Course Objective
This course was created to teach advisors (CPAs, EAs, accountants, attorneys, financial planners and insurance advisors) about Qualified Retirement Plans. Retirement planning is a topic that many advisors think they know well, but could use more information in order to give the best advice possible to high income clients. As a general statement, most medium to small businesses owners would like to defer as much money as possible while contributing the smallest amount for the employees.
While many advisors simply tell their clients to “max out” a 401(k)/Profit Sharing Plan, there are several variations to 401(k)/Profit Sharing Plans that can dramatically favor the highly compensated owner/employees. In addition to 401(k)/Profit Sharing Plans, due to recent tax law changes, Defined Benefit Plans, in particular Cash Balance plan designs, as well as, 412(e)(3) Defined Benefit Plans (formerly referenced as 412(i) Plans) have once again become viable retirement vehicles for many business owners.
This material will cover common and advanced “qualified” retirement plans available to clients and illustrate to advisors why one plan is better than another (depending on the type of client looking for benefits). The material will also discuss some of the problems with the plan in the marketplace and how to avoid the pitfalls when implementing non-prototype plans for clients.
Qualified Retirement Plans
Introduction
U.S. households held $10.7 trillion in retirement assets at the end of 2010, according to a pair of retirement industry analysts who culled information from the Federal Reserve’s Flow of Funds report and U.S. Census data. In the year 2000, one of every eight Americans was over age 65 and this will increase to one of every five by the year 2025. These facts alone witness the tremendous and lucrative opportunities now and for years to come for advisors who choose to give advice to clients on retirement planning.
Many of these opportunities are with current clients. An important part of being an advisor is to offer ideas to your clients. They may not always be interested in those ideas, but a message is sent to them that you are aware and care about their particular situation. A question you may ask to your clients is, “Do you need to accumulate retirement savings and/or need tax deductions on your corporate or personal tax return?” Usually the answer is “YES”. A critical question at this point in time is what type of retirement plan does my client need?
________________________________________________________________________ A retirement plan is sponsored by a business (vs. an individual taxpayer). An unincorporated, self-employed individual (sole proprietor), partnership, LLC or a corporation is eligible to sponsor a qualified retirement plan even if there are no employees other than the owner(s).
For most privately held businesses, choosing the right retirement plan is one of the most important financial decisions because the plan must suit not only the owner/employee’s immediate needs but also his or her financial, business and retirement profile. A major consideration is that in retirement years, income for retirees usually comes from three sources:
-Social security benefits.
-The regular savings or equity of the retiree, (home(s), investments) and -Retirement plan savings, such as IRAs and employer-sponsored
retirement plans
For most successful clients, Social Security benefits will not offer a significant portion of that income at retirement. This leaves the other two items to provide the bulk of retirement income.
A qualified plan offers benefits to both employer and employees:
Employers
-Employer may receive a tax-deduction for plan contributions
-Employers are able to attract and retain high-quality employees. A qualified plan may be the tiebreaker that wins over a skilled person who is offered relatively similar compensation packages from different potential employers.
-Business owners are able to reduce their income (and in turn their income taxes) by sometimes as much as several hundred thousand dollars a year.
Assets in a qualified retirement plan are not subject to general creditors of either the employer or any employee participant under Federal law.
Employees
-Employees are provided with the opportunity for their retirement years to be more financially secure when an employer funds a qualified retirement plan for their benefit.
-For plans that provide salary-deferral features, employees are able to defer paying taxes on a portion of their compensation until their retirement years, when their tax bracket is usually lower.
This material will review the more popular retirement plan options available in today’s market. Those providing clients with the most tax savings will be explored in greater detail.
Individual Retirement Account (IRA) Plans
For an employer, an IRA, SEP and SIMPLE plans are the easiest to understand and administer. However, these plans are also the most limiting on how much can be put into them in a tax deferred manner each year. In addition, these plans are the most rigid in the eligibility, contribution limits.An
Individual Retirement Account (IRA)
is a personal savings plan that allows clients to set aside funds for your retirement. Investments made within these plans grow in either a tax deferred or tax free environment. The following are the current and future contribution limits. For more information on the contribution limitations with an IRA please see the education module on IRAs.Year IRA contribution limit
Catch-up age 50+
2015 and after $5,500 $1,000
While almost anybody can make a contribution to a traditional IRA, only a few are allowed to actually deduct the amount contributed to the IRA.
If you are eligible to participate in a pension, your ability to deduct your IRA contributions is phased out based upon your income.
AGI Phase-Out
Limits for Deductible Traditional IRA
Your Filing Status Is... And Your Modified
AGI Is... Then You Can Take...
single or
head of household
$61,000 or less
a full deduction up to the amount of your contribution
limit. more than $61,000 but
less than $71,000 a partial deduction. $71,000 or more no deduction.
________________________________________________________________________
Your Filing Status Is... And Your Modified
AGI Is... Then You Can Take...
married filing jointly or
qualifying widow(er)
$98,000 or less
a full deduction up to the amount of your contribution
limit. more than $98,000 but
less than $118,000 a partial deduction. $118,000 or more no deduction.
married filing separately
less than $10,000 a partial deduction. $10,000 or more no deduction.
A
Simplified Employee Pension (SEP)
plan is a special type of individual retirement account (IRA) that is extremely popular among owners of small businesses and sole proprietors. If your clients are the owners of the business or sole proprietor, they may contribute up to 25% of the salary their pay into a SEP. The maximum annual contribution, however, is limited to $53,000 for 2015. Remember that if a client establishes a SEP-IRA, he/she must also include all eligible employees. Eligible employees include anyone who earns more than $450 and has had any service in three of the past five years. For example, if an employee/owner contributes 10% of his/her salary to a SEP, he/she must also contribute 10% of each eligible worker’s salary to their own IRA.The SIMPLE (IRA) (Savings Incentive Match Plan for Employees) is a “simplified” version of the famed 401(k) plan for employers with 100 or fewer employees. The major virtue of this plan is that nondiscrimination testing usually found with 401(k) plans is eliminated. A SIMPLE also has certain administrative aspects that have made it the plan of choice for many small employers. A SIMPLE plan allows employees to defer dollars from their own paycheck (up to 12,500 for 2015), and generally requires a dollar for dollar match up to 3% of pay or a 2% non-elective contribution from the employer. This 3% match or 2% contribution is the buyout of the testing requirements usually found in 401(k) plans.
The SIMPLE 401(k) has been largely replaced by the safe harbor 401(k). Here’s a Comparison Chart for SEP vs. SIMPLE:
Description
SEP SIMPLE
Specifically designed for self-employed people and small business owners who typically employ less than 25 employees.
Designed for small businesses with 100 or fewer employees. The plan is funded by employer contributions and can also be funded by elective employee salary
deferral.
