Adding Layers: Building a Successful Tax and Retirement Accumulation

Changes in the tax code frequently create an exciting opportunity to take a company retirement plan to new levels by way of innovative design or to implement a brand new strategy to help clients achieve their retirement accumulation and tax savings goals. Pension Protection Act brought about a new opportunity in our ability to effectively combine Defined Benefit and Defined Contribution plans, just like layers of a cake, building a compelling solution to savings shortfall and increasing tax burden.


Retirement plans fall into two basic categories: defined benefit and defined contribution. Defined benefit (DB) plans promise specific benefits to employees upon retirement. Employers are responsible for funding defined benefit plans adequately, so the earned benefits can be paid to plan participants after separation of service or retirement. Defined contribution plans (DC), on the other hand, do not guarantee any specific benefit at retirement. They are generally funded with employee salary deferrals and employer contributions, and provide a lump sum payout that is made up from contributions and earned interest.

For a plan sponsor offering a defined benefit and a defined contribution plan, prior to the passing of the Pension Protection Act of 2006, the maximum deductible employer contribution to all plans for a fiscal year was the greater of the required defined benefit plan contribution or 25% of participants’ eligible compensation. As a result, many employers tended to have either a defined benefit plan or a defined contribution plan, but not both, since a paired plan would not increase the employer’s deduction.

New Opportunity Post-PPA

The PPA changed the rules to allow employers to deduct contributions to a DC plan in addition to the required DB contribution, even if the resulting total exceeds 25% of participants’ eligible compensation.

Profile of an Ideal Combination Plan Prospect

Ideal candidates for such an arrangement are business owners who seek to save substantially more than a defined contribution plan would allow on its own. The business sponsoring a plan should be consistently profitable. The business owner should plan to work at least 3-5 years before retiring, and there should be a substantial difference in the owner’s age and income compared to the employees. Ideally, these businesses should have less about 10-12 rank-and-file employees per highly compensated employee.

Building the layers: Start with a 401(k)

401(k) provision allows eligible employees (including the owner) to defer a portion of their current compensation until retirement and receive immediate tax benefit while allowing the money to grow and compound on a tax-deferred basis. For plans which cover non-owner employees the employer will typically make a special Safe Harbor contribution to eligible participants. In doing so, the employer guarantees deferrals of the highly compensated employees do not violate 401(k) tests, helps fulfill the plan’s top heavy requirements, and can count this contributions as a part of profit-sharing allocation used to satisfy the non-discrimination testing.

Building the Layers: Add Profit Sharing

The remaining deduction is typically allocated to eligible by way of a cross-tested profit-sharing plan. The cross-tested profit-sharing plan design allows allocation of the bulk of the profit-sharing dollars to key contributors without violating non-discrimination requirements.

Building the Layers: Top it off with a Defined Benefit plan

The final layer of a combination plan is the Defined Benefit plan or a Cash Balance Plan. Contributions to these plans require a complex calculation encompassing the benefit promised at retirement, the length of time until retirement, the assumed growth of plan assets, and other actuarial factors. The annual funding requirement is recalculated each year to account for the actual performance of plan assets and any changes to the plan’s liabilities. In general, the more one makes, and the less time they have before retirement, the greater is the contribution required to fund that individual’s defined benefit plan.

Contribution & Tax Savings Opportunity under a Layered Plan Strategy

Current Age Retirement Age Compensation 401(k) Profit Sharing Defined Benefit Total Estimated Tax Savings*
45 62 $250,000 $17,000 $15,000 $155,148 $187,148 $74,859
50 62 $250,000 $22,500 $15,000 $199,148 $236,648 $94,659
55 62 $250,000 $22,500 $15,000 $255,624 $293,124 $117,249
60 65 $250,000 $22,500 $15,000 $263,727 $301,227 $120,490

There is Still Time

It’s not too late to take advantage of qualified plan opportunities. Employer contributions are not due until the following year. As long as they are contributed before the employer’s tax filing deadline, including extensions, they are deductible for the preceding tax year.

As you discuss year-end tax planning with your clients, consider introducing these concepts to them. We are ready to help all the way. Give us a call today, (888) 926-0600 or send us an email to .