tax advantaged retirement plan strategies for small businesses

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Tax Advantaged Retirement Plan Strategies for Small Businesses

Presented by:TJ Orr, ERPA, QPA, QKAandKevin Donovan, CPA, EA, MSPA

www.pinnacle-plan.com

http://www.pinnacle-plan.com/

The information contained in this presentation is accurate as of June 2014

Defined Contribution Plans

• Individual Retirement Accounts• SIMPLE IRAs• SEPs• 401(k)/Profit Sharing Plans• Referred to throughout outline as DC

Plans or DCPs

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Defined Benefit Plans• Traditional DB plans

• Cash Balance Plans

• Much life still in DB plans

– Particularly in professional settings where combined with DC plans and limited DBP benefits provided to rank and file employees

– See Chapter 10 AICPA’s CPAs Guide to Retirement Plans for Small Businesses

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Defined Benefit Plans• Assets pooled • Benefits paid based on plan document

– Though in small employer situations owner often takes “haircut” upon plan termination if liabilities > assets

– In PBGC covered plan only 50% owners may take reduced benefits

• Investment risk with employer

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Defined Contribution Plans

• Account maintained for each participant - bookkeeping or actual– i.e. pooled or individually directed

• Credited with actual contributions and earnings

• Benefit paid based on value in account• Investment risk with employee

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Individual Retirement Accounts (IRAs)

• $5,500 limit for 2014 – IRC §219(b)(5)(A)

• $6,500 if 50 or over by year-end – IRC §219(b)(5)(B)(ii)

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SIMPLE IRAs

• Often best solution where limited funds available for retirement

• Deferral limit $12,000 for 2014 [IRC §408(p)(2)(E)(i)]– Additional $2,500 “catch-up” if age 50 or over

by calendar year-end [IRC §414(v)(2)(B)(ii)]– Effected by elective deferrals to other plans

(e.g. 401(k) of prior employer)

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SIMPLE IRAs

• Limited plan administration – e.g. no Form 5500• No “permanency” requirement

– Whereas a qualified plan must be intended to be a “permanent” program when established [Reg. §1.401-1(b)(2)]

• Not subject to ERISA Title I– Investment responsibility with employee only– No bonding requirement under ERISA §412

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SIMPLE IRAs

• Increased penalty for early withdrawal– 25% for two years

• Measured from the first day on which contributions are deposited to the individual's account

– IRC §72(t)(6)– IRS Notice 98-4, Q&A I-5

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SIMPLE IRAs

• Must cover each employee of employer who – earned at least $5,000 in any two prior years and – is expected to earn $5,000 in current year – may be less restrictive

• May exclude union employees, certain non-resident aliens and certain pilots

• IRC §408(p)(4)

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SIMPLE IRAs

• Notice requirement• Provide no later than 60 days before

beginning of year• See IRS Notice 98-4, Q&As G-1 and H-1

for required content– Model Notice in IRS 5304-SIMPLE

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SIMPLE IRAs

• Required employer contribution– 100% match of employee deferrals up to

3% of compensation OR– 2% of compensation irrespective of

deferrals– IRC §§408(p)(2)(A)(iii), 408(p)(2)(B)

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SIMPLE IRAs

• Compensation limit ($260,000 for 2014) not applicable in case of matching contribution [IRC §408(p)(2)(B)(ii) applies IRC §401(a)(17) limit only to 2% option]

• SO … catch-up eligible individual with compensation of at least $483,333 can get $29,000 into SIMPLE for 2014– i.e. 3% of $483,333 = $14,500 employer match plus

$14,500 deferral

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SIMPLE IRAs

• In 2 of every 5 years may limit match to 1% of compensation

• There appears to be no prohibition against this being the first two years of the plan– And as no requirement to be permanent could

then suspend/terminate plan

• IRC §408(p)(2)(C)(ii)(II)

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SIMPLE IRAs

• Maintained on calendar plan year basis– Notice 98-4, Q&A A-3

• Employer must have less than 100 employees who earned $5,000 in previous calendar year– Including excludable employees (i.e. union

employees, etc.)– 2 year grace period after passing 100 ees– IRC §408(p)(2)(C)(i); Not. 98-4, Q&As B-2

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SIMPLE IRAs

• Employee deferrals must be deposited no later than 30 days after end of month of withholding – but DOL plan asset rules [IRC §408(p)(5)(A)(i), Notice 98-4 Background]– DOL regulations provide safe-harbor of 7 days

• Reg. §§2510.3-102(a)(2); 2510.3-102(f)(1)

