires a prescribed employer contribution be made on behalf of all employees and they must be 100 percent vested. With that, employers can skirt the testing for contributions required of regular 401k plans – otherwise referred to as a “safe harbor.”
These plans are well-suited for smaller businesses with less than a half dozen employees which are weighted more towards the highly compensated. While it’s a significant step towards increasing their contribution capacity, it still leaves a significant amount on the table.
Adding an Age-Based Profit Sharing Plan
An age-based profit sharing plan is generally compared to a defined benefit plan that allows discretionary contributions. Factors such as age, retirement timeline, and length of employment are considered as part of the formula for allocating contributions. So, in businesses where the owners or key employees are significantly older than the other employees, it can favor the former while not being discriminatory against the latter. That’s because the contribution amount is based on projected benefits an employee can expect to receive at retirement. The closer an employee is to retirement, the higher proportion of employer contributions he or she can expect to receive.
In a simple example, an owner and his wife, both 48, earning $250,000 and $100,000 respectively could increase their total contributions substantially by combining a Safe Harbor 401k plan with an age-based profit sharing plan.
Under a normal plan rules, the owner and his wife could contribute up to $18,000 and receive a 4 percent employer match bringing their total contributions to $27,800 and $22,000 respectively.
By adding a profit sharing component, they could receive an additional contribution up to his 415 limit of $53,000 (2015 limit) and his wife’s total to $35,877. In doing so; however, they would have to include eligible employees in the profit sharing contribution.
Based on profit sharing calculations, they would have to make a contribution of approximately 7 percent on behalf of their three employees earning $41,000, $36,000 and $32,000. Based on a total payroll of $109,000, the 4 percent match made under the 401k plan would amount to just under $4,400. The additional 7 percent profit sharing calculation would add $7,630, bringing their total exposure to just over $12,000. However, this additional investment will enable the business owner and his wife to increase their contributions by more than $40,000. The additional tax savings realized by the business partially offsets the increased investment.
In the right situation, the Safe Harbor 401k – Profit Sharing arrangement is a win-win for the business and its employees. And, because profit-sharing contributions are not mandated, businesses enjoy the flexibility to adjust their contribution strategy according to its changing circumstances. Although it does require plan design, administration and reporting, the benefits to the business, key employees and employees invariably outweigh the costs.