Adding Layers

Insulating Clients from Increased Tax Liability and Underfunded Retirement

When used in the same sentence, the words “change” and “tax code” are seldom associated with good news. Yet, every so often, changes in the tax code create opportunities for innovative design that take retirement plans to a whole new level. The Pension Protection Act (PPA) and subsequent regulations brought about new opportunities to effectively combine cash balance defined benefit plans and defined contribution plans, building a compelling solution to help insulate clients from the risk of an underfunded retirement and increased tax burdens.

Background Retirement plans fall into two basic categories: defined benefit and defined contribution. Defined benefit plans contain a promise of specific benefits upon retirement; cash balance plans promise a lump sum payment, which is a product of annual contribution credits and interest credits allocated to a participant’s hypothetical account (read more on cash balance plans here). Employers are responsible for funding defined benefit plans adequately, so the earned benefits can be paid to retirees. Defined contribution plans, on the other hand, do not offer any guarantees. They are generally funded with employee salary deferrals and employer contributions, and provide a lump sum payout made up from contributions and earnings.

For a company offering a cash balance defined benefit plan and a defined contribution plan, prior to the passing of the PPA, 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. A paired plan would not increase the employer’s deduction.

The PPA changed the rules to allow employers to deduct contributions to a defined contribution plan in addition to the required defined-benefit contribution, even if the resulting total exceeds 25% of participants’ eligible compensation (subject to certain limits). Subsequent regulations expanded and clarified how these plans may be designed and operated, further increasing their appeal for closely held businesses.

Who’s an Ideal Combination Plan Prospect? Ideal candidates for a combination plan are business owners who seek to save substantially more than a defined contribution plan, such as a 401(k) or profit-sharing plan, would allow on its own. Given the added cost and complexity of these arrangements, typically a $70,000 per year contribution goal is when it makes sense to explore this plan option. The business sponsoring a plan should be consistently profitable. The business owner should plan to work at least three years before retiring, and, ideally, there should be a substantive difference in the owner’s age and income compared to the non-owner employees.

Building the Layers: Start with a 401(k) A 401(k) plan allows eligible employees to save a portion of their current compensation for retirement and receive immediate tax benefit, while allowing the money to grow and compound on a tax-deferred basis. A Roth 401(k) alternative trades the current deferral of taxation for tax-free growth and distribution in retirement.

For plans that cover non-owner employees, the employer will typically make a special safe harbor contribution to eligible participants. In doing so, the employer guarantees that deferrals of the highly compensated employees do not violate 401(k) non-discrimination tests (no need to return those contributions to key staff), helps fulfill the plan’s top heavy requirements (most small business plans are top heavy), and—in some cases—can count this contribution as a part of the profit-sharing contribution used to satisfy the non-discrimination testing. So, safe harbor contribution really plays a triple duty. Missed the safe harbor deadline? No worries, we can still make the plan work with the little-known 5% rule.

Add Profit Sharing The remaining deduction is typically allocated to participants by way of a profit-sharing plan. Typically, new comparability design is used in this case. This approach allows allocation of the bulk of the profit-sharing dollars to key contributors without violating non-discrimination requirements outlined by the IRS.

Top It Off with a Cash Balance Plan The final layer of a combination plan is a cash balance plan. Contributions to these plans require a complex calculation that encompasses age, compensation, the length of time until retirement, the promised benefit, the assumed growth of plan assets and a variety of 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 benefit under the plan. The end result is a robust plan that helps achieve tax reduction and retirement savings objectives. Here is a snapshot of contribution opportunities in a multilayered retirement plan.*


Age On 12/31/16 Retirement Age Plan Compensation* 401(k) Deferral Profit Sharing Cash Balance Total Est. Tax Savings
35 62 265,000 18,000 15,900 66,000 99,900      39,560
40 62 265,000 18,000 15,900 85,000 118,900      47,084
45 62 265,000 18,000 15,900 132,000 165,900      65,696
50 62 265,000 24,000 15,900 168,000 207,900      82,328
55 62 265,000 24,000 15,900 197,000 236,900      93,812
60 65 265,000 24,000 15,900 200,000 239,900      95,000
65 70 265,000 24,000 15,900 255,000 294,900    116,780
70 75 265,000 24,000 15,900 328,000 367,900    145,688

Setup and Funding Deadlines Generally, for a plan to be effective in the current year (or for another layer to be added), the plan document needs to be signed or amended by the last day of the employer’s tax year. For most small businesses, their tax year coincides with the calendar year, making December 31 the deadline for current year plan implementation. Employer contributions, however, are not due until the following year. As long as they are deposited before the employer’s tax filing deadline, including extensions, they are deductible for the preceding tax year.

*Assumes that the top dollar is taxed at the 39.6% marginal rate. Plan compensation for sole proprietors is defined as net Schedule C income less the contribution amount and 1/2 of the self-employment tax. The numbers illustrated assume the participant can establish a high three-year salary to support the benefit, will fund the plan to their retirement age, and meets certain other criteria. This chart is intended to be used for informational purposes only and may not reflect the contributions actually available for a particular client. Assumed form of distribution is a lump sum at normal retirement age. The costs represent the target Normal Cost as generated using PPA funding methods. Individual results may vary.