Thousands of 401(k) plans are designed each year to promote savings in the most cost-effective manner. Most are established as stand-alone plans and will remain that way for their entire existence. Some, however, are initially set up as stand-alone, only to be paired with a cash balance plan down the road. Since most cash balance plans are designed to provide owners with the majority of the benefits, they cannot pass the nondiscrimination tests, so combining the cash balance plan with the 401(k) plan creates a cost-effective method to pass testing.
Most 401(k) plan provisions have no impact on the potential future combined nondiscrimination testing. For example, provisions such as automatic enrollment, loans and investment options give participants options without affecting any future combined testing. However, provisions that define eligibility and company contributions can have a significant impact on the ultimate cost of a combined plan design.
In our January Cash Balance Corner, we described the provisions to select for owner only plans – in the expectation that the company will one day hire employees. Those provisions include:
- Safe harbor elections
- Profit sharing allocations
Here, we will expand on that by reviewing any changes the sponsor of a stand-alone 401(k) should consider in anticipation of combining with a cash balance plan. Before we dive into the main topics, there is one important rule to point out - all plans that are combined for coverage and nondiscrimination purposes must have the same plan year. This is rarely an issue since almost all plans operate on a calendar year, but we would be remiss if we didn’t at least mention it. OK, now on to the discussion at hand.
A major goal of most 401(k) plans is to increase participant savings rates. As a result, many plan sponsors elect eligibility provisions that allow employees to contribute for themselves before they are eligible for a company contribution. Since employee deferrals are counted for nondiscrimination testing, allowing early entry this way may or may not impact test results.
If it is primarily non-highly compensated employees only that contribute early, then there is no negative effect on the combined testing. This is a very, very important disclaimer when dealing with any combined plan situation! If, on the other hand, it is predominantly HCEs who enter the plan early and begin deferring right away, it can negatively affect the test results. This becomes even more of a potential issue when family members of the owner join and defer large amounts of small salaries.
Best Practice: Keep eligibility for all allocations at age 21 with one year of service and semi-annual entry dates.
Safe Harbor 401(k) Plans
As noted above, most combination plan designs are meant to target benefits to the business owners, so any way to build in a free pass on any test results is helpful. That means the 401(k) part of the combo design is almost always a safe harbor 401(k) plan. The next question is, therefore, what is the best type of safe harbor to use.
If looking at a stand-alone 401(k) plan, we’d have to go with the never-popular-but-usually-applicable answer of “it depends.” We provide a great discussion on this topic here. With a combo design, though, the safe harbor nonelective option is almost always the most cost-effective choice. The main reason is quite simply – safe harbor nonelective contributions count toward the minimums required for non-HCEs, while safe harbor matching contributions do not.
Let’s look at an example. Assume a plan sponsor must provide a 7.5% gateway allocation to pass nondiscrimination testing. If the plan already provides a safe harbor nonelective contribution of 3% of pay, then the company only has to kick in another 4.5% to reach the gateway. However, if the plan provides a safe harbor match (equal to 4% of pay for any participant who defers at least 5% of pay), it does not count toward the gateway. That means the company must still contribute 7.5% of pay on top of the match.
Best Practice: Adopt the safe harbor nonelective feature in the 401(k) plan.
Profit Sharing Allocation Method
This one is quite simple. If the current allocation is not new comparability with each participant in his or her own group, it should be amended. If the 401(k) plan is going to be combined tested with a cash balance plan, it is imperative that the allocation method be flexible enough in this way to target contributions where needed to most efficiently satisfy testing. Plus, there is the fact that with each participant in his/her own group, we can replicate just about all other allocation methods anyway.
Best Practice: Change the profit sharing allocation method to individual groups (new comparability).
Profit Sharing Allocation Requirements
It is fairly common for stand-alone 401(k) plans to require participants to complete at least 1,000 hours of service during the year and/or be employed on the last day of the year to share in any profit sharing contributions. These provisions do not play nicely in the sandbox with cash balance plans.
Once again, the addition of a cash balance plan creates a cascading effect. A quick example will help illustrate. Assume Roger terminates during the year with more than 1,000 hours and earns a cash balance benefit (Note that a cash balance plan is not permitted to include a “last day” rule). In a stand-alone 401(k) profit sharing plan that is top-heavy, the company must provide Roger a 2% profit sharing allocation on top of the 3% safe harbor to satisfy the gateway requirement. Most DB/DC combined plan designs result in larger minimum contributions – top heavy increases from 3% to 5% and the required gateway minimum often increases to 7.5% of pay. That means Roger must now receive a profit sharing contribution of 4.5% of pay on top of the 3% safe harbor. However, if the 401(k) plan has a last day requirement for profit sharing allocations, the plan is stuck – Roger has to get a profit sharing contribution to pass testing, but the terms of the plan say that he is not entitled to a contribution. That means the company must adopt a corrective amendment to provide Roger with the additional profit sharing allocation.
Note that for a stand-alone 401(k) plan, top heavy minimums only need to be provided if the participant is working at the end of the plan year. For defined benefit plans, top heavy is provided for those participants who work 1,000 hours. In a combined plan situation where the top heavy minimum is provided in the DC plan, most plan documents require the additional profit sharing allocation if the participant earns a DB accrual – regardless of whether the participant is working on the last day of the plan year.
Best Practice: Amend the plan to remove allocation conditions.
Recap + A Trick of the Trade
So let’s recap the 401(k) plan provisions that work best in a combo plan design:
Attainment of age 21 and completion of one year of service (1,000 hours in 12 months)
Nonelective equal to 3% of pay
Profit Sharing Allocation Method:
New comparability with each participant in a separate allocation group
Profit Sharing Allocation Requirements:
There are some amendment timing restrictions that could come into play if the existing 401(k) does not already have these provisions. If the plan does not include a last day requirement, it may be necessary to wait until the start of the next year to make some of these changes. But that does not mean the cash balance plan has to wait until next year.
Often times, it is possible to setup a separate profit sharing plan with new comparability and no allocation requirements. Since all of the company’s plans must be combined for testing purposes, the profit sharing contributions required to pass testing are made to the new plan (rather than the existing 401(k) plan). Then in the next plan year, when the existing 401(k) plan has been properly amended, the new profit sharing plan can be merged into it. Yes, there are additional fees, but typically the additional fees are a small fraction of the cost savings created from using the optimal allocation method.
It gets even better. Now that cash balance and profit sharing plans can be adopted after the end of the year, a plan sponsor may wish to add a cash balance plan retroactively. While a 401(k) plan generally cannot be amended retroactively, adopting a new profit sharing plan retroactively alongside the new cash balance plan will usually give the flexibility needed to achieve the most efficient plan design.
Yes, there are a lot of options. But, no, you do not need to know them all. That’s why you have us! Give us a call, and we will look at the current documents and help create the best combined plan design for the situation.
We took a break from Robert’s plans this month since both his cash balance and 401(k) plans were set up properly from the start! Next month we will touch base with Robert to see how PBGC coverage affects the administration and funding of his plans.