2.2 Profit Sharing, Money Purchase & 401(k) Cash or Deferred Arrangements (CODAs)

2.2 Profit Sharing, Money Purchase & 401(k) Cash or Deferred Arrangements (CODAs)

[!IMPORTANT] Core DC Plan Spectrum: Defined Contribution plans encompass several distinct plan architectures under IRC §401(a). While modern retirement administration is dominated by 401(k) arrangements, a 401(k) is not an independent plan type—it is a Cash or Deferred Arrangement (CODA) governed by IRC §401(k) that is formally attached to an underlying qualified profit-sharing plan, stock bonus plan, or pre-ERISA money purchase plan. Understanding the foundational mechanics of profit-sharing and money purchase designs is essential for mastering 401(k) compliance.

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Profit-Sharing Plans: Discretionary Architecture

A Profit-Sharing Plan is a defined contribution individual account plan established and maintained by an employer to enable employees to participate in company capital accumulations.

+-----------------------------------------------------------------------------------------+
|                         PROFIT-SHARING PLAN ALLOCATION FLOW                             |
+-----------------------------------------------------------------------------------------+
|                                                                                         |
|               [ Employer Annual Board Resolution / Discretionary Decision ]             |
|                                            │                                            |
|                                            ▼                                            |
|                     [ Total Contribution Pool (Capped at 25% Payroll) ]                 |
|                                            │                                            |
|         ┌──────────────────────────────────┼──────────────────────────────────┐         |
|         ▼                                  ▼                                  ▼         |
|  [ Pro-Rata Comp-to-Comp ]       [ Permitted Disparity §401(l) ]      [ Cross-Tested §401(a)(4) ]
|  Uniform percentage across       Tiered rate above/below Social       New comparability groups  |
|  all eligible participants       Security Taxable Wage Base (SSTWB)   tested on annuity rates   |
|                                                                                         |
+-----------------------------------------------------------------------------------------+

Discretionary Employer Contributions

Unlike pension plans, a standard profit-sharing plan features complete employer contribution discretion:

• The employer's governing body (e.g., Board of Directors) decides each year whether to make a contribution and determines the total contribution dollar amount or percentage of compensation.
• The employer has zero legal obligation to contribute in any given year, providing financial flexibility during business downturns.

The "Substantial and Recurring" Requirement

While annual contributions are discretionary, plan sponsors cannot treat a profit-sharing plan as an intermittent or abandoned vehicle. Under Treasury Regulation §1.401-1(b)(2):

• Contributions must be "recurring and substantial" for the plan to maintain its qualified status.
• If an employer fails to make contributions over an extended multi-year period without legitimate business hardship, the IRS may deem the plan permanently discontinued.
• Under IRC §411(d)(3), upon a formal plan termination or complete discontinuance of employer contributions, 100% immediate vesting is automatically triggered for all affected participants, regardless of the plan's nominal vesting schedule.

Profits Are NOT Required (IRC §401(a)(27))

Historically, employers could only make contributions to a profit-sharing plan out of current or accumulated net earnings ("profits"). However, the Tax Reform Act of 1986 added IRC §401(a)(27), which eliminated this restriction.

• Employer contributions to a profit-sharing plan do not require current or accumulated profits.
• Consequently, non-profit tax-exempt organizations, governmental entities, startup ventures, and corporations running substantial net operating losses (NOLs) can sponsor and fund qualified profit-sharing plans.

Allocation Methodologies

Once the employer determines the aggregate contribution dollar amount, it must be allocated to participant accounts in accordance with a definite predetermined formula specified in the plan document:

1. Comp-to-Comp (Pro-Rata): Each participant receives an allocation strictly proportional to their compensation as a percentage of total eligible compensation.
2. Permitted Disparity (Social Security Integration under IRC §401(l)): Allocates an additional contribution on compensation exceeding an integration level (typically the Social Security Taxable Wage Base), recognizing that Social Security benefits disproportionately favor lower-paid workers.
3. Age-Weighted Allocations: Uses actuarial present value factors to allocate larger contribution percentages to older participants closer to retirement.
4. New Comparability / Cross-Testing (Treas. Reg. §1.401(a)(4)-8): Groups employees into distinct allocation classes (e.g., Owners, Management, Staff) and tests for nondiscrimination by converting account allocations into projected retirement annuities at NRA. Must satisfy statutory minimum gateway requirements (the lesser of 5% of compensation or one-third of the highest HCE allocation rate).