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SIMPLE IRAs

• Employer contributions required by due date of tax return for tax year with or within which SIMPLE (calendar) year ends [IRC §408(p)(5)(A)(ii)]– Note that this is a SIMPLE qualification rule, not a

tax deduction rule

• Employer contributions also deductible in tax year with or within which SIMPLE (calendar) year ends [§404(m)(1)]

• And … 18

SIMPLE IRAs

• Must be made by due date (including extensions) of tax return for tax year with or within which calendar year of SIMPLE plan ends [§404(m)(2)(B)] – Ex. Employer has 6/30 tax year. Employer contributions

under SIMPLE for calendar year 2013 (including contributions made in 2013 before 6/30/13) are deductible in the tax year ending 6/30/14.

– Notice 98-4 Q&A I-7

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SIMPLE IRAs

• When must SIMPLE be established?– Existing employer adopting first SIMPLE –

by October 1 of year in which effective– New employer – later of 10/1 or as soon

as reasonable after employer formed– January 1 if previously sponsored SIMPLE– Notice 98-4 Q&A K-1

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SIMPLE IRAs

• Employer may not maintain qualified plan to which contributions are being made (DC plan) or benefits are being accrued (DB plan) for any plan year beginning or ending in calendar year of SIMPLE– Transfers, rollovers and forfeiture allocations OK

• Exception for union plan if union employees not in SIMPLE

• Transition rule if acquired employer maintains qualified plan

• Notice 98-4, Q&A B-321

SIMPLE IRAs

• What if employer sponsoring SIMPLE decides qualified plan makes more sense in year in which SIMPLE deferrals have been made?– Adoption of qualified plan will render

SIMPLE unqualified for year and contributions must be returned

– Have seen it done – not pretty but doable

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SIMPLE IRAs

• Example– Employer maintains SIMPLE – When doing year-end tax planning CPA sees

large profits and determines defined benefit plan can help (and otherwise makes sense)

– DB plan adopted– SIMPLE terminated - deferrals for year

returned to employees

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SIMPLE IRAs

• EXAMPLE - FISCAL YEAR TAXPAYER– Maintains SIMPLE– In December of 2014 decides DB & 401(k) plans make

sense for year-ending April 30, 2015– SIMPLE ceased January 1, 2015 – runs though 2014 so

no deferrals need be returned– DB and 401(k) plans adopted with initial short year

1/1/15-4/30/15– Compensation defined as compensation earned

during 12 months ending on last day of Plan Year– Effect is full year of contributions for 4/30/15

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“Employer”

• “Employer” includes related employers under IRC sections §§414(b), (c) and (m) - i.e. treated as single employer. SO …– ALL related employers must sponsor the SIMPLE –eligible

employees of ALL such employers covered– Employees of ALL related employers count in 100

employee determination– Qualified plan may not be maintained by any related

employer

• Notice 98-4 Q&A B-5

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Simplified Employee Pensions

• Often best solution where non-owner employees mostly short term

• Contribution limit for 2014 lesser of– 25% of Compensation or– $52,000 (reduced where integrated with

Social Security)– IRC §402(h)(2)

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• Limited plan administration – – no Form 5500 required– no bonding requirements

• No “permanency” requirement– i.e. no need for recurring contributions

• May be established as late as due date of employer’s tax return– Extended returns may still adopt for 2013

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• Must cover all employees who have– Attained age 21– Performed (any amount of) service for

employer in any 3 of preceding 5 years and– Earned $550 during current year

• No minimum earnings needed in prior years• May exclude union employees and

certain non-resident aliens• May be less restrictive• IRC §408(k)(2)

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• If owner is only employee in year 1 can conceivably go 4 years with no other employees in plan– 2013 business started, owner hired– 2014 hire 1st additional employee– 2013 SEP requires no service– 2014 SEP requires service in 1 prior year– 2015 SEP requires service in 2 prior years– 2016 SEP requires service in 3 prior years

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• Contributions must bear uniform relationship to the compensation– May integrate with Social Security– IRC §408(k)(3)(C)

• Full and immediate vesting• Contributions made to IRA set up

and controlled by employee– So like SIMPLE employee bears

investment responsibility30


• Example – Small company owned by Jane since 2002– Consistently 3 other employees - but 2 of 3

turnover regularly– Current employees, all over 21, employed in

2010, 2012 and 2013 respectively – SEP for 2013 could cover only Jane and

employee hired in 2010

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• Example (cont) – Jane earns $200,000– Covered employee earns $45,000– Jane wants to contribute $30,000 for self

