The past several years have seen changes to those sections of the tax code that govern qualified retirement plans, the largest and most significant of which concern 401(k) plans. The forces behind this liberalization, when properly understood, will not only help maximize the benefit that clients derive from these changes, but also put you on the cutting edge of the next round of legislative enhancements.
Underpinning the changes are a decrease in the savings rate and a weakening of the confidence in governmental programs, notably Social Security. Add in support for the small business owner and you have a recipe for liberalized pension limits. The net effect has been a boom in retirement planning, both in terms of plans started and overhauls of existing plans.
Three primary changes to 401(k) regulations have fueled this growth, including:
o The increase in maximum deferrals ($14,000 for 2005 and $15,000 for 2006);
o The creation of catch-up provisions ($4,000 for 2005 and $5,000 for 2006); and
o The ability to defer up to 100% of pay (subject to the previous limits) into a plan.
Each of these changes, when paired with secondary changes, has created an opportunity for well-advised clients and sophisticated advisors to maximize their savings rate and build flexibility into their long-range planning.
A) Profit-Sharing Plan changes
Coupled with the first change–the dramatic increase in deferral limits (the maximum was $10,000 just a few years ago) –has been a liberalization of profit-sharing plans, in general. Truth be known, 401(k) plans are actually a subset of profit-sharing plans.
Formerly, the limit in these plans was 15% of pay (as opposed to the defined contribution limit of 25% of pay). This forced the plan sponsor who wanted to cap out at 25% of pay to offer either only a money purchase plan, or pair a 15% profit-sharing plan with a 10% money purchase plan.
Once profit-sharing plan limits were increased to the lesser of 25% or $42,000 (2005 limit under Section 415), more “room” became available under these plans. With the 401(k) deferral limit at $14,000, $28,000 was left for an employer-funded profit-sharing deposit.
Overall, this represents a lower percentage of pay (also capped at $210,000 for 2005) than just a straight profit-sharing plan. (Here is the math: $42,000 is 20% of $210,000 and $28,000 is 13% of $210,000.) The net effect is that a profit-sharing/401(k) combination can save the business owner who wants to make a maximum deposit roughly 7% of pay.
B) Better allocation formula methods–SafeHarbor Plans
The second primary change, the addition of a catch-up provision for employees over age 50 as of Dec. 31 of the prior year, added a new element to the 401(k) plan. As a result, people of a certain age had a different set of rules applied to them. In addition, the catch-up provision is not based upon either tenure with the firm, status as a highly compensated employee (it is open to anybody) or testing (these amounts are not factored into the average deferral percentage and discrimination testing).