Statutory Deduction Limit (IRC §404(a)(3))

Employer tax deductions for contributions to a profit-sharing plan are capped at 25% of aggregate eligible participant compensation paid or accrued during the taxable year. Compensation counted for each individual participant cannot exceed the annual statutory limit under IRC §401(a)(17) ($345,000 in 2024; $350,000 in 2025).

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Money Purchase Pension Plans: Mandatory Funding

A Money Purchase Pension Plan (MPPP) is a defined contribution plan that is classified under the Internal Revenue Code as a pension plan.

Mandatory Contribution Formula

Unlike profit-sharing plans, an MPPP does not allow discretionary employer funding:

• The plan document mandates a strict, fixed contribution formula (e.g., "10% of compensation for each eligible participant").
• The employer must contribute the exact formulaic amount each year, regardless of profitability, cash flow, or macroeconomic conditions.

Minimum Funding Rules (IRC §412)

Because an MPPP is a pension plan, it is subject to the minimum funding standards of IRC §412:

• If an employer fails to deposit the mandatory required contribution by the statutory deadline (8½ months following the close of the plan year), an initial 10% excise tax under IRC §4971(a) is imposed on the accumulated funding deficiency.
• If the deficiency is not corrected within the statutory taxable period, a catastrophic 100% penalty tax under IRC §4971(b) applies.

In-Service Distribution Restrictions

Historically, pension plans were strictly prohibited from distributing benefits to active employees prior to Normal Retirement Age. While the Pension Protection Act of 2006 (PPA 2006) relaxed this rule by permitting in-service distributions at age 62, and the SECURE Act further reduced the threshold to age 59½ (IRC §401(a)(36)), an MPPP cannot permit early in-service distributions prior to age 59½, unlike profit-sharing plans which can allow distributions after a fixed number of years (e.g., 2-year or 5-year rules under Rev. Rul. 71-295).

The Historical Rise & Fall: The EGTRRA 2001 Consolidation

A critical piece of retirement history frequently tested on ASPPA QKA exams explains why standalone MPPPs are rare today:

PRE-2002 DEDUCTION STRUCTURE (Prior to EGTRRA):                        POST-2001 DEDUCTION REFORM (EGTRRA 2001):
+───────────────────────────────────────────────────+                  +───────────────────────────────────────────────────+
| • Profit-Sharing Deduction Limit: 15% of Payroll  |                  | • Profit-Sharing Deduction Limit: 25% of Payroll  |
| • Money Purchase Deduction Limit: 25% of Payroll  |                  | • Money Purchase Deduction Limit: 25% of Payroll  |
|                                                   |  ─────────────>  |                                                   |
| Strategy: Employers paired 15% PSP + 10% MPPP to  |                  | Strategy: Employers use 100% Discretionary PSP    |
| reach maximum 25% deduction while retaining       |                  | for full 25% deduction; MPPPs became obsolete!    |
| 15% discretion!                                   |                  |                                                   |
+───────────────────────────────────────────────────+                  +───────────────────────────────────────────────────+

• Pre-EGTRRA Reality: Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the maximum employer deduction for a profit-sharing plan was strictly 15% of eligible compensation, while pension plans (including MPPPs) enjoyed a 25% deduction limit.
• The Classic "Paired Plan" Design: To achieve the maximum 25% corporate tax deduction without committing to a full 25% mandatory obligation, employers routinely established two separate plans: a 15% discretionary profit-sharing plan paired with a 10% mandatory money purchase plan.
• EGTRRA 2001 Equalization: Effective for plan years beginning in 2002, EGTRRA increased the profit-sharing deduction limit under IRC §404(a)(3) from 15% to 25% of aggregate compensation.
• Result: Because employers could now deduct the full 25% under a completely discretionary profit-sharing plan, the business justification for maintaining a mandatory money purchase plan vanished. Most employers froze, terminated, or merged their MPPPs into profit-sharing/401(k) plans.

