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Employee Benefits
Layering Retirement Plans
By Scott Ziska
Senior Financial Planner, RollingBrook Financial Advisors/Sagemark Consulting
For small-business owners looking for retirement plan solutions for themselves and their employees, off-the-shelf 401(k) plans are an easy fallback position, providing a quick solution to a complicated problem. But these standardized plans can take business owners only so far, often leading them to a dead end in terms of how much money they can save for their own retirements.
Something to consider for some small-business owners is a customized retirement strategy that layers two or more tax-deferral options, helping to increase the amount that an owner can tuck away in their own retirement plans.
The only limitation is how much you want to save, and how much you are willing to spend to accumulate those tax-deferred assets within IRS guidelines. The first step is deciding how much you want to put away every year. Then you have to decide how much you want to do for your employees. For instance, if the goal is to provide employee benefits, that’s one plan. But if the underlying goal is to put away $100,000 a year for yourself, that’s completely different.
Plans for Owners
If your goal is to put away $20,000 or less, most small-business owners are better off using a SEP-IRA or even a safe harbor 401(k) plan. These less expensive options sidestep some of the standard 401(k) plan restrictions.
A safe harbor 401(k) may offer some key advantages over traditional 401(k) plans. The first is that by making preset contributions for each employee—currently set at 3% of each employee’s salary—business owners can take the maximum allowable contribution to their own plans without having to go through discrimination testing. Discrimination testing typically limits how much highly paid employees can contribute by how much the rank-and-file are saving. As a benefit for employees, they get the 3% employer contribution without having to put up any of their own money.
Employers who want to save closer to $40,000 could consider a cross-tested profit-sharing plan. If you want to increase the benefit, you can layer on an additional defined contribution plan, effectively setting up an employee pension plan.
A cross-tested profit-sharing plan lets owners favor themselves and key employees by basing profit-sharing contributions on specific demographics of the workforce. For instance, contributions can be made based on age or length of time with the company, allowing owners to put significantly more away for themselves than for employees.
A Layered Approach
To see how a layered approach works, let’s look at the case of a doctor who had four employees. In 2005, the doctor was earning around $300,000 and wanted to put away as much as possible for his own retirement. The financial planner started by suggesting a safe harbor 401(k). By contributing 3% for each employee, the doctor was able to save the maximum $14,000 in his own account. And because he is also an employee, he could give himself a 3% employer matching on the first $210,000 of his income—the maximum allowed by law at that time—which came to $6,300.
The financial planner then increased that savings rate by adding a cross-tested profit-sharing plan. By putting 3% in for his employees, the client was able to set aside 10.7% of the same $210,000 in income for himself, adding another $21,700 to his tax-deferred savings.
But he was still short of the $100,000 that he wanted to put away, so to make that last jump, the financial planner stacked a cash balance defined benefit plan on top of the other two plans. Contributions to pension plans are based on actuarial tables, but because the doctor was in his 50s and the employees were all in their 30s, the cost of funding the employees’ pensions was very low. By contributing just 1.5% to the employees’ defined benefit plans, the doctor was able to put in 31% of his income, or $63,500.
Of course, all of this planning only works if the out-of-pocket expense for funding employee retirements is offset by the employer’s tax savings. In this example, the doctor was able to put away $104,550 for himself by contributing $17,847 to his employees. These plans generated a corporate tax savings of $38,289, for a net savings of more than $20,000.
The case described in this article may not be representative of the experiences of all clients. Situations discussed or implied are dependant on the specific facts and circumstances involved in the particular case and are not indicative of future performance or potential course of action.
Before anything is implemented, be sure to sit down with your financial planner and your tax advisor to ensure that any plan will be cost effective in the long run.
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