This short article will approach the topic of retirement plan design from a business owner’s standpoint, focusing on benefits from the owner’s perspective vs. cost for the employees. Further, it will focus on the types of designs available in the Defined Contribution and Defined Benefit world, which have the opportunity to allow the business owner to save significant amounts of money for him/herself on a tax-deferred basis and in some cases cover the employees only to a minimal extent.

Why do business owners sponsor Qualified Plans? Normally the first reason is taxation: Generally, contributions are tax-deductible in the year in which they are made, and growth of the assets is tax-deferred. (There are exceptions to this – such as ROTH 401(k), but that has its own set of tax-favorable rules). In addition to the favorable tax treatment, assets held inside Qualified Retirement Plans also enjoy creditor protection, under federal law. Federal law also affords substantial protection to IRAs in bankruptcy proceedings. However, IRAs outside of bankruptcy and other non-qualified investment vehicles are typically subject to state law regarding creditor protection, and some states give better protection than others.

In our experience the third reason a business owner sponsors a Qualified Plan is to provide a benefit to the businesses’ employees. Typically this is a secondary consideration in the business owner’s mind. Consequently, when designing a retirement plan program, we tend to focus on maximizing what the business owner can contribute for his or her own benefit, while simultaneously minimizing what is required to be contributed to the employees’ accounts.

Defined Contribution Plans: The Profit Sharing Plan
The first form of a Qualified Defined Contribution Retirement Plan that we are going to discuss is a profit sharing plan. These allow for the company to “share the profits” among its employees, subject to certain limits and rules.

The most basic form of profit sharing allocation formula is called a “comp-to-comp” allocation, and requires the employer to contribute the same percentage of pay into everyone’s account. So, if Dr. Big makes $200,000 and his nurse makes $50,000; a 10% comp-to-comp profit sharing allocation will put $20,000 into Dr. Big’s account and $5,000 in his nurse’s. The maximum profit sharing contribution allowed is 25% of total payroll, up to the maximum contribution limit for Defined Contribution Plans, which is $49,000 per participant in 2010. The entire contribution to the profit sharing plan is deductible to the business, as long as the Plan continues to be Qualified (meaning that is meets all the testing requirements on an annual basis).

There are alternate formulas for the profit sharing contribution, usually benefitting either the owner of the company or certain employees over others (or both). These are completely legal, so long as the plan passes annual testing requirements.

The first of these alternate formulas is an “Integrated” formula. This approach “integrates” the profit sharing plan with the benefits that will be derived from Social Security, in essence giving highly compensated employees additional benefits due to the fact that they receive no additional social security credit from income they earn in excess of the Social Security Wage Base.

An “Age-Weighted” profit sharing allocation gives additional benefits to those who are older and therefore have less time until retirement.

Finally, “New Comparability,” also known as “Cross Tested” is the final (and most recently allowed) profit sharing formula. The cross tested allocation utilizes employees’ age, service and income in determining what contribution will be required for them. In addition, this allows the Plan Sponsor to group employees along the lines of job description, duties or department. In short, this type of profit sharing formula utilizes defined benefit approaches to testing to allow for a certain amount of discrimination, (subject to limits), so that the Plan will still pass the antidiscrimination tests.

In our experience, the most beneficial formulas (for the owners / Highly Compensated Employees) are typically either the integrated or the cross-tested profit sharing formulas.

The 401(k) Provision
A 401(k) provision (which can be added to a profit sharing plan) allows employees to contribute to their own retirement account. In 2010, the maximum any employee is allowed to defer out of their income into their 401(k) account is $16,500. In addition to this, any participant who is 50 or older by the end of the year is allowed to make a “catch up” contribution of up to $5,500. The total overall contribution allowed (including a profit sharing contribution, as discussed above) is $49,000; or $54,500 including the catch up contribution.

There are testing requirements that must be met for the Highly Compensated Employees (HCEs) to be allowed to defer those maximum amounts. HCEs are those who make $110,000 or more this year or who own 5% or more of the company.

The first of these tests is the Average Deferral Percentage (ADP) test, which tests the average percentage of compensation that Non-Highly Compensated Employees defer, and compares that to the same for Highly Compensated Employees. Without getting into the weeds, the HCEs can generally only defer 2% more than the average of NHCEs’ deferrals. In short, Non-Highly Compensated Employees (NHCEs) must participate to a significant extent in order for the HCEs to be able to defer the $16,500 maximum. However, the failure of NHCEs to participate can be overcome by making the Plan a “Safe Harbor” plan.

Safe Harbor
A Safe Harbor retirement plan allows the HCEs to defer as much as they like, up to the $16,500 limit, without worrying about how much the NHCEs defer. In order to be a “Safe Harbor” plan, the Employer must make contributions to the employee’s accounts. These can be either an across-the-board 3% contribution to everyone who is eligible to be in the plan, or a match formula (100% on the first 3% deferred, plus 50% on the next 2% deferred by the employee), thereby benefitting only those employees who themselves participate. Considerable “leverage” (high contributions for owners or key employees, and lower contributions required for everyone else) can be gained using the combination of Safe Harbor Plan design and an integrated or cross-tested Profit Sharing allocation.

