As a plan sponsor you know the tax savings of sponsoring a 401(k) plan. What you may not know is there are considerable tax savings that are often left on the table. Our view is that a 401(k) plan should be an investment in your business, and established as a tax favored compensation planning tool, not an entitlement program. In this section we will help you discover and unlock tax savings in your 401(k) plan through effective plan design.
Real-World Benefits of Plan Design
The scenarios above illustrate the importance of plan design.
The Blue Scenario assumes a $25,000 annual contribution, a market return of 8.0% and investment and plan expenses of 1.75%. After 20 years the accumulated balance is $944,741.
The Red Scenario is the same as blue except investment and plan expenses is reduced to 0.75%. With the same contribution and market return over 20 years the accumulated balance is $1,053,304; a modest increase just by reducing expenses.
The Green Scenario assumes a market return of 8.0%, investment and plan expenses of 0.75% but an annual contribution of $35,000. The increase is attributable to a restructuring of the plan allowing the business owner to increase their contribution. At the end of 20 years the accumulated balance is $1,474,625. That’s an increase of $529,884 over the blue scenario, not even taking into consideration the tax savings!
What is Plan Design?
Ask most retirement plan advisors to define plan design, and after a certain amount of throat clearing, they would probably start talking about things such as entry dates, Roth provisions, matching contributions, investment options, etc. They may even throw out terms like “fiduciary compliance,” “disclosure regulations,” and if you are really unlucky, even a few code words like “408(b)(2)” and “404(a)(5).” But while all of these things might be relevant features of retirement plans, none of them get to the heart of what plan design really is.
In a nutshell, plan design comes down to two key points:
- Who is included?
- How much do they get?
3 Steps to Greater Tax Savings
It has been our observation that when it comes to planning for retirement employees fall into one of two categories:
(missing “Two Groups” graphic)
Those who don’t save reduce the benefit the business owner derives from the plan. Regardless of the level of matching contribution or other benefits offered under the plan, you will typically not change the behavior of the employees who have not already taken advantage of the 401(k) plan, so why let them be a drag on contributions and tax savings for everyone else?
Step 1: Divide and Conquer
The first step to conquering the plan design challenge is to identify which employees are serious about planning for retirement. This is the group that will help us leverage contributions to the business owner. Simply take a look at who is considered to be a participant in the 401(k) plan. An employee is considered a participant if they have satisfied the eligibility requirements, even if they are not making deferrals. Now divide the participants into the two groups described above; those who are actively planning for retirement (making elective deferrals), and those who are not. This information provides the starting point of building an effective plan that will maximize the benefits to the business owner and key employees.
Note: It is not our objective to “take away” benefits, but rather focus resources on those who take planning for retirement seriously.
Step 2: Who is included?
Now that you have identified the two groups it’s easy to determine where your resources should be targeted; specifically to the group who proactively plans for retirement. Internal Revenue Code Section 410(b) states that only 70% of the eligible workforce has to be included in the plan. It goes on to state the method of division has to be “a reasonable business classification.” This “coverage” test is the most overlooked provision in the tax code and the primary one we attempt to exploit for the benefit of our clients.
With our two groups identified in Step 1, our next task is to determine who will make up the 70%. Since the IRS says this must be a “reasonable business classification” we may need to use job descriptions, length of service, or some other creative description to target the employees who will be included in the plan, bearing in mind the initial focus will be on those who are currently contributing to the 401(k).
Step 3: How much do they get?
Owners should know that everyone does not have to get the same contribution! Typically 401(k) plans are very plain vanilla. If you defer x then you will get a matching contribution of y. This has been the primary approach to plan design for the past 30 years and is very outdated. Are all of your employees paid the same hourly rate or salary? Probably not, so then why should everyone get the same employer contribution? Your 401(k) plan can be an effective compensation planning tool.
In 2009 the IRS issued a new Revenue Ruling which in essence states that each individual employee can be allocated a different contribution if the appropriate language is included in the plan document. This one Ruling has opened up almost limitless plan design opportunities. For example, under our redesigned plan Sue gets a 5% of pay contribution, Joe gets 3% and Mark gets 1%. While the contributions vary by employee we have been able to leverage them into a 3 to 1 ratio for the business owner. In other words, the 3% to Joe could be leveraged into a 9% contribution for the business owner.
Tax Implications of Plan Design
In addition to the tax savings on increased contributions to the business owner and key employees, there are other potential tax savings such as payroll taxes that you can take advantage of. The tax savings can be significant if the plan is structured in a way that is a bona fide compensation planning arrangement. The provisions in the tax code should be utilized to benefit you, the business owner, and your key employees.
Isn’t it worth a small investment of your time to boost your retirement income by over 50%? We have been very successful in redesigning 401(k) plans for the optimal benefit of the business owner. Contact us for your complimentary review today.