When does it not make financial sense for owners to do 401k profit sharing?

[zlandar]

What is the % split of profit sharing between owner(s) and employees when it's better for the owner to pay taxes and forego profit-sharing?

[spiritrider]

This can be a difficult and not just a purely financial determination.

It is almost always best to have a safe harbor 401k plan. This allows the owner and other HCEs to maximize their employee deferrals regardless of what non-HCEs deferr. This requires a minimum 3% non-elective* employer contribution or an employer match of 100% of the first 3% of compensation and 50% of the next 2% of compensation.

The purely financial consideration of increased or the addition of non-elective employer contributions: Is the comparison of the tax benefit of the owner's contributions vs. the total staff cost based on the total staff compensation. However, one should not fail to look at the value of increased employer contributions on staff morale and retention.

Note: Depending on the staff census, you could benefit from New Comparability Method profit sharing. Subject to analysis, this could allow you to have a disproportionately higher employer contribution rate than other employees. Your contributions could even allow you to maximize the annual addition limit, but would require higher employer contribution rates of 5%+, subject to cross testing.

*Profit sharing is almost always a legacy misnomer, because very few such contributions are now based on the company's profits.

[zlandar]

This can be a difficult and not just a purely financial determination.

It is almost always best to have a safe harbor 401k plan. This allows the owner and other HCEs to maximize their employee deferrals regardless of what non-HCEs deferr. This requires a minimum 2% non-elective* employer contribution or an employer match of 100% of the first 3% of compensation and 50% of the next 2% of compensation.

*Profit sharing is almost always a legacy misnomer, because very few such contributions are now based on the company's profits.

To clarify we would keep the 401k safe harbor. It's the amount of profit-sharing the owners would do. I was examining the profit-sharing breakdown for my group the last two years. The owner-to-employee split of the profit-sharing money has varied from 57% to 85%.

57% seems pretty awful. 85% sounds pretty good. How does one determine what is a good percentage?

[childay]

To clarify we would keep the 401k safe harbor. It's the amount of profit-sharing the owners would do. I was examining the profit-sharing breakdown for my group the last two years. The owner-to-employee split of the profit-sharing money has varied from 57% to 85%.

57% seems pretty awful. 85% sounds pretty good. How does one determine what is a good percentage?

Why did it change so much? Did owners not contribute for some reason one year themselves to max out individually?

[spiritrider]

To clarify we would keep the 401k safe harbor. It's the amount of profit-sharing the owners would do. I was examining the profit-sharing breakdown for my group the last two years. The owner-to-employee split of the profit-sharing money has varied from 57% to 85%.

As I mentioned, a New Comparability Method of profit sharing would allow the owner to have a higher contribution rate than groups of other employees. This would increase the percentage split of the owner. How much so would depend on the employee census, analysis and actual cross-testing.

If you are already doing additional non-elective employer contributions over the safe harbor minimums, it may not require much if any increase in total employer contributions.

If you are using an employer match as the safe harbor contributions. You will want to switch to all non-elective employer contributions with a minimum 5% contribution rate. 3% of which meets the safe harbor requirement.

The employee's cross-tested rate will usually be somewhat higher. However, depending on the employee census, the owner's rate can be 2X - 3X higher.

[The White Coat Investor]

In my opinion it's less a function of math (how much will the match cost me versus how much tax benefit I will get) and more a function of how much your employees value your 401(k) contributions for them. Mine value them A LOT. They have been taught and believe that they are MORE valuable than salary. One asked for a raise not too long ago. In what form did that person want a raise? As a higher 401(k) match (when it went up from $58K to $61K). But lots of medical and dental clinic employees don't value that at all. If that's your staff, then maybe it's all about the numbers.

[zlandar]

In my opinion it's less a function of math (how much will the match cost me versus how much tax benefit I will get) and more a function of how much your employees value your 401(k) contributions for them. Mine value them A LOT. They have been taught and believe that they are MORE valuable than salary. One asked for a raise not too long ago. In what form did that person want a raise? As a higher 401(k) match (when it went up from $58K to $61K). But lots of medical and dental clinic employees don't value that at all. If that's your staff, then maybe it's all about the numbers.

It's a mixed of office staff and employed docs. The office staff are not HCE and most will want more salary. Employed docs are a mixed bag but I get the sense most would prefer salary. The same $1 on a paycheck is worth more to them than on a 401k statement that they can't access until retirement.