(15% of $200,000)– Without integration contribution for

employee would be $6,750

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Simplified Employee Pensions• Example (cont) with integration

– Jane’s compensation $200,000 – SS Wage Base 113,700 – “Excess Compensation” 86,300 – 5.7% of excess Compensation 4,919 – Needed to reach $30,000 25,081 – As % of Jane’s total compensation 12.54% – Required contribution for employee – $45,000 X 12.54% $5,643– (Savings of $1,107 by integrating with SS) – 5305-SEP will not work – need prototype

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Qualified Plans

• Must meet qualification requirements under IRC §401(a)

• Subject to reporting & other requirements of Title I of ERISA, e.g.– Form 5500– Bonding– Fiduciary duties (ERISA §404)

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Qualified Plans• Vesting Rules [IRC §401(a)(7)]

– Defined benefit plans (unless top-heavy or cash balance)• 5-year cliff; or• 7-year graded (20% after year 3, 20%/year

thereafter)– IRC §411(a)(2)(A)

• 100% after 2 years if more than 12 months to become eligible employee

– IRC §410(a)(1)(B)(i)

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Qualified Plans• Vesting Rules [IRC §401(a)(7)]

– Defined contribution plans (& top-heavy DBPs)• 3-year cliff; or• 6-year graded (20% after year 2, 20%/year

thereafter– IRC §411(a)(2)(B)

• 100% after 2 years if more than 12 months to become eligible employee

– IRC §410(a)(1)(B)(i)

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Qualified Plans

• Vesting Rules [IRC §401(a)(7)]– May exclude certain years including

• years of service before age 18• years during which the employer did not

maintain the plan (or a predecessor plan)• IRC §411(a)(4)

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Qualified Plans

• Vesting Requirements [IRC 401(a)(7)]– If employer establishes a plan within 5-year

period preceding or following date other plan terminates, terminated plan is predecessor plan with respect to such other plan

– Reg. §1.411(a)-5(b)(3)(v)

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Qualified Plans

• Coverage Requirements [IRC §401(a)(3)]– Percentage of Non-highly Compensated

Employees (NHCs) benefiting under plan must be at least 70 percent of

– Percentage of Highly Compensated Employees (HCEs) benefiting under the plan

– IRC §410(b)(1)(B)– OR pass average benefits test of IRC §410(b)

(2) - Beyond scope of this session

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Qualified Plans

• Coverage requirements – Can ignore (“excludable employees”)

• Employees under age 21 and employees who have not completed a year of service [IRC §410(b)(4)]

– Often however employees under age 21 can be helpful in testing so exclusion due to age may not make sense

• Union employees and non-resident aliens with no US source income [IRC §410(b)(3)]

• Terminated employees with no more than 500 hours [ Reg. §1.410(b)-6(f)(1)(v)]

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Qualified Plans

• HCEs– Greater than 5% owner

• Current or previous year• Attribution under IRC Section §318

– Or, earned more than $115,000 in prior year• May limit to 20% of employees (“Top-paid Group

election”)

– IRC §414(q)(1)

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Qualified Plans

• Example• Company has 11 non-excludable employees

– 3 HCEs – Husband, Wife and their Son – 8 NHCs

• Desire plan to cover husband and wife– Will cover 2/3 or 66.67% of HCEs– Must cover min. 66.67% X 70% = 46.67% of NHCs– 46.67% X 8 = 3.73– Plan can exclude 4 of 8 NHCs and pass coverage

• Exclude by class or even by name if necessary• Have even specifically INCLUDED certain

employees only42

Qualified Plans

• Nondiscrimination rules [IRC §401(a)(4)]– Satisfied “if the contributions or benefits provided

under the plan do not discriminate in favor of highly compensated employees”

– ~ 5 pages of regulation for each of above 18 words [Treas. Reg. §§1.401(a)(4)-0 to 1.401(a)(4)-13]

– IMPORTANT TO NOTE THAT NOT ALL EMPLOYEES MUST BENEFIT IN SAME MANNER

• To be continued …

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Qualified Plans

• Compensation limit [IRC §401(a)(17)]– In determining allocations or benefits under

a qualified plan, compensation in excess of threshold is ignored

– $260,000 for years beginning in 2014

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Qualified Plans

• Top Heavy Rules [IRC §§401(a)(10)(B), 416]• Plan top heavy if more than 60% of assets belong to

“key employees” – Officers earning more than $170,000– More than 5% owners– More than 1% owners earning over $150,000