It is important to note some limitations of a safe harbor plan design – there is not as much flexibility with a safe harbor contribution as with other types of employer contributions. First, a Safe Harbor contribution must vest immediately, so it cannot be made subject to any vesting schedule. Further, whether a plan decides to be a Safe Harbor Plan must be determined and communicated to eligible employees at least 30 days in advance of the beginning of the applicable Plan Year. So, if Plan X is going to be a Safe Harbor plan for 2011, it must communicate that fact via a Safe Harbor Notice to the eligible employees by November 30, 2010.

Defined Benefit Plans
Up until now, we have focused exclusively on Defined Contribution Plans in this article. Defined Contribution Plans are fairly flexible and allow for contributions up to $49,000 per individual (in 2010). If a higher level of contribution is desired, the business should investigate adding a Defined Benefit Plan.

Defined Benefit Plans specify the benefit a participant will receive in retirement, and an actuary performs the calculation to determine what contribution is required on an annual basis to get there. Consequently, these plans have much less flexibility but can result in much higher levels of tax-deductible contributions.

Defined Benefit Plans have historically been sponsored by large corporations, and set up as a benefit to employees. These can be expensive if the business has older, highly paid employees. Further, these types of plans potentially have variations in required contributions, depending on the actual performance of the investments held by the Plan. Because of costs and other reasons, DB plans have fallen out of favor recently in the large employer market.

However, Defined Benefit Plans have a place in smaller, high cash flow businesses, due to the much larger contributions which may be possible and the relatively small number of people most of these types of business employ.

Cash Balance Defined Benefit Plans
There has been a lot of talk lately about Cash Balance Defined Benefit Plans, particularly regarding how they can be used in tax shelter planning for high-cash flow practices. First, let’s do a quick overview of the idea. On the simplest level, these are Defined Benefit plans that define the promised benefit in terms of a stated account balance, rather than an income stream. This approach is generally more understandable and therefore more appreciated by Plan participants. The actual payment made to a participant may be in the form of a lump sum (able to be rolled into an IRA or other Qualified vehicle) or a guaranteed income stream at retirement.

Due to the fact that these are Defined Benefit plans, they have a different set of rules from those of Defined Contribution plans. In general, DB plans allow for greater contributions toward older employees and those with larger amounts of compensation. Typically, this lines up very well with the goals of the (typically older and higher paid) professional and / or HCEs.

The difficulty has been that many advisors and/or administration firms tend to view a Cash Balance Plan as a replacement to a 401(k) or profit sharing plan that is currently in place. The problem with this is twofold: (1) many employees have come to like the 401(k), and do not want it taken away, particularly when it is replaced with a plan that they don’t fully understand and over which they have little control. (2) Keeping the 401(k) profit sharing plan in place will generally result in lower overall contributions to the non-HCEs and higher contributions to the HCEs.

The Cash Balance “Combo”
Greater leverage (higher contributions in favor of owners or HCEs) can be found when a Cash Balance DB Plan is added to - and tested in combination with - a Defined Contribution Plan. By installing a Cash Balance Plan in combination with a Defined Contribution Plan, both sets of limits can be taken advantage of, typically increasing the total contribution by a good margin. Further, testing the two plans together usually results in significantly larger contributions toward the Highly Compensated Employees (HCEs), while requiring only a modest increase (if any) in the contribution required for Non-HCEs.

In order to best take advantage of this “Combo Plan” idea, a business should be small-to-mid size; we have seen this implemented with favorable results in professional practices with up to 110 employees. The HCEs on average should be roughly 10 years older than the Non-HCEs. The business should have a history of strong cash flow, as this is a Defined Benefit Plan, and therefore must follow the Plan permanency requirements of ERISA and subsequent Treasury regulations and IRS Revenue Rulings1. Finally, the HCEs should want to make large annual contributions. Note that not all HCEs must participate - individual HCEs may opt-out, if they so choose.

We have seen plans where combined annual deductible Plan contributions can get to (and above) $250,000 per HCE, per year. With an ideal census, required contributions for Non-HCEs can be limited to 6% of compensation on the Defined Contribution Plan, and less than $1,000 in the Cash Balance Plan.

1 Treas. Regs. § 1.401-1(b)(2), IRS Rev. Ruls. 72-237, 69-25

About the Authors:
Larry Boord, JD ChFC and Steve Haxton, CPA are partners in Jacob, Haxton & Boord, LLC; an actuarial, retirement plan administration and consulting practice located in Worthington, Ohio. JHB traces its history back over 40 years and specializes in providing consulting, administration and actuarial work to defined contribution plans (401 k), defined benefit pension plans, non-qualified executive compensation programs and other company-sponsored benefit plans.

Tom Wyatt, JD CFP is a retirement plan consultant and Certified Financial Planner® working in Worthington, Ohio. Tom is a consultant at JHB. Tom also is a licensed attorney and Certified Financial Planner®, and maintains a financial planning and business planning practice in addition to his work with retirement plans.