Employer Contributions
Required uniform percentage of each employee’s pay
Employer is required to make either an annual matching contribution or a
non-elective contribution of 2% of compensation. Maximum Total
Annual Contributions
25% up to $53,000 2015 Maximum employee contribution of $12,500 and ER contribution of 2% -
3% of salary. Maximum
Deductions
25% of all participant’s
compensation Same as maximum contribution
Vesting Schedule for
Employer Contributions
All contributions 100% vested All contributions 100% vested
Withdrawals / Distributions
(Follows traditional IRA
Regulations)
Permitted subject to tax and, if under 59 ½½, potential 10%
penalty.
Permitted, however, if under age 59 ½, potential 10% penalty. (25% penalty if
account is less than 2 years old.)
Deadline for Establishment
of Plan
Any time up to date of employer’s return (including extensions).
Any time between 1/1 and 10/1 of the calendar year. For a new employer coming in to existence after 10/1, as
soon as administratively feasible.
Deadline for Contribution
Due date of employer’s return (including extensions).
Employee contributions: 30 days following the end of the month
with respect to which the contributions are made.(12/31)
Employer contributions: Due date of employer’s return (includes
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ERISA Plans
Perhaps the single most profound piece of legislation regarding tax-qualified retirement plans was the Employee Retirement Income Security Act of 1974 (ERISA). This landmark legislation tamed the “wild-west” of old retirement plans by codifying requirements regarding:
1. Eligibility
2. Participation and Coverage 3. Minimum Vesting Standards 4. Nondiscrimination Rules 5. Fiduciary Responsibility
6. Minimum Funding Standards for “pensions” 7. Reporting requirements
8. Creation of the Pension Benefit Guarantee Corporation (PBGC) Essentially, pension plans must operate by specific rules set forth in a written plan document and participants must receive periodic information about their plan. ERISA resulted in IRC section 401(a) being added, hence many of these plans are often referred to as “401(a)” plans. You may recognize the noted subsection 401(k) which falls under this Code section.
When working with ERISA plans, you should be aware of these specific issues and terms:
-The Plan Document (establishes and provides rules for the Trust) -Summary Plan Description (SPD) issued to all “interested parties” -Plan Sponsor (the business owners who adopt the Plan)
-Plan Trustee (often the business owners, but may be another party)
-Third Party Administrator (TPA) (a firm that specializes in providing pension services and reporting to assist the Trustees)
-IRS form 5500 series (annual IRS reporting)
The single most important thing for you to remember when working with retirement plans is that every recommendation you make must be allowable within the Plan Document. Another important issue is that the Plan must exist PRIOR to the end of the plan or fiscal year (e.g. by 12/31).
Related Employers
Perhaps the largest issue in making sure that a qualified plan satisfies nondiscrimination testing and remains compliant is the inclusion of all “related employers” as joint sponsors of the plan. That’s because many small business owners may indeed own or control more than one enterprise. It is tempting to adopt a 412(e)3 plan to benefit one group of employees, and not cover all the related employees, but this may not be possible under current pension law as a plan must meet specific coverage and participation rules. [IRC §410(b) and §401(a)(26)]
Generally, all the employees of businesses under common control are aggregated for nondiscrimination testing vesting and top-heavy rules. Also the 415(a) contribution and 415(b) benefit limits will aggregate as if all the employees worked in one single employer. [IRC §414(b)]
Presented here are definitions of the “controlled” and “affiliated” service groups that the professional advisor must consider before recommending adoption of any qualified retirement plan.
Parent-Subsidiary Controlled Group
1. One business must own at least 80 percent of another business.
2. If the businesses in item 1 together own 80 percent of a third business, the third business is also a member of a parent-subsidiary group.
Brother-Sister Controlled Group
1. Five or fewer persons own in combination at least 80 percent of the stock of each business, AND
2. The same persons own more than 50 percent of each business counting only identical ownership in each business.
3. A person’s stock ownership is not taken into consideration for the 80 percent test in item 1 above unless the person owns some stock in each business. [IRC§1563(a)]
4. Attribution rules for stock ownership of spouses and certain family members may apply. [IRC §1563(d)]
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Brother-Sister Controlled Group (con’t)
Example:
Owner Business 1 Business 2
A 50% 40%
B 30% 60%
C 20% 0%
Result: Businesses 1 and 2 are members of a Brother-Sister Controlled Group because A and B own at least 80 percent of both businesses and more than 50 percent of both, counting only up to 40 percent ownership for A and 30 percent ownership for B. Because C owns no stock in Business 2, C is disregarded for the 80 percent ownership test.
Combined Group
1. Consists of three or more businesses, each of which is a member of a parent-subsidiary or a brother-sister group; and
2. One company is both a parent of a parent-subsidiary group and a member of a brother-sister group.
Affiliated Service Group
1. Consists of a service organization (e.g., medical practice, law firm or other service business) and an affiliated organization (e.g., employs nurses or paralegals) which is at least 10 percent owned by highly compensated employees of the organization, AND
2. The affiliated organization performs services for the service organization, which account for at least 5 percent of the gross receipts of the affiliated organization. [IRC §414(m)]
Example: Dr. Smith owns 100 percent of Medical Practice. She also owns 20 percent of Nurses, Inc., a firm whose employees provide nursing services to Medical Practice. 50 percent of Nurses, Inc.’s gross receipts are on account of services provided to Medical Practice.
Result: Medical Practice and Nurses, Inc. are members of an Affiliated Service Group.
PBGC Plans
Only defined benefit pension plans that are qualified under Internal Revenue Code (Code) Section 401(a) are covered by the PBGC's plan termination insurance program. Certain defined benefit pension plans are exempted from coverage, however, if they are classified as any one of the following types of plans:
1. A governmental plan, including plans under the Railroad Retirement Act; 2. A church plan that elects not to be covered;
3. A non-U.S. plan for nonresident aliens;
4. An unfunded deferred compensation plan for a select group of management or highly compensated employees;
5. A plan that since the enactment of ERISA has not provided for employer contributions;
6. A plan that benefits only substantial owners, where a substantial owner is a sole proprietor or partner who owns 10 percent or more of the capital or profit interest in a business entity, or in the case of a corporation, a person who owns 10 percent or more of the voting stock or total stock of the corporation;
7. A plan of an international organization that is tax exempt under the International Organizations Immunities Act;
8. A defined benefit plan to the extent that it is operated as an individual account plan; or
9. A plan established and maintained by a professional service employer that did not have, at any time since the enactment of ERISA, more than 25 active participants
What is an individual account plan?
A plan that provides benefits based solely on the amount available in an individual's account is an individual account plan. Therefore, a target benefit plan is an individual account plan and would not be covered by the PBGC. A cash balance plan, however, does not provide benefits directly through an individual account and is covered by the PBGC.