• Minimum benefits and accelerated vesting– Recall above vesting schedules

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Qualified Plans• Top-heavy minimum benefits [IRC §416(c)]

– DC only - employer contribution of 3% of compensation (or highest key employee % if less)

– DB only - benefit of 2% of (hi 5-year) average compensation per year of participation (maximum 20%)

– If DB and DC – generally either • DB minimum above OR • employer contribution of 5% of compensation to DC plan• Reg. §1.416-1 Q&A M-12

– Only non-key employees must get TH minimum

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Qualified Plans

• Maximum benefit limits [IRC §§401(a)(16), 415]

• DC plans, annual allocation lesser of – 100% of compensation– $52,000 (plus catch-up if applicable)– IRC §415(c)(1)

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Qualified Plans

• Maximum benefit limits [IRC §§401(a)(16), 415]• DB plans, annual benefit lesser of

– 100% of average compensation • Reduced if less than 10 years of service

– $210,000 (if age 62-65)• Reduced if less than 10 years of participation• Adjusted if benefit commences pre age 62 or post age 65

– IRC §415(b)

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Qualified Plans – DB $ limits Plan Years ending in 2014

Est Max• RA $ Limit Est Max LS Cont

45 70,476 1,120,564 112,056 50 95,027 1,436,798 143,680

55 130,374 1,843,044 184,304 60 182,436 2,364,953 236,495 62 210,000 2,613,190 261,319 65 210,000 2,441,115 244,112 68 260,000 2,798,113 279,811 70 260,000 2,640,870 264,087

Annual benefit limited to §401(a)(17) comp49

401(k)/Profit Sharing Plans

• Cash or Deferred Arrangements [CODA - IRC §401(k)]– Provide for employer and employee contributions– Employee deferrals limited to $17,500 for 2014

[IRC §§401(a)(30), 402(g)(1)(B)]– Additional $5,500 for employees reaching age 50

by end of calendar year [IRC §414(v)(2)(B)(i)]

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• Discrimination testing of elective deferrals and employer matching contributions– ADP testing under IRC §401(k)(3)(A)(ii) – ACP testing under IRC §401(m)(2)(A)

• But safe harbors available– ADP safe harbor IRC §401(k)(12)– ACP safe harbor IRC §401(m)(11)

• Will concentrate on safe harbor plans51


• ADP Safe harbors [IRC §§401(k)(12)(B); 401(k)(12)(C)]– 3% contribution to all eligible NHCs, or– Matching contribution of 100% of

deferrals up to 3% of compensation plus 50% of elective deferrals over 3% of compensation but not in excess of 5% to all eligible NHCs

• Enhanced match of 100% up to 4% of comp. frequently substituted for ease of administration

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– Employer safe harbor contributions may, but need not be, provided to HCEs

• We often design plans where such contributions do not go to HCEs to provide maximum flexibility with respect to HCEs (make up in PS allocation)

– 3% nonelective contribution considered employer contribution for purposes of discrimination testing (as well as required top heavy minimum contributions)

• Reg. §1.401(k)-3(h)(2)53


• Safe harbor requirements– Plan year must be at least 3 months (or

as soon as feasible for new employer)– May be added to existing PS plan if

401(k) arrangement in effect for at least 3 months

• Existing 401(k) at least 30 days prior to B.O.Y.

– Reg. §1.401(k)-3(e)(2)54


• Safe harbor requirements– Safe harbor contributions (nonelective

or match) must be 100% vested [IRC §401(k)(12)(E)(i)]• Other employer contributions may be

subject to vesting schedule

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• Safe harbor requirements– Withdrawal restrictions apply to deferrals and

safe harbor contributions [§401(k)(12)(E)(i)]• See IRC §401(k)(2)(B) for restrictions and

exceptions (generally no withdrawal prior to plan or employment termination or age 59 ½)

• Apply to deferrals whether or not safe harbor• Deferrals may be withdrawn if certain

hardship and plan allows [IRC §401(k)(2)(B)(i)(IV)]

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• Safe harbor requirements– Safe harbor notice must be provided to

participants “within a reasonable period before the beginning of the Plan Year”

– 30 days deemed reasonable– Reg. §1.401(k)-3(d)(3)– Reg. §1.401(k)-3(d)(2) for req. content

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• Post 2007 “automatic enrollment” 401(k) provides additional SH alternative– AKA “negative election” plans– New IRC §401(k)(13)

