With all the good intentions of their competing legislation to fix 401(k) plans, neither the White House nor Congress fully understand the real problem facing employees about their retirement plans.
And, for all the commotion of the lost value from too much worthless stock held in the Enron and other large company plans, many small employers may still put off sponsoring any plan for their own employees.
This is unfortunate because the changes effective January 2002 under the Economic Growth and Tax Relief Reconciliation Act of 2001 give small businesses and their owners so much more flexibility and opportunity to fulfill their retirement needs, as well as those of their employees. And, the contributions made to these plans are mostly made in cash, not employer stock.
The challenge is to explain these important new advantages without being sidetracked by the medias “bad press” and the restrictive legislation that is being proposed to fix a problem that doesnt exist in the small plan situation. So, here it goes.
First, the new rules permit a profit-sharing plan to have a full employer tax deduction up to 25% of the pay of all participants. Second, the dollar contribution can be as high as $40,000 (up to 100% of salary). The old maximum of 25% no longer applies.
Another change is 401(k) plans that permit voluntary employee salary deferrals (defined as profit-sharing plans) will no longer count these deferral amounts against the employer deduction.
The 2002 maximum dollar 401(k) salary deferral is $11,000 and an extra $1,000 “catch-up” is available to any employee age 50 or older, with both of these amounts increasing by $1,000 each year through 2006.
By providing for a “safe harbor” 401(k) plan design, maximum deferrals can be achieved for an owner even if employees elect not to make any deferrals. However, the plan gets even better for all when the employer agrees to set aside a full “non-elective” 5% of pay whether they defer or not.
So, using the above summary of the 2002 EGTRRA changes, how can we design a retirement program that will be attractive to a small business owner and his family as well as rewarding employees– but at not too great a cost to the company?
As an example, I will use the census of employees in Exhibit 1. (See this page.)
We have two owners–Pat and Tracy. Pat is paid a salary of $80,000 and Tracy is paid $40,000.
There are 10 other eligible employees paid in amounts as shown in Exhibit 1 for a total employee payroll of $300,000. Under the old rules for a traditional profit-sharing plan, the employer would be restricted to a maximum deduction of 15% of total payroll–$63,000 (15% x $420,000). And each employee, including Pat and Tracy, would receive a uniform allocation of 15% of their respective salaries.
Pat would receive $12,000 and Tracy $6,000. All the other employees would share in the overall remaining contribution amount of $45,000. The owners percentage share results in less than 30% of the deduction.
This would hardly motivate them to adopt such a program. And they would probably elect to split the entire $63,000 as a taxable bonus just for themselves. However, this could cost them over $15,000 in combined taxes.
And, in fact, the companys overall profit for the year is closer to $100,000, so the taxes on their bonuses would really be closer to $30,000.
Their accountant might recommend that they consider a SIMPLE IRA plan instead.
A SIMPLE plan would permit both Pat and Tracy to defer $7,500 of their bonus, but they would have to agree to match 3% of any deferrals the employees chose to make under the SIMPLE plan.
That could “cost” them a match of up to $9,000 if all employees chose to make 3% salary deferrals. They would, likewise, also get a 3% employer match, giving Pat a total contribution of $9,900 and Tracy a total contribution of $8,700. Here their percentage share improves to 67% of the total employer outlay.
Now, along comes an astute retirement planner, who suggests an innovative solution.
Noting the comparative age spread between the owners and the employees, a “new comparability” plan is designed. But because of the changes effective for 2002, this would also be combined with a 401(k) salary deferral feature.
In order to avoid any discrimination in favor of the owners, the retirement planner explains that a “safe harbor” 3% employer contribution must be made for the employees. Also, in order to “pass” the new comparability discrimination test, another 2% must be contributed–a total 5% of employees’ payroll, $15,000–which is $6,000 more than the SIMPLE IRA plan.
As shown in Exhibit 2, the contribution amounts now available for Pat and Tracy total a hefty $81,000–84% of the $96,000 aggregate total contribution.
Is this legal? The answer is a resounding YES!
All the new rules have been utilized in this case study. The old restriction of 25% of an individuals pay as a maximum contribution is no longer a barrier.
The 401(k) deferral amount for Tracy does not count as an employer contribution, so Tracy may defer up to $12,000 under 401(k). This is restricted to an overall 100% of salary ($40,000) for defined contribution plan limits. The “catch-up” for age 50 and over is an extra $1,000 deferral amount above the dollar limit for Pat and it increases over each of the next five years.
I believe this shows the incredible new flexibility under EGTRRA to enhance retirement accumulations for small business owners.
Thomas B. Higgins, CLU is president of Creative Pension Concepts, Inc., Barre, Vt. Contact him via e-mail at CPCPension@aol.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, March 4, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.