Turbo Charged 401k Plans
Posted November 23, 2018
Oftentimes business owners want to put away a ton of money in a small business 401k plan, but cannot due to inherit limitations within the plan. Or business owners want to keep most of the plan money for themselves, which is shocking yet natural. For example, to have the business make a 10% profit sharing contribution, every eligible employee will also receive a 10% contribution which is usually undesirable. You only thought having a staff was a pain because of drama and turnover. Add this dilemma to the list.
You work hard to make money, and you shouldn’t have to work too hard to keep most of it. There are turbocharger kits you can add to your normally aspirated 401k plan. These usually work best with an underlying safe harbor 401k plan. Here we go-
- Age-Weighted / New Comparability Profit Sharing Plan, and
- Defined Benefits Pension / Cash Balance Plan
A profit sharing plan based on age allows older employees to receive more of the profits than younger employees (hence the tricky name of age-weighted). Another way to look at this is to consider those closer to retirement possibly needing the most assistance in saving for retirement. This also makes sense since older employees are usually more valuable, and therefore profit sharing plans can be used to discriminate in their favor.
Age-weighted profit sharing plans are designed to be top heavy, and two people earning the same salary can have very different profit sharing contributions simply based on age which is perfectly acceptable. No, there is a not a weight-weighted formula where older employees are usually heavier and therefore get more of the profit sharing. That would be fun though. Brings a whole new meaning to a top heavy plan. There are probably some more jokes in there, yet we digress.
How the formula works is beyond this book, but an age-weighted profit sharing plan allows a business to contribute more to those employees who are older including owners.
The new comparability profit sharing formulas take age-weighted formulas one step further by grouping certain employees together such as officers, executives, clerical, etc. Officers are given a higher portion of the profit sharing, and within the officer group the older employees are given a higher portion. A double shot. For example, a crusty officer will have a much larger contribution than a new administrative assistant.
The new comparability method is also referred to as cross-tested, and will normally have underlying actuary consultants defending the plan’s provisions and discrimination. Remember, discrimination is not bad as long as it can be justified and supported. Yes, this adds to the cost. But let’s look at a real life example that WCG worked on to see how this works first.
The following is a husband and wife business with over $600,000 in net profits from 2016. Yeah, it is a bit old but the illustration remains meaningful.
Tilt. Analysis on the next page.
Here are some observations and clarifications-
- NEC refers to non-elective contributions, and in this example these are the contributions required under the safe harbor 401k plan provisions.
- Profit sharing is based on salary and age. Note the subtle differences for everyone except Mike and Susie.
- $53,000 was the maximum allowed under a 401k plan with tiered profit sharing for 2016.
- In this real case, the owners kept 75% of all monies put into the plan. Not shabby.
- The annual cost in 2016 to administer this plan was $2,500.
- The tax deferral savings was over $53,000 for these business owners including state income taxes too (based on 39.6% Federal rate and 11% state rate). This was California, and the couple plan to retire in Nevada- instant 11% tax savings.
- Yes, those salaries for Mike and Susie are ridiculously high. So the increase in payroll taxes must be weighed against the savings and benefits. After $137,700 (for the 2020 tax year) only Medicare taxes are being “unnecessarily” paid at 2.9%. The benefits could outweigh this 2.9%.
Defined Benefits Pension / Cash Balance Plan
If the age-weighted or new comparability profit sharing plans supercharge a 401k plan, the defined benefits pension and cash balance plan turbocharges it. We can hear gear heads moaning all over the country above turbo and super charging your engine. Regardless, the defined benefits pension and cash balance plan adds a ton of meat to your 401k platter. Here we go.
A defined benefit is in contrast to a 401k plan since a 401k plan is a defined contribution. A defined contribution plan specifies the amount going into the plan and has nothing to do with how much will be available when you start taking withdrawals. It could be $0 or millions. A defined benefit is a calculus where some future benefit is defined, and is usually a stream of payments similar to an annuity.
