So your business is humming along and you’d like to maximize retirement benefits and 401(k) savings for your top performers. And, if your company can boost business deductions along the way, you’ve got a win/win on your hands.
But how should contributions to retirement accounts be allocated? There are quite a few ways to shine a penny. The minimum is to allow employees to contribute to their own 401(k) accounts. Or, you can arrange for employees and the company to contribute. You can even have the company alone contribute to a profit sharing plan – even though the contributions really have nothing to do with profits. Or you can run a combination plan – a 401(k) where employee contributions along with company profit sharing contributions are allowed. We often refer to this as a 401(k) plan with a profit sharing feature.
These are just some of the options to defer taxes and shelter greater sums of retirement savings. You could also create a cash balance plan – a hybrid approach with defined contribution and defined benefit characteristics – which allows for far higher contribution limits, larger company tax deductions, and a chance to divert more assets into tax deferred investments.
401(k) Contribution Limits
To make sense of how to approach your defined contribution options it may be helpful to start with the contribution limits for these plans. A contribution limit is the most the IRS allows an employee or an employer to place into a qualified account. Why a limit? Because every dollar an employee contributes to the company 401(k) is a dollar of wages that may go untaxed – at least for now (unless the employee is making Roth contributions). Withdrawals in retirement are taxed at personal income tax rates (except for the withdrawal of Roth contributions). So when it comes to defined contribution plans, tax policy encourages retirement savings by allowing a portion of wages to go untaxed on the front end, as well as allowing investment returns to compound untaxed. But tax policy is also designed to generate revenues for the federal government, hence there are limits to employer and employee deductions.
So what are the limits? Let’s start with $55,000. That’s the most that an employee can contribute and receive in their defined contribution plan each year. ($61,000 for employees 50 and older.) That is, that’s the most the employee and the employer together can contribute to an individual’s 401(k) account. At least that’s the case for the year 2018. And we’ll stick to 2018 limits in this blog post. (The $55,000 limit holds even if a profit sharing plan is available along with the 401(k).)
There are also limits to contributions made by the employee alone. An employee is limited to contributing $18,500 to their 401(k) in a single year. That leaves $36,500 that the employer can add to that same employee’s 401(k). But there are a few caveats:
- That total of $55,000 can’t be greater than the employee’s salary.
- Any matching or safe harbor contribution by the company must be based on a maximum salary of $275,000. That means if the company is providing up to a 5% match, the most it can contribute to a single employee is $275,000 x 5%, or $13,750. To contribute more, the company would have to raise the match percentage or make a supplemental contribution. This is called a profit sharing contribution.
- An employer’s tax deductible contributions are limited to 25% of total eligible payroll.
Flexing your contribution muscle
So companies have lots of flexibility when it comes to reaching the $55,000 maximum combined contribution. Employees are largely responsible for funding their own 401(k), but it is common for companies to either match employee contributions up to a certain percentage, say up to 3% or 5% of salary, or to make a contribution of 3% of salary to all eligible employees. It’s up to the employer to decide whether or not to provide a company contribution, and how much.
The employer also has the option of supplementing the 401(k) with a profit sharing plan. Finally, a company has the option to offer a profit sharing plan only. In this case the company will be responsible for all contributions and will receive all the tax benefits. While a formula determines how the funds are allocated among participants, different formulas can satisfy quite different objectives.
Formulas for Profit Sharing Contributions
Much like 401(k) contributions, it is up to the company whether or not to make profit sharing contributions. The so-called traditional approach allocates profit sharing contributions according to each employee’s salary. That’s called the salary ratio method. For example, each employee might get a contribution equal to 5% of salary.
But there are also formulas that allocate contributions differently. One method is based on the compensation and age of employees. Here the focus is not on the amount each employee receives in a single year. Rather, the contribution limit takes into consideration funds available at retirement. As a result, an older employee can receive a larger profit sharing contribution in one year than a younger employee earning the same salary. A key point here is that non-discrimination testing is based not on a particular year’s contribution, but on projected benefits at retirement.
Another approach is the “new comparability” or “cross tested” allocation. This approach allows the employer to place employees into different categories for allocating contributions. This allows companies to direct contributions to specific groups of employees. Similar to the age-based formula, the focus remains on projected benefits. As a result, larger contributions can often be made to older employees and the plan will still pass non-discrimination tests.
How you design your 401(k) and profit sharing plans depends upon your objectives for these plans. If the goal is to attract or retain employees, the profit sharing plan might be structured one way. But if the goal is to maximize tax-efficient contributions for key employees, another approach may be a better fit. For example, at ForUsAll we often help small business set up new comparability plans with specific employee groups receiving contributions based on a formula.
Thinking outside the 401(k) – Defined benefit plans
Combining 401(k) and profit sharing plans can provide considerable flexibility, while sheltering a significant portion of the income of key employees. But regardless of who makes the contribution – the employer or the employee – the combined contribution limit is $54,000 for employees under 50.
Sheltering larger annual amounts requires leaving the defined contribution world. Defined benefit plans can offer much large contribution limits, and can be particularly valuable for older employees who are within shouting distance of retirement age. But there are trade-offs, including higher expenses.
Cash balance plans
One popular defined benefit option is the cash balance plan. Although the cash balance plan is a defined benefit plan, that promised benefit is stated in terms of an account balance rather than monthly payments. So the plan “looks” similar to a defined contribution plan to participants. That is, the statement shows a beginning balance, contribution credits, interest credits, and an ending balance.
But the cash balance statement does not represent an actual account controlled by the participant. The assets are pooled and invested by the plan’s trustees and investment advisors. Also, the “interest credits” are not based on actual gains or losses from the invested assets. The interest credit represents a predetermined rate of return promised to the participants. If the actual value of the assets fails to match the promised return, the plan sponsor (your company!) must make up the difference with larger contributions.
When it comes to retirement benefits, participating employees are promised a certain account balance at a certain retirement age. When the employee retires, he can access the account balance by taking a lump sum or an annuity. In addition to the “defined benefit” of a promised account balance, the cash balance plan allows considerably more money to be set aside each year.
The annual contribution limits for a cash balance plan are based on age and can top $200,000 for workers over the age of 58. But unlike 401(k) plans, contribution limits are based on benefits available at retirement, not a limit on the dollars contributed each year. This is a similar approach to the age-based and new comparability profit sharing formulas mentioned above.
For cash balance plans, the monthly benefit limit is $17,500, or $210,000 per year in retirement. That translates into a maximum lump sum retirement benefit of around $2.6 million. Given this benefit limit, the maximum company contribution for a particular year is actuarially determined. You might say, the annual contribution limit is “backed into” given the limit on benefits at retirement.
These calculations can be complicated and are one reason that cash balance plans are generally more costly to run than a 401(k)/profit sharing plan. But the bottom line is, the cash balance option allows for significantly more pre-tax salary to be diverted and invested in tax-deferred assets.
While the promised benefit puts the cash balance plan into the defined benefit category, these plans do differ from traditional pension plans. For example, a traditional pension heavily weights the final years of employment when determining pension benefits. The cash balance plan provides benefits based on a simple average of every year’s salary. This can have implications for long time workers who find their pension plan has been converted to a cash balance plan. But for smaller companies now looking to supplement the retirement nest eggs of key employees, a cash balance plan can turbo charge retirement assets.
One important difference between traditional defined benefit and cash balance plans is that pension plan liabilities are far more sensitive to changes in interest rates than those of cash balance plans. For pension plans, a drop in interest rates can lead to plan underfunding and require the company to hike contributions so that plan assets once again match liabilities.