________________________________________________________________________
PBGC Plans (con’t)
What is a professional service employer for purposes of PBGC coverage requirements?
A professional service employer is a sole proprietorship, partnership, or corporation that is owned or controlled by professional individuals. A professional service individual includes, but is not limited to, physicians, dentists, chiropractors, osteopaths, optometrists, other licensed practitioners of the healing arts, attorneys at law, public accountants, engineers, architects, draftsmen, actuaries, psychologists, scientists, and performing artists. [ERISA §4021(c)(2)]
In addition, the PBGC generally defined a professional individual in PBGC Opinion Letter 76-106 [Sept. 3, 1976] as follows:
In our view, a professional individual generally is one who provides services which require knowledge of an advanced type in a field of science or learning customarily acquired by a prolonged course of specialized intellectual instruction and study, as distinguished from a general academic education and from an apprenticeship or from training in the performance of routine mental, manual or physical processes. The rendering of professional services generally requires the consistent exercise of discretion and judgment in its performance and would be predominantly intellectual in character.
________________________________________________________________
Profit Sharing Plans
A profit sharing plan is often the plan of choice for many small-business owners and professional practices because the contributions can be made with complete discretion. These tax-deductible contributions may be reduced or suspended in any given year that the employer chooses. Actually, “profit sharing plans” is a bit of a misnomer. We prefer to think of these plans as entirely discretionary retirement plans. Employers can fund them in an unprofitable year, or decide not to contribute in even the most profitable year. Non-profit organizations may also adopt them. That’s flexibility.
Recent favorable tax laws have made these plans better than ever. Advisors who do not sell qualified plans for a living can team up with a qualified advisor who can show clients how to harness these new rules and take their planning to what the client will perceive as the “Next Level.”
Profit Sharing Contributions
Each year, the sponsoring employer may decide to allocate from 0 – 25% of the “eligible payroll” into the plan. Eligible payroll is the total of the allowable wages of the participants who are eligible to receive a contribution that year. It should be noted that, allowable wages for any individual participant above $265,000 (indexed limit for 2015) are ignored for profit sharing calculations.
The following point is often confused under the tax law: any one participant may contribute a 401k elective up to 100% of pay, not to exceed $18,000 plus a catch-up limit of $6,000 for participants that are age 50 or older (indexed elective 401k and catch-up limits for 2015). Additionally, a profit sharing contribution can be made. The total 401k elective plus profit sharing contribution cannot exceed the annual addition limit of $53,000 (indexed annual addition limit for 2015). The catch-up contribution requires a 401k plan provision, however it is not a calculable part of the annual addition limit and it is disregarded for all plan testing purposes.
It should also be noted that the total employer contribution still can not exceed 25% of the eligible payroll unless combined with a cash balance or traditional pension plan under the rules as outlined in the Pension Protection Act of 2006 (PPA 2006).
Non-PBGC profit sharing plans when combined with a defined benefit pension plan in any form limit the employer contribution to a sum not to exceed 6% of the eligible payroll. This apparent “disadvantage” is more than offset by upto a 100% defined benefit contribution, as well as, an optional 401(h) add-on post-retirement medical benefit account provided by the pension. 401(h) maximum contributions are 33.33% of the total pension retirement contribution.
Three “Next Level” Tools to Consider
A retirement plan can not discriminate in favor of “highly compensated employees” in either contributions or benefits. This, however, does not mean that everybody has to receive the same contribution. Far from it; when designing a “Next Level” profit sharing plan, many pension plan providers offer three tools that can be used to craft the plan that best meets your client’s goals and budget. These Include:
1. “Integration” with Social Security 2. Age-Weighting the Contribution
3. New Comparability Classification Plans
________________________________________________________________________
Current Age- New-
Employee Name Age Salary Traditional Integrated Weighted Comparability
Owner (key) 55 $265,000 $53,000 $53,000 $53,000 $53,000 % of Pay 20% 20% 20% 20% Key Employee 45 $100,000 $20,000 $16,484 $15,701 $5,000 % of Pay 20% 16.85% 15.70% 5% Employee 1 30 $40,000 $8,000 $6,740 $1,847 $2,000 % of Pay 20% 16.85% 4.62% 5% Employee 2 35 $35,000 $7,000 $5,897 $2,431 $1,750 % of Pay 20% 16.85% 6.95% 5% Employee 3 30 $25,000 $5,000 $4,212 $768 $1,250 % of Pay 20% 16.85% 3.10% 5% Total $93,000 $76,300 $73,747 $63,000 % to Owner 57% 55% 72% 84%
Integrated Profit Sharing Plans
All employers already sponsor at least one retirement plan, jointly funded by employers and employees. It’s called the Old Age & Survivor Benefit of Social Security. Government rules let you take this into account by allowing you to “integrate” your qualified retirement plan with your Social Security contributions. Although the rules are flexible and somewhat complex, this concept helps employers skew additional benefits to the highly compensated employees while lowering them somewhat for the lower-paid workers.
Under an Integrated Profit Sharing Plan, compensation is broken out into two parts; the amount above the integration level (excess compensation), and the amount below the integration level (base compensation). Usually the integration level is the Social Security Taxable Wage Base in effect for the applicable year. The employer is permitted to “offset” their contribution to Social Security by applying a lower contribution percentage to the base compensation (i.e.: the base percentage) and a higher contribution percentage to the excess compensation (i.e.: the excess percentage).
A Profit Sharing Plan Integrated with Social Security works best in situations when the company wants to make greater contributions to highly compensated employees who are the same age or younger than the other employees.
Age-Weighting
The final regulations governing nondiscrimination (found in IRC 401(a)(4)) introduced an old pension plan concept to profit sharing plans. Recall that the contribution can not discriminate in either contributions or benefits. Therefore, giving everybody 20% of pay is clearly nondiscriminatory. However, giving each the same theoretical retirement benefit is also nondiscriminatory (as with a defined benefit plan).
Why is Age-Weighting a profit sharing plan helpful? The reasoning is simple: with fewer years until retirement, older participants require larger contributions than younger participants to get to the same benefit level.
A review of the design chart shows that this plan is perhaps the most favorable to the owner. However, in operation, it is a little cumbersome. Older employees get higher contributions, period. Employees in the same job, getting similar wages, will get very different contributions unless they share the same age. Because of these reasons, this plan is less popular than the next option.
New Comparability
Perhaps the most exciting development in pension plans, this “Next Level” design offers a method to allocate significantly greater contributions to specific classes of employees. It combines both the integration and age-weighted rules, but uses weighted averages to determine the contribution. This plan is ideal for principals who:
-Are older and earn more than most of their employees;
-Want the biggest possible share of the plan contribution allocated to their own accounts; and,
-Desire the contribution flexibility of a profit sharing plan.
