By Frank Fantozzi
Many business owners received an unexpected surprise this tax season when their company's retirement plan administrator informed them they had to refund a portion of 401(k) deferrals because the company retirement plan failed their annual ADP/ACP Test (Actual Deferral Percentage/Actual Contribution Percentage).
These rules are in place to ensure all participants are benefiting equitably and that the plan does not favor highly compensated employees (HCES) to the detriment of non-highly compensated employees (NHCES). As a result, business owners who are in the HCES group are prevented from maximizing their personal deferrals of $17,000 (or $22,500 for those who are 50 or older). The general rule of thumb is that highly compensated employees can defer, on average, only 2% more than the non-highly compensated employees' deferrals.
How much can this hurt you as a business owner? The following is a common scenario many business owners face: The owner of a thriving manufacturing practice deferred the maximum allowable $22,500 (over age 50) into his 401(k) plan only to find that about $17,000 would be refunded to him, requiring him to include that amount back into income. Subject to a federal income tax bracket of 28%, the businesses owner incurred an about $5,000 increase in his tax bill. Situations like this can be very frustrating for business owners who take pride in providing quality benefits to their employees yet feel penalized because employees do not take full advantage of the benefits offered. Some have talked of terminating their retirement plans because of the cost of maintaining the plans. The good news is, there are many plan design options and alternatives available to business owners to help them overcome these challenges without having to terminate important benefits that help attract and retain key talent.
First, it is important to understand why this is happening with increased frequency. Certain behaviors have remained in place since the start of the great recession, including:
1. Little to no wage growth since the Great Recession. Many employees wait for a wage increase before increasing retirement plan deferral rates.
2. A focus on paying down debt. While paying down debt can help improve cash flow, most workers are not redirecting this money into their retirement plan accounts.
3. Making sacrifices during the recession. After several years of more conservative saving and spending behaviors, many consumers are beginning to direct money toward delayed expenditures like home improvements or purchasing a new car.
4. Increasing college costs without a commensurate increase in grant and scholarship aid. While there is a willingness by colleges to provide loans, people have become wisely debt adverse so families and graduating students do not become buried with high debt repayments in a soft job market.
What can business owners do? Business owners need to spend time reviewing their plan design periodically. Changes in employee demographics and savings rates can catch them by surprise, impacting their ability to maximize their deferral. Options to consider for improving deferral amounts include:
1. Educating employees on the importance of saving for retirement to improve the average non-highly compensated employee deferral rate.
2. Changing the employer match to a safe harbor program (discretionary match, non-elective match or automatic enrollment). Any of these safe harbor programs allow highly compensated employees to maximize their deferrals.
For business owners looking to maximize their salary deferrals and contribute additional dollars in their profit sharing plans, modifications to their profit-sharing plan design can yield dramatic results. For example, age-weighted, new comparability plan designs or a combination of other methods, while required to satisfy IRS non-discrimination testing, do allow business owners to target dollars to employee groups that obviously include themselves. As a general guideline, if the plan design can target 70% or more of the plan assets during the plan year to the highly compensated group, it makes sense.
Given the tax deduction and the fact that profit sharing contributions are not subject to FICA or FUTA taxes, the corresponding income tax savings will cover the benefits provided to the non-highly compensated group. This is a great win-win since non-highly compensated employees are receiving retirement contributions they would not normally receive, and the highly compensated employees, who include the owners, are able to drive a high level of contributions into their accounts. A maximum combination of salary deferral and profit sharing contribution of $50,000 for those over age 50 can be achieved.
What is the downside? These plans are more costly to administer but the income tax savings should justify this cost as part of the decision making process. In addition, the company is not required to make contributions every year if the cash is not available so flexibility exists.
Lastly, for those cash rich companies where the business owners are really focused on diversifying away from their business and desire to drive even greater dollars into their retirement accounts, cash balance plans can be integrated with the company's salary deferral/profit sharing plan. A cash balance plan is a type of defined-benefit plan that can target a monthly benefit for employees. Under the same premise as the age-weighted and new comparability plans, benefits can be targeted, allowing the highly compensated group to receive a high retirement benefit.
What is the downside to cash balance plans? As with age-weighted and new comparability plans, they are more costly to administer but the tax benefits normally make them worthwhile. However, they are less flexible in that contributions are not discretionary. Once these plans are started they typically have to be funded each year so there is a level of commitment that has to be thought through beforehand.
The best advice is to be proactive and begin to make the following year's planning decisions in the fall of the previous year, similar to the way you plan ahead for your personal income tax needs. Pro forma benefit projections can be developed from an employee census that illustrates the flow of dollars so an informed decision can be made. Some of the decisions, like the safe harbor elections, have to be made and announced by December 1 for calendar year plans. As part of our normal business owner year-end planning meetings, we make sure business owners are aware of the options and opportunities available to them in the following year where their retirement plans are concerned.
Frank Fantozzi, president and CEO of Planned Financial Services, began his career in 1987 with Arthur Anderson, an international accounting firm where he became a Certified Public Accountant (CPA) in 1988. His tax and financial planning skills were honed during his years in the organization's wealth management department. Fantozzi earned the AICPA's Personal Financial Specialist (PFS) designation and a Master's in Taxation degree (MT) from The University of Illinois. He also holds a CDFA (Certified Divorce Financial Analyst) from the IDFA (Institute for Divorce Financial Analysts) and the AIF (Accredited Fiduciary) from FI 360, an institution dedicated to prudent fiduciary practices. He is a registered representative (Series 7) with LPL Financial and a branch manager for an Office of Supervisory Jurisdiction. He also holds his license in life and health Insurance.