The 401k/CBP rep I have worked with for the last 3 years asked me early last year why we kept doing 3% non-elective safe harbor across the board instead of just limiting them to non-HCEs. It's been that way since I joined the group 10+ years ago. I had no idea we could do that and we amended the plan which took affect in tax year 2021.

Made me consider what else I don't know. I have always wondered what the mathematical "cutoff" is for owner/employee split vs owner just not doing profit sharing and taking the tax hit.

[The White Coat Investor]

It's a mixed of office staff and employed docs. The office staff are not HCE and most will want more salary. Employed docs are a mixed bag but I get the sense most would prefer salary. The same $1 on a paycheck is worth more to them than on a 401k statement that they can't access until retirement.

The 401k/CBP rep I have worked with for the last 3 years asked me early last year why we kept doing 3% non-elective safe harbor across the board instead of just limiting them to non-HCEs. It's been that way since I joined the group 10+ years ago. I had no idea we could do that and we amended the plan which took affect in tax year 2021.

Made me consider what else I don't know. I have always wondered what the mathematical "cutoff" is for owner/employee split vs owner just not doing profit sharing and taking the tax hit.

If one really wanted to run the numbers, you'd have to come up with a value for the asset and tax protection over decades including 10 years after you die. Pretty tough. Especially since tax law can change at any time. It's not just the upfront tax savings against the match amount, which is what most people do.

[jacoavlu]

If one really wanted to run the numbers, you'd have to come up with a value for the asset and tax protection over decades including 10 years after you die. Pretty tough. Especially since tax law can change at any time. It's not just the upfront tax savings against the match amount, which is what most people do.

this is a good point. The future is always unknown. The real future value of the present day tax deduction (for owners) cannot be known.

As a reply to another post above. Owners can discriminate against HCEs in terms of profit sharing. You can’t discriminate against NHCEs.

[litovskyassetmanagement]

What is the % split of profit sharing between owner(s) and employees when it's better for the owner to pay taxes and forego profit-sharing?

There is no specific percentage that can be used for this. Here are some considerations:
1) The higher your tax brackets, the lower this % can be and still make sense.
2) If you are breaking even, you are still better off giving money to staff vs. to the government, so profit sharing might still make sense.
3) Some practices decide that this can be used as a benefit to staff even if the cost is higher than the breakeven. This is a business decision. PS is subject to a vesting schedule, so some practices use this as part of their benefit package to the staff.

If on the other hand you find that the cost of doing PS is high (for example, 50% going to the owners while the breakeven point is higher), there are several ways to address this:
1) Make sure that your plan design and profit sharing allocation formula is optimal. I'm assuming that it is if you have a good TPA working on your plan. At some point demographics becomes too much, so PS is often too expensive as the practice grows.
2) Switch to a discretionary match. This might or might not be enough to max out the contribution into the plan, but this will only reward those who participate. This will work if you have a low participation rate from the staff. This type of match is also subject to vesting which is good.
3) Consider adding a Cash Balance plan. The cost of making CB contributions is usually a lot lower than the cost of making PS contributions, so you might improve your % to owner by anywhere between 10% and 20%, and possibly even higher depending on your practice demographics. This is usually the preferred way if the partners want to contribute more into their retirement plans.

[litovskyassetmanagement]

It's a mixed of office staff and employed docs. The office staff are not HCE and most will want more salary. Employed docs are a mixed bag but I get the sense most would prefer salary. The same $1 on a paycheck is worth more to them than on a 401k statement that they can't access until retirement.

The 401k/CBP rep I have worked with for the last 3 years asked me early last year why we kept doing 3% non-elective safe harbor across the board instead of just limiting them to non-HCEs. It's been that way since I joined the group 10+ years ago. I had no idea we could do that and we amended the plan which took affect in tax year 2021.

Made me consider what else I don't know. I have always wondered what the mathematical "cutoff" is for owner/employee split vs owner just not doing profit sharing and taking the tax hit.

The analysis can be done, typically it is a side by side taxable vs. tax-deferred comparison that looks at the total cost of one vs. the other with opportunity cost component. I've been working on an article on this topic, but haven't published one yet as there are lots of details to consider (and of course due to the fact that numbers are all over the place for different practices depending on their size and demographics).