This type of plan is known by many names: “super-integrated,” classification plan, group allocated plan and more commonly “new comparability.” Because it was finalized in the Code in 1993, it is really no longer new, so we prefer to call it super comparability since it is among the most flexible of plans and can target, with precision, extra benefits to select classes of employees.
New Comparability is highly customizable and can be matched to your client’s business quite easily. For example, groups can be created for different profit centers, subsidiaries, sister companies or, most commonly, by job class—in short, any clearly identifiable group. Some common examples include:
________________________________________________________________________ 1. Owners 1. Sr. Partners 1. Executives
2. Non-Owners 2. Jr. Partners 2. Managers
3. All Other Employees 3. Employees of Subsidiary A 4. Employees of Subsidiary B
Some sponsors get quite creative to create clearly identifiable classes that best match their business organization. Interestingly, creating different classes does not mean you have to give different contributions in any given year. In some years, you can give each class zero or perhaps 25% of pay to everyone. It’s your call, as long as the contribution satisfies testing each year.
The basic rule of thumb is that the contribution you give to the bottom group(s) will determine how much you can give to the others. If the preferred groups are, on average, older than the bottom groups, you should be able to leverage modest contributions to the rank and file employees into substantial contributions to the other groups.
Nondiscrimination Testing
Because “New” Comparability can be perceived as potentially abusive, the IRS updated the rules effective January 1, 2002, to provide firm guidance on how to establish a plan. These rules help us to advise you on how to tailor your groups and allocate the contribution. There are two basic issues that you should be familiar with:
1. The 3:1 Rule 2. The 5% Rule
Generally, the allocation to the top group can not exceed three times the allocation to the bottom group and must satisfy the testing. Therefore, if you give 3% of pay to each employee in the bottom group, then the top group can not receive more than 9% of pay, assuming that 9% passes testing. Once you award 5% of pay to the bottom group, then the 3:1 ratio disappears. With the proper circumstances, plans with allocations of 25:5 can be created when the top group was 15 years older than the average employee.
401(k) Plans
The 2001 Tax Law has, perhaps for the first time, made the 401(k) Plan among the best retirement plan designs for even the smallest of employers. That’s because the new law fundamentally altered the way these plans operate regarding treatment of the employer contributions vs. the employee contributions. When combined with sophisticated tools and concepts found in other sections of the tax code, you get the unparalleled advantages of “Next Level” 401(k) Plans.
The Economic Growth and Tax Relief Reconciliation Act of 2001 greatly expanded and simplified the 401(k) world. Each employer may now contribute up to 25% of the “eligible payroll” in the form of profit sharing, matching contributions or combinations of each. The prior limit was only 15% of the payroll and was reduced by the salary deferrals, which is no longer the case.
Salary Deferrals
401(k) Employee Voluntary Elective Contributions
The new law dramatically increased the amount that any employee can potentially defer into a profit sharing plan with a 401k voluntary elective deferral provision. It also allows any participant who is age 50 or older during the plan year to contribute additional “Catch-Up” deferrals. These limits are typically adjusted annual. 2011 401k elective deferral limits are as follows:
Deferral Catch-up Total Age 50+
2015 $18,000 $6,000 $24,000
These individual, elective deferrals, upto 100% of pay with a maximum of $18,000 (indexed limit for 2015, can now be added to profit sharing contributions and matching contributions with the total of all contributions not to exceed $53,000 plus the catch-up if over age 50 of $6,000 or a total of $59,000 (indexed limit for 2013
The Problem
Many small-business owners would like a plan that is fairly inexpensive to fund yet provides significant benefits for the owners, family members or highly skilled workforce.
Unfortunately, in a 401(k), the amount that “highly compensated”
employees may save is dictated by the savings rate of the “non-highly compensated” employees.
Although the rules are complex, salary deferrals of the highly compensated employees versus the others, as a percent of salary, may be summarized as follows:
________________________________________________________________________ Average Deferral Percentage (ADP)
Non-Highly Compensated Highly Compensated
0% 0% 1% 2% 2% 4% 3%* 5% 4% 6% 6% 8% 8% 10%
*For the first year of a new plan, the rate of deferrals for the non-highly compensated employees can be assumed to be 3% of pay, so the highly compensated employees may defer 5% as a group.
Key Issues for Consideration
Who is “Highly Compensated?”
A highly compensated employee is defined by government regulations to be:
1. A greater than 5% owner and any linear family member (e.g., son, daughter, mother, father) of such owner.
2. Anyone who received more than $120,000 (indexed amount for 2015) of compensation in the prior year, and (at the option of the plan sponsor) was in the top 20% of all employees.
Most small-business owners employ spouses and other family members. Even though they may earn far less than $120,000, they still are considered “highly compensated.”
“Top Heavy” Concern
Another problem that often arises in a small-business 401(k) is that once 60% or more of the plan assets attribute to the owners, their family (as described above), or certain officers, the plan becomes “top heavy.” Although having 60% or more of the plan assets is often desired by the owners, it may necessitate that the employer contribute at least 3% of salary to all the eligible employees, or the smallest percentage contributed for a Key Employee, if less.
Thus, a plan that was supposed to encourage employee savings with a minimal cost for the sponsor may be more expensive than anticipated. Fortunately, the new law counts any matches against this minimum, reducing the problem somewhat.
“Safe Harbor” 401(k)
Congress has recognized the pitfalls of traditional 401(k) plans and has offered two alternatives for you to consider. These “Safe Harbor” provisions can steer the plan sponsor clear of the troubled waters they may have once faced. These provisions remove the Average Deferral Percentage (ADP) test and, with the new tax law, also satisfy the “Top Heavy” concern. However, the prime consideration is that any safe harbor contribution made using either method must be immediately vested and is owed to all employees even if they leave the plan during the plan year.
1. Safe Harbor “Match”
The employer agrees to match employee contributions, with immediate vesting as follows:
-100% up to 3% of pay -50% on the next 2% of pay
Thus, an employee who defers 5% or more of pay will get total matches of at least 4% of pay. Of course, if employees defer less, they get less, or nothing if they are eligible and elect not to defer anything.
2. Safe Harbor “Non-Elective”
Another very easy way to add a fail-safe provision to the plan is simply to award 3% of pay, with immediate vesting, to each eligible participant. Thus, all employees receive some benefit in the plan, regardless of whether or not they elect to defer anything.
How to Use These 401(k) Safe Harbors
As easy as these provisions are to understand, they become a bit trickier to implement. That’s because the IRS is concerned that unscrupulous plan sponsors would choose to use these provisions at the end of the plan year, and the employees may not be able to take full advantage of them in a short period of time. Here are the guidelines for using them:
1. A brand new 401(k) can use either design as long as the plan is installed before the fourth quarter of the plan year (e.g., prior to 10/01 for calendar year plans).