Comprehensive Comparison: Profit-Sharing vs. Money Purchase

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401(k) Cash or Deferred Arrangements (CODAs)

A 401(k) Cash or Deferred Arrangement (CODA) is a mechanism under IRC §401(k) that allows an eligible employee to choose between:

1. Receiving an amount in cash as taxable wages, OR
2. Having that amount contributed by the employer to a qualified trust as an elective deferral.

Deferral Classifications

• Pre-Tax Elective Deferrals: Contributed to the trust before federal (and most state) income taxes are withheld. Earnings grow tax-deferred. Distributions are taxed as ordinary income.
• Designated Roth Contributions (IRC §402A): Contributed on an after-tax basis (included in gross taxable income for the year of deferral). Qualified distributions (made after satisfying a 5-year holding period AND attaining age 59½, death, or disability) are 100% federal income tax-free.
• FICA / FUTA Tax Treatment: Crucially, both pre-tax and Roth elective deferrals are fully subject to Social Security (FICA) and Federal Unemployment (FUTA) taxes at the time the wages are earned.

The Cash Advance Prohibition / Timing Rule

Under Treasury Regulation §1.401(k)-1(a)(3)(iii), a CODA must adhere to strict cash or deferred timing requirements:

• No Retroactive Elections: An employee's deferral election must be executed prior to the date the compensation is earned or becomes currently available.
• Cash Advance Prohibition: An employer cannot advance elective deferrals or contribute deferrals to the trust in anticipation of future employee services. Deferrals can only be deducted from wages after the service has been performed and before paychecks are disbursed.

DOL Deposit Timing Rules (DOL Reg. §2510.3-102)

Participant deferrals and loan repayments are treated as plan assets as soon as they can reasonably be segregated from the employer's general assets:

• General Rule (Large Plans): Deferrals must be deposited into the trust on the earliest date feasible, but under no circumstances later than the 15th business day of the month following the month in which the amounts were withheld from payroll.
• Small Plan Safe Harbor (< 100 Participants): Under a DOL safe harbor regulation, contributions deposited within 7 business days following the payroll pay date are automatically deemed in timely compliance.
• Prohibited Transaction Penalty: Failure to timely segregate deferrals constitutes an illegal employer loan from the plan, violating ERISA §406(a)(1)(D) and triggering a 15% excise tax under IRC §4975 reported on Form 5330.

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Automatic Enrollment & Negative Election Architectures

In an Automatic Contribution Arrangement, an employer utilizes a "negative election": newly eligible employees are automatically enrolled to contribute a specified percentage of pay unless they affirmatively elect zero or choose a different deferral percentage.

+─────────────────────────────────────────────────────────────────────────────────────────────────+
|                     AUTOMATIC ENROLLMENT REGULATORY SPECTRUM                                    |
+─────────────────────────────────────────────────────────────────────────────────────────────────+
|                                                                                                 |
|  1. BASIC ACA (Automatic Contribution Arrangement)                                              |
|     • IRC §414(w) framework; standard auto-enrollment with required annual participant notice.    |
|     • Subject to standard ADP/ACP testing and standard 2.5-month correction deadline.           |
|                                                                                                 |
|  2. EACA (Eligible Automatic Contribution Arrangement)                                          |
|     • Uniform default percentage applied to all covered employees.                              |
|     • Permissive 90-day withdrawal window: opt-out refunds without §72(t) 10% penalty.          |
|     • Extends ADP/ACP excise-tax-free refund deadline from 2.5 months to 6 full months!         |
|                                                                                                 |
|  3. QACA (Qualified Automatic Contribution Arrangement)                                         |
|     • Safe harbor design under IRC §401(k)(13); completely exempt from ADP/ACP testing!         |
|     • Statutory auto-escalation schedule: Year 1 (>=3%) -> Yr 2 (>=4%) -> Yr 3 (>=5%) ->         |
|       Yr 4+ (>=6%, max 15%).                                                                    |
|     • Employer contribution: 100% match on 1st 1% + 50% match on next 5% (total 3.5%), or       |
|       3% nonelective. Permitted 2-year cliff vesting on employer contributions!                 |
|                                                                                                 |
|  4. SECURE 2.0 §101 MANDATORY AUTO-ENROLLMENT                                                   |
|     • Mandatory for new 401(k) and 403(b) plans established on/after Dec 29, 2022               |
|       (effective for plan years beginning after Dec 31, 2024).                                  |
|     • Initial default rate: 3% to 10%, escalating 1% annually to 10%-15%.                        |
|     • Exemptions: Small businesses (<= 10 employees), new businesses (< 3 yrs), church, gov.    |
|                                                                                                 |
+─────────────────────────────────────────────────────────────────────────────────────────────────+