• Employer contributions – Fully vested after 2 years– Match 100% of first 1% plus 50% of next 5%

• Max match therefore 3.5%

– Or nonelective employer contribution of 3%58


• Absent election to contrary employee automatically defers an amount, no less than– 3% through end of year following initial year of

participation– 4% in next year– 5% in next year– 6% each year thereafter– These are minimums – could e.g. just say 6% all

years59


• Employee must have ability to elect not to defer– Simply changes default from not deferring to deferring

• Similar notice requirements as other safe harbor– Must also discuss default investments – IRC §401(k)(13)(E)

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• Top Heavy pass [IRC §416(g)(4)(H)]– Safe harbor 401(k) plan that receives no

contributions other than elective deferrals and safe harbor employer contribution deemed not top heavy

• Forfeitures from prior years must be used to reduce safe harbor employer contribution (i.e. cannot be allocated)

• Provision providing for profit sharing OK if not used• Revenue Ruling 2004-13• e.g. if matching variety used then employees not

deferring receive no employer allocation61

Non-discrimination rules – DC Plans

• Contributions or benefits provided under a defined contribution plan must be nondiscriminatory– Reg. §1.401(a)(4)-1(b)(2)

• Where testing on contributions may use– Safe harbor, or– General test– Reg. §1.401(a)(4)-2

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• Safe Harbor [Reg. §1.401(a)(4)-2(b)]– Generally all employees receive same % of

compensation– Exception for “permitted disparity” (aka Social Security

Integration) – recall SEP example

• General Test [Reg. §1.401(a)(4)-2(c)]– Used where disparity in contributions not consistent

with permitted disparity– Examples later

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• Cross testing [Reg. §1.401(a)(4)-8(b)]– Convert contributions to equivalent benefits– General test of Reg. §1.401(a)(4)-2(c) then run on

benefits basis• Converting DC contributions to benefits

– Standard interest rate 7.5%-8.5%– Standard mortality table – Reg. §1.401(a)(4)-12

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Non-discrimination rules – DB Plans

• Safe Harbor [Reg. §1.401(a)(4)-3(b)]– Generally all employees receive benefit of

same % of compensation– Exception for “permitted disparity” (aka

Social Security Integration)

• General Test [Reg. §1.401(a)(4)-3(c)]– Used where disparity in benefits not

consistent with permitted disparity65


• DB plan must also pass the minimum participation rules of IRC §401(a)(26) standing on its own

• IRC §401(a)(26) does not apply to DC plans• Must provide “meaningful benefits” to lesser of 50

employees or 40% of the non-excludable employees (regardless of whether the benefiting participants are HCEs or NHCEs) [Treas. Reg. §1.401(a)(26)-3(c)(1)]

• Regulations provide no bright line test to determine if benefits being provided are meaningful - facts and circumstances [Reg. §1.401(a)(26)-3(c)(2)]

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• Again here it is important to understand that retirement plans do not have to provide the same level of benefit to all employees

• Simply must show that benefits that are provided pass the complex rules, including, e.g. IRC §§401(a)(4) and 401(a)(26)

• So back to meaningful benefits

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• In a document entitled “MEMORANDUM FOR MANAGER, EP DETERMINATIONS QUALITY ASSURANCE” issued in June of 2002, the Service implied that a current benefit accrual of .5% of compensation is meaningful

• Consistent with “Alert Guidelines No. 5A on Coverage and Nondiscrimination Testing For Defined Benefit Plans” (Revised 4-2000) at Section III

• Service has consistently applied this guideline in Determination Letter filings

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• Consider a company that has 5 non-excludable employees, an owner/Dr and 4 NHCs. A DB plan provides the Dr with a benefit of 10% of pay per year of service, provides 1 other employee with a benefit of .5% of pay per year of service, and excludes the other 3 (somehow – by name, job class – NOT AGE)– This plan passes IRC §401(a)(26) as 2/5 = 40%

• Or consider Dr, spouse and 3 others. DB could cover Dr and spouse and exclude others

• Would need something else (e.g. a companion DC plan covering the others) to get by 401(a)(4)

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• Other §401(a)(26) issues– Arrangements in or outside of plan that effectively

provide for participant investment direction result in separate plans, each of which must meet 40%/50 participant rule [Treas. Reg. §1.401(a)(26)-2(d)(1)(iii)]

• Prevents two owners e.g. from having DB plan, separately investing their plan dollars & economic effect within plan or by outside agreement is that each gets what his account earns

– Watch plans with 1,000 requirement – only terminees under 501 hours excludable

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• Example– Dr. Jones sponsors DB plan. Dr. Jones has only 1

employee and employee has met eligibility requirements and is in plan. Plan requires 1,000 hours of service during year to accrue benefit. Employee terminates during year after working only 700 hours. Plan would fail IRC §401(a)(26).