________________________________________________________________________ 2. An existing plan must provide notice at least 30 days prior to the beginning of the plan year (e.g., by 12/01 of the preceding year for calendar year plans) stating either that they MAY or they WILL use the provision the following year. 3. Assuming the “we may” notice was given in the prior year, the employer must decide 30 days before the beginning of the plan year (e.g., by 12/01 for calendar year plan) whether or not he or she will be using the safe harbor to satisfy discrimination testing. If the employer chooses to use the safe harbor, then the plan must be amended to include the safe harbor provisions.
As these rules are somewhat cumbersome, it is recommended that the plan document specify whether or not this will be a safe harbor design in the next or first plan year. If you do not specialize in 401(k) planning, it is wise to affiliate with a reputable pension plan administrator who has a staff dedicated to helping advisors with these difficult issues.
Planning Note 1: The 401k account can be given different eligibility ‘terms” than the profit sharing account. For example a plan can be written requiring Age 21, 1 year of service and full time status to participate in the 401k. The Profit Sharing part of the plan can have immediate eligibility for all. Why? This arrangement allows your employer to include part timers for testing purposes i.e. they are participants in the profit sharing plan but not the 401k. If a safe harbor is used it vests 100% immediately. So the part timer, not eligible for the 401k will be used for testing in PS, will not vest due to part time status unless they become full time or reach retirement age.
Planning Note 2: Safe harbors can be conditional or unconditional. Conditional allows for an owner “look back” between 90 to 30 days before the plan year end to post a Notice of whether or not the Safe harbor will be used in the current plan year. The issue may be vesting, 100% immediate with a safe harbor or graded upto 6 years otherwise or the employer/plan sponsor may simply not have the funds do to economic conditions. An unconditional safe harbor must be funded no matter what the economic circumstances are. The plan sponsor may want to make some additional plan change. The unconditional safe harbor could prevent him from doing so. The conditional safe harbor = planning flexibility.
“DASH 401(k)”
Perhaps the most exciting development in retirement plan design today is the “New Comparability” Profit Sharing Plan.
This innovative method allows the sponsor to make substantial contributions to selected groups of employees while limiting the cost for other groups by using an “age-weighted” mechanism to satisfy nondiscrimination testing. Essentially, if the preferred employees are older than the average age of
the non-preferred employees, this design can dramatically skew benefits to the older groups.
A Double Advantage Safe Harbor (DASH) 401(k) plan combines a “safe harbor” 401(k) plan with a new comparability profit sharing feature. The results are often dramatic, and compelling.
Current Salary 3% Safe New Total
Employee Name Age Salary Deferral Harbor Comparability Contribution Owner (key) 55 $265,000 $18,000 7,950 27,050 $53,000 % of Pay 6.8% 3.0% 10.21% 20% Key Employee 45 $100,000 14,000 3,000 5,000 22,000 % of Pay 14% 3.0% 5.0% 22% Employee 1 30 $40,000 ? 1,200 564 1,764 % of Pay 3.0% 1.41% 4.41% Employee 2 35 $35,000 ? 1,050 494 1,544 % of Pay 3.0% 1.41% 4.41% Employee 3 30 $25,000 ? 750 353 1,103 % of Pay 3.0% 1.41% 4.41% Total 13,950 33,461 79,411 % to Key 78.5% 95.8% 94.5%
In the case above, you will note that there are two “key” employees, the owner and an officer of the company. The owner wants to favor himself first and the key employee second. Another goal is to keep the employee benefit cost reasonable or minimal, if possible.
A DASH 401(k) accomplishes these objectives by first awarding a flat 3% “safe harbor” to all eligible employees. This is the ONLY required employer contribution each year. By awarding this safe harbor, both the owner and the Key employee may defer the maximum with ADP testing. By including a new comparability profit sharing feature, the owner can dramatically skew added benefits to himself and his Key employee with discretion. Thus, the safe harbor and the new comparability provision combine to offer a Double Advantage.
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The “Micro(k)
SM”
Another plan that should be considered in lieu of a SIMPLE or SEP-IRA is what we call the “Micro(k).” These are known by various other names to include: “Uni-K,” “One-Life 401(k),” “Solo 401(k)”, etc., and have strong appeal following the passage of EGTRRA ’01.
A 401(k) salary employee deferral can now be added on-top of the employer profit sharing contribution until the participant reaches the 100% of pay not to exceed $53,000 indexed defined contribution limit (for 2015).
Those participants who turn age 50 or older during the current year may also make “catch-up” contributions even if they exceed the $53,000 limit. Thus, a 50-year-old may have up to $59,000 between the employer contribution and salary deferral in 2015, as long as he/she is deferring the maximum allowed under the law or the plan.
Importantly, when there are no common-law employees (e.g. Micro(k) plans only work when the only eligible employees include the owners and their spouses), there is no need to worry about nondiscrimination testing and ,there are relaxed reporting rules. This translates into lower administrative and set-up costs. The “Micro(k)” is a moniker we use to denote “very small” 401(k) plans. It is a marketing concept, rather than a statutory plan design.
Let’s compare a Micro(k) to a SEP-IRA for the following participant, age 50:
SEP-IRA Micro-K W2 Salary $100,000 $100,000 Owner Contribution $25,000 $25,000 Salary Deferral - $18,000 Catch-Up - $6,000 TOTAL $25,000 $49,000
Unlike a SEP or SIMPLE, life insurance can be a permitted investment in the “Micro(k)” which presents interesting sales opportunities for those who have life insurance needs. A properly crafted, cash-value life insurance contract may have a long-term yield that is comparable to a bond-fund and thus may be an excellent diversifier.
A Micro(k) can also include a loan provision where the owner employees may borrow up to ½ the account balance from the Plan, up to $50,000. These loans are paid back into the plan (with interest) ratably over five years. This added liquidity can be very important to a small business owner who has a bad year and needs cash. As he essentially borrows money from himself, all the interest goes back into his account. By contrast, a SEP or SIMPLE-IRA can not offer this important feature.
Money Purchase Plans
Unlike profit sharing and 401(k) plans, a Money Purchase Plan is a true “pension” plan and is therefore subject to minimum funding standards. Under a money purchase pension plan, a fixed percentage of compensation is contributed to the plan each year, regardless of profits. The contribution is paid by the company and is deductible by the company. The maximum allowable contribution to a single participant cannot exceed 25% of annual compensation or the annual addition limit in effect for that year ($53,000 in 2015). The disadvantage of the money purchase plan is that once the company decides on the percentage contribution, it becomes fixed for subsequent years unless amended. Even if the revenues from the business are down, the employer is still obligated to make the contribution in the required amount. Failure to meet the contribution, or during requirements will result in an excise tax on the deficiency.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) dealt the Money Purchase Pension Plan a severe blow. The annual deductibility limit for the Profit Sharing Plan has been increased from 15% to 25% of compensation, therefore making it equivalent to the contribution limit on a Money Purchase Plan. When plan employers consider the inflexibility of the Money Purchase Pension Plan’s contribution and distribution requirements relative to the Profit Sharing Plan, few will elect to use a Money Purchase Plan.
