Business owners often feel constricted due to their limited ability to contribute to qualified retirement plans, which can leave benefit advisers at a loss as to how to help. However, when advisers and business owners get creative, they can find new ways to maximize contributions while slashing tax bills in the process. A couple of novel and often-overlooked strategies include safe harbor and cash-balance plans.
A safe harbor 401(k) plan features two types of contributions that allow owners to maximize deferrals and employer contributions for highly compensated employees while eliminating the need for nondiscrimination testing.
The qualifying types of contributions owners have to choose from include:
- Non-elective (“profit-sharing”) contributions equal to at least 3% of compensation for all eligible employees, regardless of whether they defer any of their salaries.
- Matching contributions equal to 100% of the first 3% of salary deferred, plus 50% of the next 2% of salary deferred.
The fallback — and reason why some employers don’t utilize this plan — is the fact that the owner has to then make contributions eligible to all employees. However, this stipulation, along with the cost of contributions, is often offset by the resulting tax savings for the owner.
Keep in mind, safe harbor plans are subject to several other requirements, including the immediate vesting of employer contribution.
Advisers can also work with business owners to utilize a cash-balance plan — similar to a pension plan — that incorporates certain aspects of a 401(k) and other defined contribution plans. Like a defined benefit plan, a cash-balance plan provides a guaranteed benefit at retirement, but, similar to a defined contribution plan, it expresses participants’ benefits in the form of annual credits to hypothetical accounts. Types of contributions include pay credits, based on a fixed amount or percentage of compensation, and interest credits, usually based on a conservative indexed rate.
This approach can be an easy pitch for benefit advisers and business owners to employees because of the advantages it offers. This plan does not require employee contributions, benefits are easy to understand and the employer bears the investment risk (benefits are based on a formula, regardless of the plan assets’ actual performance). Another employee advantage in a cash-balance plan, unlike a traditional pension plan, is the ability to roll over or transfer benefits into a new employer plan if an employee leaves the company.
For the business owner, cash-balance plans offer limitless annual contributions. This presents the opportunity to rapidly accelerate retirement savings, generating significant tax deductions for the business. There is, however, a limit on annual benefits in retirement (currently $215,000).
Additionally, because contributions are based on the amount required to yield a certain benefit, contributions on behalf of business owners or executives near retirement can easily top $200,000 per year. In a cash balance plan, because contributions for younger employees are lower, the plan doesn’t violate nondiscrimination rules as long as projected retirement benefits for HCEs and non-HCEs are comparable.
Safe harbor and cash-balance plans are just two examples of the many options available to business owners who want to accelerate their retirement savings while reducing their tax bills. Advisers should work with business owners to not only find the particular plan that will satisfy employees, but also find a plan that is best for the future of the business and the bottom line.
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