Note: This article originally appeared in the Cincinnati Business Courier’s Goering Center Supplement.
In an economic climate where tax increases may be imminent, smart privately-held companies are taking a second look at their current tax qualified retirement plans. Business owners with an eye on their own retirement goals are requesting innovative changes to their plan designs so they can wisely shelter more of their wealth. It may be time for you to review your benefit plan options and their tax consequences to determine if you’ve got the right plan in place. The primer below is a helpful start. A Qualified Plan Professional can creatively design your company’s plan to meet your specific personal goals, and those of your organization.
Defined Benefit Plans and Defined Contribution Plans
A defined benefit plan is a tax qualified retirement plan funded by tax deductible employer contributions. The annual benefit at retirement is generally determined based on each participant’s compensation and years of service. Defined benefit plan assets are invested in a pooled account, and the plan sponsor is responsible for the plan’s investment return. So investment gains result in smaller plan contributions, and investment losses result in larger plan contributions. At retirement or termination of employment, the plan participant is entitled to the benefit defined by the plan document, subject to the vesting provisions of the plan.
In a defined contribution plan, such as a profit sharing plan, 401(k) plan, or money purchase pension plan, fixed contributions are paid into an individual account by employers and employees. Future benefits fluctuate on the basis of investment earnings.
A defined benefit plan is often more attractive to business owners because:
• It is the most effective way to provide a guaranteed level of retirement benefit – the promised benefit at retirement is not a function of investment results.
• The plan can be designed to encourage early or late retirement.
• Employer costs can be reduced by favorable investment results.
• It can provide a much larger tax deduction, and accumulation of retirement funds on a tax favored basis, for older business owners or favored employees because the IRS limits retirement benefits, not contributions.
• Investment losses result in additional employer contributions since the promised benefit under the plan is not changed by investment results.
• Only with a defined benefit plan can you be certain of achieving your retirement planning goals.
As compelling as these benefits are, they can be enhanced when combined with attributes of a defined contribution plan. Hybrid plan designs can offer the best of both options.
Floor Offset Plans
A floor offset plan generally pairs a defined benefit plan with a defined contribution plan. This strategy provides a minimum guaranteed benefit, or “floor” benefit, from both plans combined. The total benefit, based on participant compensation and years of service, is described in the floor offset plan. It is reduced, or “offset”, by a benefit that is equivalent to the amount accumulated as a result of employer contributions to the defined contribution plan. After this reduction, the floor offset plan provides the remaining benefit. The total benefit from both plans equals the total benefit called for in the floor offset plan.
In many cases floor offset plans can be designed so that only the business owner and other favored employees receive any benefit from the floor offset plan. This is possible because the defined contribution plan account fully offsets the minimum benefit for everyone else and the plans are combined to pass the non-discrimination requirements of the Internal Revenue Code (IRC). In order for this strategy to work, the non-favored employees must generally be younger than the owners and other favored employees. Additionally, the non-favored employees must receive a minimum contribution to the defined contribution plan (generally in range of 5% to 7% of their pay).
Since the floor offset plan is technically considered a defined benefit plan, in most cases it provides an older business owner with much larger benefits and tax deductible contributions than a defined contribution plan alone.
Cash Balance Plans
A cash balance plan is a defined benefit plan that looks like a defined contribution plan. The benefit in a cash balance plan grows, similar to an account under a defined contribution plan. Each year a participant’s “account” is credited with contributions and earnings. When a participant is entitled to receive a distribution (retirement, death, disability, or termination), the amount is equal to the vested balance in their hypothetical account.
The earnings aren’t necessarily tied to the actual investment results of the plan; they are specified in the plan document. The account balance never loses value so the investment results are absorbed by the plan sponsor, not the plan participant.
A cash balance plan can be designed, unlike a traditional defined benefit plan, for key employees with the same pay and years of service to receive the same contribution and benefit payout from the plan regardless of differences in ages. Cash balance plans provide some of the best features of both defined benefit and defined contribution plans. They allow large tax deductible contributions and offer a clear, predictable benefit formula.
A cash balance plan works well in conjunction with a 401(k) plan. It offers the potential to substantially increase the amount the business owner can set aside for retirement each year with little or no additional cost for other employees.
A comparison of your company’s benefit plan options can be an eye-opener, and is easily completed by a Qualified Plan Consultant.
For more information contact Bill Edwards at [email protected].