It is interesting to note that many clients still have money purchase plans due to the lack of good service on the part of their pension advisors.
If your clients have a money purchase plan, you should counsel them to re-visit whether it makes sense for them to switch to the much more flexible profit sharing plan or perhaps a DASH 401(k).
Once employees have “accrued” or earned a benefit, which will generally happen when an employee participant has attained 1000 hours of service in a plan year, that benefit cannot be taken away. Accordingly plan changes should be made prior to accruals being earned. A plan change subsequent to accruals being earned must recognize the accruals already earned.
All pensions are subject to earned accrual rules.
Defined Benefit Plans
Following some very favorable tax legislation in the late 1990s, defined benefit plans have once again emerged as one of the best ways for a successful small-business owner to save substantial sums for retirement. Unlike defined contribution plans (e.g., 401(k) and profit sharing), defined benefit plans are not limited to a $53,000 individual contribution limit, nor is the business owner limited
________________________________________________________________________ to no more than 25% of the “eligible payroll.” A properly crafted defined benefit plan can take retirement savings to the “Next Level” by creating much greater tax deductible contributions and retirement benefits.
The Problem
Many small-business owners and professionals put off saving for retirement to invest money in their business or practice, pay for their children’s education and enjoy their working years. Now, with stable and growing income (profits), they look to catch up in a fairly short period of time. Unfortunately, it takes both money and time to build retirement savings. Even if the money is available, most retirement plans severely limit the amount that can be deducted and placed within the plan. Retirement dollars not placed within the Plan are eroded by federal, state and local income taxes and by payroll taxes that can easily add up to 50% of income.
The Solution
Consider the following: a 52-year-old small business owner who earns $210,000 or more in salary and plans to retire at age 62 can select from the following plans, with an assumed 5.5% investment yield:
Annual Accumulation
Accumulation At age 62* Profit Sharing $53,000 $682,394 Defined Benefit $202,618 $2,608,780
How is This Possible?
As read in the previous material defined contribution plans provide a tax-deductible contribution that is limited to a fixed dollar amount (e.g., $53,000). The monies are placed within a retirement trust and grow tax deferred until received at retirement as ordinary income. The retirement benefits depend solely on the investment yield achieved for the dollars invested. Thus, the retirement benefit is unknown, but the contribution is predictable.
A defined benefit plan works in reverse. The benefit is known (as selected by the employer), and the necessary contribution is calculated to
achieve that benefit at “normal retirement age.” Because this calculation is complex and is subject to stringent government guidelines, an enrolled actuary must review the plan each year and certify that it is operating properly. The basic concept, however, is fairly simple: the fewer the years until retirement, the larger the required contribution.
Who Should Consider This Plan?
A defined benefit pension plan will reward the high-income, mature participants (the Baby Boomers, for example, will benefit far more than
Generation X). In fact, age is more important than salary when calculating the anticipated level cost for the benefit. Although there are many ways to design a plan, let’s return to our example of a person earning $170,000 who wants the maximum benefit at age 62 using an assumed 5.5% investment yield for various ages: W-2 Comp Required ages 35 to 40 = $70,000; 45 = $80,000; 50 = $100,000; 55 = $130,000.
Age DB Plan Contribution Accumulation
35 $68,200 $2,600,000
40 $87,300 $2,600,000
45 $123,700 $2,600,000
50 $145,400 $2,600,000
Today a 30 year old making $70,000 can put $53,000 into a pension + up to $53,000 into a combined 401k + PS + 401(h); total $106,000. The 30 year old could also use an offset plan year and add an additional $140,000 for a total 1st year contribution of $246,000. Second and subsequent years would be in excess of $140,000.
How Do These Plans Work?
Unlike a defined contribution plan, a defined benefit plan (other than a 412(e)3 “Fully Insured” plan) does not have participant accounts. Rather, the sponsor gives the required contribution to the plan trustee who then invests all of the trust assets into the plan. Benefits are then paid from the plan as employees become eligible and are vested.
Generally, the benefit is expressed in terms of monthly income at normal retirement age (e.g., $17,500 each month, or $210,000 per year for a maximum plan from our example). However, most small-business plans will offer a lump-sum conversion for any vested benefit. In our prior example, this benefit is converted to $2.6 million, which may then be rolled to an IRA or successor defined contribution plan.
Side note: It should be noted that some advisors setup over funded defined benefits plans using low assumed rates of return and then advise their clients to terminate the plans after five year of funding. The money would be rolled over to an IRA which does not have growth limits on the return on investments. This is not a good idea for advisors looking to keep their clients and themselves out of trouble with the Department of Labor.
________________________________________________________________________ Should a participant opt for monthly income for life, this liability is often shifted to an insurance company. This protects the trustee from having to ensure that sufficient assets exist until all retired participants die. The lump-sum conversion amount is a good approximation of what the insurance company may require to guarantee the benefit.
Participants married for one year or more must be offered a Qualified Joint and Survivor Annuity. This means that the monthly benefit is paid for the life of the retired participant. Should the spouse survive the participant, then at least 50% of the monthly check must continue to the spouse until his or her death. However, should the spouse consent, a single life annuity or lump sum may be paid from the plan. Often, life insurance is used to provide for the spouse who makes this election.
Defined Benefit Plan Design
The maximum benefit allowable in 2015 is 100% of pay, not to exceed $210,000 per year at age 62 if (and only if) the participant has ten years of participation in the plan. However, not all plans should be designed for age 62 retirement. A “Normal Retirement Age” (NRA) can be selected between age 62-65 for participants with at least five years of participation. Thus, a 62-65-year-old new participant could have an assumed retirement age of 70.
This (NRA) does not mean the person must retire at this age, it is simply used as an assumption to determine the theoretical benefit and required annual contribution. The basic principle is that the benefit is reduced for early retirement before NRA, and increased for delayed retirement beyond NRA. Also, recall that a reduction is made for less than 10 years of participation.
So that you can better see the design flexibility of these plans, let’s look at the effect of selecting Normal Retirement Ages. We’ll assume our participant earns $170,000 with a 5.5% investment assumption.