If you already have a CB plan, why concentrate on PS only? I usually include all of the plans into the % to owner comparison, not just a specific component, as it is all part of a whole and you can't just mess with PS if you have CB plan in place as PS is often mandatory if you are paying only the minimum necessary. If you are able to max out PS, then your TPA/actuary should have looked at the design where CB is maximized and PS is what it has to be vs. maximizing PS and having CB contribution be what it is (not maximum). This is also sometimes done to max out 401k PS. Usually a good actuary would max out CB and PS would be what it has to be to pass the testing, this is usually an optimal design, but not always, and your TPA/actuary should explain to you the tradeoffs specifically for your practice as there may be an advantage to one of the two, as maximum PS design can be better for you vs. the alternatives. You should have gotten multiple illustrations side by side to see % to owner comparison (and that's where they should have considered 3% to NHCEs only).

It is standard if you have a good actuary that they exclude HCEs from 3% NEC, so it sounds to me like your TPA/actuary are not that good in the first place if they miss something like that (though this should have been introduced at the plan design stage as this is the very first thing that is done - proper design study for the combo plan). But this is often the case if plan sponsor is not well versed in plan design and the TPA/actuary is not really doing a good design study and providing advice to the plan sponsor. Someone has to fill that role, and usually it would be the plan adviser - they should educate the plan sponsor/partners and work with the TPA/actuary on a design study, as well as help evaluate designs side by side. Unless the actuary is really good and does it all on their own, it is up to the plan sponsor to do it (or up to the plan adviser to assist the plan sponsor).

[zlandar]

The analysis can be done, typically it is a side by side taxable vs. tax-deferred comparison that looks at the total cost of one vs. the other with opportunity cost component. I've been working on an article on this topic, but haven't published one yet as there are lots of details to consider (and of course due to the fact that numbers are all over the place for different practices depending on their size and demographics).

If you already have a CB plan, why concentrate on PS only? I usually include all of the plans into the % to owner comparison, not just a specific component, as it is all part of a whole and you can't just mess with PS if you have CB plan in place as PS is often mandatory if you are paying only the minimum necessary. If you are able to max out PS, then your TPA/actuary should have looked at the design where CB is maximized and PS is what it has to be vs. maximizing PS and having CB contribution be what it is (not maximum). This is also sometimes done to max out 401k PS. Usually a good actuary would max out CB and PS would be what it has to be to pass the testing, this is usually an optimal design, but not always, and your TPA/actuary should explain to you the tradeoffs specifically for your practice as there may be an advantage to one of the two, as maximum PS design can be better for you vs. the alternatives. You should have gotten multiple illustrations side by side to see % to owner comparison (and that's where they should have considered 3% to NHCEs only).

It is standard if you have a good actuary that they exclude HCEs from 3% NEC, so it sounds to me like your TPA/actuary are not that good in the first place if they miss something like that (though this should have been introduced at the plan design stage as this is the very first thing that is done - proper design study for the combo plan). But this is often the case if plan sponsor is not well versed in plan design and the TPA/actuary is not really doing a good design study and providing advice to the plan sponsor. Someone has to fill that role, and usually it would be the plan adviser - they should educate the plan sponsor/partners and work with the TPA/actuary on a design study, as well as help evaluate designs side by side. Unless the actuary is really good and does it all on their own, it is up to the plan sponsor to do it (or up to the plan adviser to assist the plan sponsor).

I didn't think about the owner/employee split for CBP and PS until I was reviewing the group's 2020 CBP/PS breakdown that the previous plan actuary (he took another job) had created. That's when I noticed he had the owner/employee splits also calculated. Before then it was just a bunch of dollar figures next to each participant. The new actuary submitted an Excel worksheet for 2021 and it was easy to add a separate column totaling the contributions and getting the % owner/employee split.

The group does have a CBP and I calculated the owner/employee split for the CBP is >99% for the owners in 2021. The PS split is lower but still looks good.

As for why no one said anything about excluding HCEs from the 3% NEC... the 401k used to be handled by the officer manager for the group before I joined 10+ years ago. She was HCE as is the current office manager. I would guess it's difficult for the plan provider rep to suggest plan modifications to benefit the owners if it's going to cost the officer manager money. In the future I will periodically touch base with our current plan rep and have a private conversation so we are clear what the goals of the 401k/CBP are.