EACA Permissive Withdrawals & Extended Correction Window

An Eligible Automatic Contribution Arrangement (EACA) grants participants a permissive withdrawal window under IRC §414(w):

• Employees who were automatically enrolled can elect to withdraw all default deferrals (adjusted for earnings) within 30 to 90 days following the first deduction date.
• Permissive withdrawals are exempt from the IRC §72(t) 10% early withdrawal tax.
• In addition, an EACA grants plan administrators an extended 6-month correction window (instead of the standard 2.5 months) following plan year-end to distribute excess contributions under ADP/ACP testing without incurring the 10% excise tax under IRC §4979.

QACA Safe Harbor Mechanics

A Qualified Automatic Contribution Arrangement (QACA) under IRC §401(k)(13) exempts the plan from annual ADP and ACP nondiscrimination testing if it satisfies three statutory pillars:

1. Default Deferral Schedule: Minimum 3% during year 1, 4% during year 2, 5% during year 3, and 6% during year 4 and subsequent years (capped at a statutory maximum of 15%).
2. Employer Contribution: Either a 3% nonelective contribution to all eligible NHCEs, or a QACA safe harbor match of 100% on the first 1% of deferral plus 50% on deferrals between 1% and 6% (yielding a maximum 3.5% employer match on a 6% deferral).
3. Vesting Advantage: Unlike traditional safe harbor 401(k) plans (which mandate 100% immediate vesting), QACA employer contributions may be subjected to a 2-year 100% cliff vesting schedule.

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One-Participant / Solo 401(k) Plans

A Solo 401(k) (also known as an Individual 401(k) or Uni-401(k)) is an ordinary 401(k) profit-sharing plan covering a business where the only participants are the business owner(s) and their spouse(s).

Dual Contribution Capacity

Because the business owner functions as both an employee and the employer, the owner can maximize contributions up to the IRC §415(c) annual additions limit ($69,000 in 2024; $70,000 in 2025, plus catch-up):

1. Employee Capacity: Elective deferrals up to the IRC §402(g) limit ($23,000 in 2024; $23,500 in 2025, plus $7,500 catch-up if age 50+).
2. Employer Capacity: Discretionary profit-sharing contribution up to 25% of W-2 compensation (for corporate entities) or 20% of net adjusted self-employment income (for sole proprietors and partners).

Title I ERISA Exemption (29 C.F.R. §2510.3-3)

Under Department of Labor regulations, an individual and their spouse who wholly own an incorporated or unincorporated business are not considered common-law employees for purposes of Title I of ERISA:

• A plan covering only the business owner(s) and spouse(s) is exempt from Title I of ERISA.
• Exempt from Summary Plan Descriptions (SPDs), Summary of Material Modifications (SMMs), Summary Annual Reports (SARs), ERISA claims procedures, and ERISA fiduciary bonding requirements.

Form 5500-EZ Reporting Thresholds

• Asset Exemption Threshold: A one-participant plan is completely exempt from filing Form 5500-EZ if total plan assets across all one-participant plans of the employer at the end of the plan year are $250,000 or less.
• Once Assets Exceed $250,000: Annual filing of Form 5500-EZ is mandatory by the last day of the 7th month following plan year-end.
• Final Return Trap: When a Solo 401(k) plan is terminated and all assets are liquidated/distributed, a final Form 5500-EZ must be filed regardless of the asset balance (even if the balance is $0).