Defined Benefit Plan Design (con’t)
Age NRA Contribution Monthly
Benefit Lump Sum at NRA 50 62 125,852 14,167 2,062,154 55 65 149,297 14,167 1,922,252 60 65 172,199 7,083 961,058 65 70 235,674 11,075 1,315,321 70 75 254,094 14,167 1,418,118
Making a Commitment
Unlike a profit sharing plan, a defined benefit plan must be funded each year. This means that even in a “bad year,” the pension plan contribution must be made since the benefit is promised by the employer. It is possible to make changes to the plan benefit formula on a prospective basis, but for benefits that are already accrued, the employer must deliver. For the plan to qualify as a bona fide retirement plan, the employer should be prepared to make a minimum five-year commitment. If this commitment can not be made, then an employer should consider staying with a profit sharing plan, where contributions are generally not required.
To make sure that any non-owner employee is guaranteed to receive a benefit, the federal government requires most defined benefit plans to pay insurance premiums to the Pension Benefit Guaranty Corporation (PBGC).
Survivor Benefits
A defined benefit plan has great flexibility in designing both the retirement benefit and the pre-retirement survivor benefit. A plan can specify the survivor benefit to be as low as zero, but it is often at least the “present value of the accrued benefit.” This is calculated by the plan actuary if a participant dies, and is similar to the benefit for somebody leaving the plan with a vested lump sum benefit.
However, a significant pre-retirement survivor benefit can be added at the option of the employer. Since this benefit may be in addition to the retirement benefit, it should be insured by life insurance contracts or it could exhaust (or potentially exceed) the available trust assets.
Interestingly, this added benefit may have a very low impact on the plan’s current cost (see Envelope Funding vs. Split Funding). Let’s return to our 50-year-old, earning $170,000 and with NRA 62.
Annual Accumulation Added Survivor Contribution at age 62 Benefit
Plan A $125,852 $2,062,152 $0
Plan B $128,864 $2,062,152 $1,000,000
Many planners believe that using life insurance as a funding vehicle for guaranteed plans is a very efficient method of providing this coverage.
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Envelope Funding vs. Split Funding
Plans using life insurance to provide a pre-retirement death benefit must consider the policy cash values as a part of the plan’s funding.
The Split Funding Method is often used with Whole Life insurance policies where the guaranteed cash value of the policy at retirement is known. The Envelope Funding Method must be used with Interest Sensitive policies (such as Universal Life), where the cash value at retirement is not guaranteed or known. The Envelope Funding Method may also be used for Whole Life policies. When the Envelope Funding Method is used for Whole Life policies, plan contributions in the 2nd and future years may increase each year. The Plan Sponsor should be aware of which funding method is being used when a plan is partially funded using life insurance. The following chart illustrates the difference between Envelope & Split Funding for a 50 year-old participant who has a $165,000 salary history with a Normal Retirement Age (NRA) of 62.
Envelope-Funding Split-Funding
Life Insurance Face Amount $1,375,000 $1,375,000
Life Insurance Premium $33,176 $33,176
Year 1 Side Fund Contribution $92,894 $103,215 Year 1 Side Fund Contribution $98,330 $103,215 Year 8 Side Fund Contribution $103,660 $103,215 Year 12 Side Fund
Contribution $126,037 $103,215
Cash Surrender Value @
NRA $310,228 $310,228
Side Fund Value @ NRA $1,691,228 $1,691,228
Total Assets @ NRA $2,001,456 $2,001,456
Side Note: This chart varies our prior examples somewhat by using a lower assumed salary as the chart numbers were readily available. The teaching point is that there is substantial flexibility in how the Plan actuary chooses to fund the life insurance. This example also assumes a whole life policy, yet a UL contract may produce an altogether different “envelope” funding pattern in Year 2 when the actual cash values are known.
“Carve-Out” Defined Benefit Plans
“Carve-out” retirement plans are fairly new to the pension industry. If you asked 10 small employers what their ultimate pension plan would look like, the employers would say they would like to put away as much money as possible for the owner/employees and as little away for the rank and file employees.
Several good things have come about in the pension industry with some of the recent law changes. New comparability (also known as super comparability) plans have come to be recognized as a viable way to help skew pension plan contributions in favor of the key employees. The rules changed to make defined benefit plans and 412(e)3 defined benefit plans a viable tool again (see the upcoming material for detailed information on 412(e)3 plans).
Carve out planning seems to be the next generation of planning to help small business owners create plans to skew the contribution amounts to key employees.
Explaining the technical details behind why Carve-Outs work is outside the scope of this material, but the following example for a hypothetical Dr. McIntire will illustrate to the readers how powerful Carve-Out planning can be. The CWPP™ course is all about giving advisors more knowledge than other advisors and knowledge that will benefit the high income/net worth client. Knowledge on Carve Out planning can help advisors accomplish these goals.
“Next Level” Retirement Plan for David C. McIntire, DMD
Step 1: Determine Your Goals and Budget
Meet David McIntire, a successful dental surgeon with a small but thriving practice. He had been using a SEP-IRA plan to meet his retirement needs because he was told it was the cheapest and best option. As many “baby boomers” nearing retirement are now learning, a SEP-IRA may fall far short of actual retirement income needs. Dr. McIntire’s goals are to receive the maximum retirement benefit allowed by law and to retire by age 62. However, he wants to make sure his employee benefit costs do not get out of control. He can commit up to $200,000 a year to his tax-deductible plan and is pleased to know that assets within his retirement plan are protected from the claims of creditors and potential litigants.
Step 2: Analyze Potential “Safe Harbor” Solutions
An initial study reveals that Dr. McIntire may certainly improve his retirement security by turning to a defined benefit plan. That’s because the tax-deductible contributions are not limited to $53,000 as with his current SEP-IRA. Interestingly, the cost of Dr. McIntire’s traditional defined benefit plan is more than triple his SEP-IRA contribution, while the attributable cost for his Generation X employees is actually lower. Although he and his wife, Rita, receive the majority of the benefits, he is troubled by the benefit cost attributed to his baby boomer employee: Linda Booker.
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Current Current
Plan
Traditional Defined
Employee Name Age Salary SEP-IRA Benefit Plan
McIntire, DMD(K) 50 $210,000 $42,000 $125,852 McIntire, R (K) 50 $40,000 $8,000 $27,634 Booker, L 55 $45,000 $9,000 $33,538 Clerk, A 30 $35,000 $7,000 $6,582 Clerk, B 25 $25,000 $5,000 $3,738
Nurse, N (Part Time) 45 $10,000 $0 $0
$71,000 $197,344
% to Key (K) 70% 78%
Projected Benefit for McIntire DMD (K) @62 $4,728 $14,167
Projected Accumulation for DMD (K) @62 688,195 $2,062,154
“Carve-Out” Planning
Although employees who do not have one year of service or who are younger than age 21 can be excluded, all other eligible employees need to be considered for non-discrimination testing. There are two tests that must be satisfied annually. The first is fairly simple: at least 40 percent of the otherwise eligible employees need to be covered in the defined benefit plan. The second rule is more complex: the ratio of rank-and-file employees benefiting in
each plan must be at least 70 percent of the ratio of the owners, their family members and other high-income employees. Note that we now included Nurse Nancy, his part-time surgical assistant, to satisfy this test in the profit-sharing plan. Thus, when there is more than one owner or family member in the business, a plan sponsor may choose to create non-discriminatory classes of employees to include or “carve-out” of the defined benefit plan.