A cash balance plan is a form of a defined benefits pension, with one major difference. The participant can see his or her account balance grow over time similarly to an IRA or 401k plan. A cash balance plan can be considered a hybrid since it does not rely on formulas and salary histories although it falls under a defined benefits umbrella by definition.
This is important. Since it is a defined benefit, the business has an obligation to fund the plan. Unlike a defined contribution, defined benefit is a 3 to 4 year commitment and a business cannot adjust contributions into the plan based on performance or cash flow needs. There are provisions allowing a business to pause the plan, but that gets tricky really fast. We have heard of cases where the IRS has seized a business owner’s house and assets until the pension was correctly funded. Ouch.
A cash balance plan is usually piggybacked onto a safe harbor 401k plan, and it truly is a separate plan (the latter is a defined contribution and the former is a defined benefit). So why would a small business want a cash balance plan in addition to a 401k plan? The usual reason- put more money into a self-employed retirement plan for the owners’ personal retirement and defer taxes.
Similar to age-weighted and new comparability profit sharing plans, cash balance plans use a person’s age to determine the amount that can be contributed and use actuary consultation to defend the plan’s discrimination.
Here is a quick list of the 2020 amounts that can be contributed into a cash balance plan based on age-
|Age||401k Plan||401k Plan w/|
Before you lose your mind on the tax savings (which is assumed to be at 45% total between Federal and state), you need the cash to do so. To save $101,475 at age 50 you need to part ways with $225,500 in cash. And if your spouse is on the payroll, you can double it. We only showed ages in chunks of 5. Here is a link to Kravitz who provides a full table-
Here is another real life example that we consulted on in 2016-
It is a lot to absorb, and we could have cut off the example after Pebbles but we wanted to give you a real case. More notes and clarifications-
- Betty and Fred are the owners, and were able to keep 92.5% of the money contributed to the 401k and cash balance plans. That is ridiculously good!
- Profit sharing can be on a gradual vesting schedule over 6 years (same holds true for standalone profit sharing plans without the cash balance piggyback).
- Cash balance contributions can have a cliff vesting over 3 years (remember the 3 to 4 year commitment previously mentioned).
- Total tax savings was 51% since this case was also in California, or about $92,000 combined for just the owners’ portion.
- The annual cost to administer this in 2016 was $1,750 for the 401k plan portion and $4,300 for the cash balance plan. Cash balance plans are pricey since actuary consultants are used to defend the plan’s discrimination. Worth every penny.
Ok, so we’ve covered the basics of how to turbocharge your 401k plan to allow for more contributions and tax savings. What are some of the downsides?
The plan costs are not low. Sure, the tax savings is much higher than the costs, but those tax savings are actually tax deferrals. And in most cases tax deferrals become tax savings, but you must be disciplined on using those savings to grow your business or invest wisely (which might be the same thing).
Asset management fees range from 1.5% to 3% for Vanguard, American Funds, Nationwide, etc. 401k plans and defined benefits pension plans have two cost elements- the direct plan cost including a per participant charge, plus the asset management fees. Granted asset management fees are everywhere you turn- but small 401k plans usually have the highest. Having said that, small 401k plans are also nimble and completely customizable so your investment options are vast.
The commitment on a defined benefits pension and cash balance can be huge. And there are some devils in details such as minimum interest rate credits and other things that can be challenging. This is not your problem- the people you retain to manage your defined benefits pension and cash balance plan take on this responsibility.
If a handful of employees are older than the owners, this will adversely affect how much the owners can contribute into the plan for themselves. As mentioned, profit sharing and cash balance plans are age-based. Ideally the owners are 8-10 years older than the rank and file for this to work well.
Total holdings in the defined benefits pension plan are limited to $2.3 million to $2.4 million, enough to cover the maximum allowed payment in retirement of $200,000 a year. The IRS also has strict required minimum contribution rules and a steady source of income is fairly important. Therefore, you cannot be a contingency based attorney with a huge stockpile of cash today without being able to demonstrate the ability to support the plan next year and the following years.
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