John T. Grace – Chernoff Diamond & Co., LLC
09.25.2018 | Practice Made Perfect
It is not unusual for business owners to ask their business advisors how they can reduce their taxes. Typically, this arises when business owners review their annual business and/or personal tax returns, or during the year when they see how much is being withheld, or being paid in quarterly estimated tax payments on their behalf.
However, qualified retirement plans can provide significant tax benefits to business owners and their employees. The following details the types of qualified retirement plans and how they work.
Defined Contribution Plans
1. 401(k) Plans
With 401(k) plans, employees make contributions of their own money into a plan. An employer may offer matching contributions as an incentive for employees to join the plan. The matching contribution can be turned on or off by the employer each year.
The contribution by the employee can be pretax, where the amount contributed by the employee is tax deductible and can reduce the employee’s taxable income dollar-for-dollar. Alternatively, if the plan provides for a Roth 401(k), the contribution is made with after-tax dollars. Specifically, there would be no tax deduction for the amount the employee contributes; however, both principal and earnings would not be subject to income tax upon future withdrawal. With a non-Roth 401(k), all distributions are subject to income tax.
The amount that a participant can contribute into a plan is reviewed annually by the Internal Revenue Service (IRS). In 2018, a plan participant is able to contribute up to $18,500. That amount is increased to $24,500 if the plan participant is 50 years or older by December 31, 2018.
2. Profit Sharing Plans
Each year, an employer has discretion as to how much the employer will contribute to the profit sharing plan. Unlike the 401(k) plan, only the employer contributes funds on behalf of the employee into a profit sharing plan. When 401(k) plans and profit sharing plans are combined, the annual combined limit in 2018 is $55,000 or $61,000 if the employee is 50 years or older in that year.
Defined contribution plans (i.e., 401(k) and profit sharing plans) are structured to provide employees with a specific dollar contribution amount each year. Each employee’s account is credited with the amounts the employee and employer contribute, and is increased or decreased by the annual investment performance. The employee is entitled to receive whatever amount is in the account balance.
3. Defined Benefit Plans
The traditional defined benefit plan provides employer funding so that an employee can receive a guaranteed payment out of the plan over the employee’s lifetime, typically, via monthly annuity amounts rather than a balance in an employee’s account. However, a lump-sum payment can be received by the employee. Also, in a traditional defined benefit plan, the investment risk rests with the employer, whereas, in a defined contribution plan, the investment risk resides with the employee. Due to investment risk and actuarial costs, the traditional defined benefit plan is not often used, if at all, today. Moreover, employees do not have separate accounts in the traditional defined benefit plan. Instead, the plan has one account balance, and a participant’s share of that balance is determined by an actuary. Furthermore, unlike a defined contribution plan (which can be turned on and off annually), a defined benefit plan must be funded for a few years, from inception, before an employer can determine not to make an annual contribution.
Today’s Defined Benefit Plans
Today’s defined benefit plans are subject to the same funding requirements and benefit limitations as the traditional defined benefit plans; however, there is a world of difference. Current defined benefit plans, in a variety of ways, look and “feel” like defined contribution plans. One such modern plan is known as a cash balance plan. Benefits are based on a participant’s hypothetical account balance. The hypothetical account balance receives pay credits each year equal to a percentage of that year’s compensation, plus earnings, using an interest rate defined in the plan document. The earnings could be a set interest rate such as 6%, or an index such as the yield on 30-year treasuries, or they may be based on the actual return on invested assets to fund the cash balance plan. For earnings based on the actual return on invested plan assets, the account balances cannot be less than the sum of all pay credits (i.e., preservation of capital).
Direct Recognition Variable Investment Plans (DR-VIP)
A DR-VIP offers the latest in defined benefit plan design. It looks and functions like a cash balance defined benefit plan. However, unlike a cash balance plan, the DR-VIP is exempt from the “preservation of capital” requirement. As a result, the DR-VIP defined benefit plan, generally, has no underfunding risk, since the core investments determine the required annual investment return. An underfunding risk can exist in a regular cash balance defined benefit plan.
It should be noted that defined benefit plans permit significantly higher annual individual contribution levels than defined contribution plans. In a DR-VIP, annual tax deductible contributions can be made up to $311,000 per annum for a participant. A DR-VIP will typically have a matrix developed, so that the annual participant’s contribution will be a function of the participant’s age and level of compensation.
Why Should Qualified Pension Plans Be Implemented?
There are several reasons motivating organizations to implement qualified retirement plans, but four of the most important are as follows:
- In general, qualified retirement plans are exempt from claims of creditors.
- The employer can obtain a deduction for payments it made and the employee does not recognize income for the contribution made by the employer. Income is recognized by the plan participant when distributions are made (for a Roth 401(k), the participant does not recognize income upon receiving a distribution).
- Earnings can accumulate on a federal and state tax deferred basis, or, possibly, state tax free basis.
- Qualified retirement plans can help in the retention of employees and can attract employees to a firm.
2017 Tax Cuts and Jobs Act
New Internal Revenue Code (IRC) Section 199A generally allows non-corporate taxpayers to obtain a 20% deduction against their share of an entity’s qualified business income. However, owners of a specified service trade or business do not benefit from this deduction, if their business involves services in the field of law, accounting, health, actuarial science, performing arts, consulting, athletics, financial or brokerage services, or any trade or business when the principal asset of the business is the reputation of, or skill of, one or more of its employees or owners, unless an owner of a specified service, trade or business has taxable income that does not exceed certain taxable income levels.
A married owner of a specified service trade or business receives only a partial deduction if the owner’s taxable income exceeds $315,000 but is less than $415,000. If the business owner is a single taxpayer, the phase-out of the 20% deduction occurs between $157,000 and $207,500. An owner of a specified service, trade or business who is married receives the full 20% deduction, if the owner’s taxable income is below $315,000; or, for a single taxpaying owner, the full 20% deduction is received if his/her taxable income is below $157,500.
It is crucial to note that the owner of a specified service, trade or business can reduce his/her taxable income through a deduction from a qualified pension plan. That reduction in taxable income could result in the business owner being able to obtain a full, or partial, IRC Section 199A deduction.
Qualified retirement plans can provide benefits to business owners and employees. Nondiscrimination rules may require that certain non-highly compensated employees (NHCEs) participate in the plan (classification of NHCEs is determined annually by the IRS annually and, in 2018, the NHCE earnings were set at $120,000 or less). Without the participation of the NHCEs, the business owner and highly compensated employees (HCEs) may be required to reduce, or eliminate, their annual contribution to a qualified retirement plan.
The best way to get a clearer picture of the costs that will be incurred, as opposed to the benefit to be derived by a business owner(s) from implementing or enhancing their business qualified retirement plans, is to “put pencil to paper” and do an analysis. The time spent in doing such an analysis may prove to be time well spent.
Questions? Contact your Berdon advisor