What about the excluded employees? Because the “carve-out” group will often contain family members and other highly paid employees who are important to the business, it is recommended that they be included in a separate plan. It is important to make sure that absolutely no employee participates in both plans, since this may cause some employer contributions to be non-deductible.
Current Profit- ““Carve-Out”” Total
Employee Name Age Salary Sharing Defined Benefit
Plan Plans McIntire, DMD(K) 50 $210,000 $0 $125,852 $125,852 McIntire, R (K) 50 $40,000 $10,000 $0 $10,000 Booker, L 55 $45,000 $11,250 $0 $11,250 Clerk, A 30 $35,000 $6,582 $6,582 Clerk, B 25 $25,000 $3,738 $3,738
Nurse, N (Part Time) 45 $10,000 $2,500 $0 $2,500
$23,750 $136,172 $ 159,922
% to Key (K) 85%
Projected Benefit for McIntire DMD (K) @62 $14,167
Projected Accumulation for DMD (K) @62 $2,062,154
Step 3: Consider Advanced Design Services as Necessary
Dr. McIntire likes the defined benefit plan idea but is concerned with the added expense and potential confusion of operating two plans for two different groups of employees. He would like to pursue a “Next Level” alternative that can accomplish a similar objective using one plan, if possible.
After consulting with a CWPP™, who is supported by a quality pension plan administrator, to see if he is a good candidate, Dr. McIntire retains the plan administrator to prepare a “Next Level” defined benefit plan alternative. By using a “New Comparability” approach that places the employees and spouse in one class and the doctor in another, he can tailor the plan to meet his objectives. Like the “Carve-Out” plan option, this design works best when there are other family members or highly compensated employees that can be included in the more modest benefit group.
Current Current
Plan Traditional
““New Comparability””
Employee Name Age Salary SEP-IRA Defined Benefit
Plan Defined Benefit Plan McIntire, DMD(K) 50 $210,000 $42,000 $125,852 $125,852 McIntire, R (K) 50 $40,000 $8,000 $27,634 $8,275 Booker, L 55 $45,000 $9,000 $33,538 $10,042 Clerk, A 30 $35,000 $7,000 $6,582 $3,942 Clerk, B 25 $25,000 $5,000 $3,738 $2,238 Nurse, N (Part Time) 45 $10,000 $0 $0 $0 $71,000 $197,344 $ 150,349 % to Key (K) 70% 78% 89%
Projected Benefit for McIntire DMD (K) @62 $14,167 $14,167
________________________________________________________________________ A “New Comparability Plan” allows clients to craft a plan specifically to meet their retirement goals and business needs. By creating non-discriminatory classes of employees and placing them in various groups, clients can accomplish their objectives, while still providing meaningful benefits to everyone eligible. Dr. McIntire’s plan formula could look like this:
1. Dentists Who are Owners: 6.71 percent of final average salary times years of future service (maximum 24).
2. All Other Employees: 2.00 percent of final average salary times years of future service (maximum 24). The minimum monthly accrued benefit for any employee earning less than $37,500 in a year will be $111.00 for that year.
Complex testing must be made each year to ensure that your plan is nondiscriminatory. For this reason, the client must supply employee census and other plan data to the actuarial firm immediately after the end of each plan year. This will allow more time to calculate and discuss alternatives if your plan does not pass testing due to a change in employee census. The added administrative time and expense of this oversight and testing should be outweighed by the reduced employee benefit cost if this “Next Level” option is appropriate for you.
Combine a Cash Balance and a Profit Sharing 401k Plan
to form a Super 401(k) Plan™
Many owners and partners are looking for larger tax deductions and accelerated retirement savings. Cash Balance plans may be the perfect solution for them. The PPA 2006 legislation is encouraging more and more professionals and successful business owners to adopt this type of plan.
A Cash Balance Benefit Plan (CBP) is a type of defined benefit retirement plan that "qualifies" for tax deferral and creditor protection under ERISA.
In a Cash Balance plan each participant has an account that resembles those in a 401(k) or profit sharing plan. To many a CBP participant account reminds them of a pass book savings account.
Participant accounts grow annually in two ways:
The company contribution – a percentage of pay or a flat dollar amount – is determined by a formula specified in the plan document, and;
An annual interest credit. The rate of return is guaranteed and is independent of the plan's investment performance. That rate changes each year but usually is equal to the yield on 30-year Treasury bonds, which has hovered around 5 percent in recent years.
The CBP often has considerably more design flexibility than a traditional or 412(e)(3) DB plan. However, either a traditional or a 412(e)(3) DB plan can also be combined with a profit sharing 401(k) plan. The combined plan design contribution depending on age will increase overall deductible contributions to 2X to 5X the otherwise DC annual addition limit. The following case study and example illustrate the dynamic planning capabilities of a Super 401k Plan™.
CASE STUDY – A RADIOLOGIST GROUP PRACTICE--The Pension
Protection Act of 2006 allowed this medical group to redesign their existing retirement plans to allow for materially larger contributions. The doctors are now enjoying contributions totaling $6,006,250 with a cost for all other participants of only $187,500. The percent to Doctors is a “whopping” 97.00%.
Comparatively a conventional stand alone profit sharing 401k plan would limit the doctors to a contribution of $1,644,000 collectively and increased the cost of other participants from a minimum of $125,000 (5%) to $187,500. The maximum employee contribution is an increase of $62,500 (subject to vesting and tax deductible) to attain an increase of $4,426,750 for the doctors.
Illustration of Retirement Plan Options for 2015
Age Compensation (IRS limit) 401(k) Plan Profit Sharing Plan Cash Balance Plan Total Max Contribution 9 Doctors (60) $265,000 $24,000 $35,000 $0 to $242,000 $301,000 12 Doctors (40-49) $245,000 $18,000 $35,000 $0 to$150,000 $203,000 5 Doctors (30-39) $230,000 $18,000 $35,000 $0 to $89,750 $142,750 4 Doctors (30-60) $220,000 $18,000 $35,000 $0 $53,000 Subtotal $7,355,000 $6,070,750
53 Employees 7.5% of pay $0 each
$2,500,000 their
discretion $187,500 $0 $187,500
Total $9,765,000 $6,258,250
Percent to Doctors 97.00%
An example is the best way to illustrate the power of a Super 401(k) Plan™.