• Could amend to provide benefit [would need to be at least partially vested – Reg §1.401(a)(4)-11(g)]; or

• Plan may contain ‘fail-safe’ language• Similar problem with coverage under IRC §410(b)

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Cash Balance Plans

• What is a Cash Balance Plan?– Hybrid between DB plan and DC plan

• DB plan that looks like a DC plan (to the employee/participant)

– Benefit defined as theoretical account balance (TAB) at time of separation

• As opposed to periodic benefit payment• TAB paper account only• Plan assets not actually divided into individual

accounts

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Cash Balance Plans

• TAB credited with– Contribution (pay) credits – flat dollar, or % of pay

or combination• Analogous to contribution in a DC plan• E.g., 2% of compensation not to exceed $1,000, or 50%

of compensation not to exceed $125,000

– Interest (earnings) credits• Analogous to investment return in DC plan

– But defined under terms of plan73

Cash Balance Plans

– Guaranty of credits makes Cash Balance plan a DB plan

• “… "defined contribution plan" means a plan which provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant's account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant's account”

• “… "defined benefit plan" means any plan which is not a defined contribution plan.” - IRC §414(j)

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Cash Balance Plans

• Example– Plan effective 1/1/12– 2012 Compensation $250,000– 2013 Compensation $255,000– Contribution credit 50% of compensation

• $125,000 for 2012; $127,500 for 2013

– Interest crediting rate 5%

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Cash Balance Plans• Example (cont)

– TAB Balance 1/1/12 $ -– 2012 contribution credit 125,000– Balance 12/31/12 (1/1/13) 125,000– 2013 contribution credit 127,500– 2013 interest credit (5% of $115K) 6,250– TAB Balance 12/31/13

$258,750

• Actual plan assets may or may not = ∑ TABs

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Cash Balance Plans• Why use a Cash Balance Plan?

– Provides larger (or additional) limits than DC plan (100% of comp; $52,000 for 2014)

• DB §415 limits apply at distribution

– Provides more “meaningful” (understandable) benefit to employee visa vi traditional DB plan

• Recall previous example – statement looked like statement from 401(k) / profit sharing plan

• Compare to statement from traditional DB plan where statement tells participant of monthly benefit payable sometime in future

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Cash Balance Plans

– In multiple owner situations – e.g. doctors, lawyers, other professionals, more able to equalize benefits or track “who owns what” in the DB plan

– Avoid lump sum swings due to interest rate shifts– Age neutral contributions for non-owners

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Cash Balance Plans

• Pension Protection Act of 2006– Require 100% vesting after 3 years

• IRC §411(a)(13)(B)• Previously could have used 5 years if not top heavy

– Earnings credit not greater than ‘market rate’• IRC §411(b)(5)(B)• Safe harbors in Reg §1.411(b)(5)-1(d)

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DEDUCTION RULES –DC PLANS

• For DC plans deduction for employer contributions limited to 25% of compensation paid to beneficiaries of the plan during tax year– IRC §404(a)(3)(A)(i)(I) – Plan wide limit – not participant level limit

• i.e., individual participant could exceed 25% of pay – recall from earlier 415 limit of 100% of compensation

• Compensation measurement period is therefore tax year not plan year– Normally same so normally not a factor

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DEDUCTION RULES –DC PLANS

• Plan definition of compensation not relevant (Revenue Ruling 80-145)– Example. Calendar year employer, calendar year plan.

Employer maintains profit sharing plan using traditional dual entry system. Employees who enter the plan mid-year receive allocation based only on their compensation earned while a participant. For purposes of the 25% deduction limit, the individual’s compensation for the full year is included

81

DEDUCTION RULES –COMBINED PLANS

• IRC §404(a)(7) applies where employer maintains both DB and DC plan and at least one person covered by both plans

• If 401(k) plan maintained with DB (and common participation), these limits apply if any employer contributions to DC

• Deductible limit to combined plans greater of:– 25% of compensation or – amount deposited to DB plan to extent of required

funding82


• Effective for tax years beginning after 2005, this 25% limit does not apply -– To extent employer contributions to DC plan do not

exceed 6% of compensation• IRC §404(a)(7)(C)(iii)

– To multiemployer plans• IRC §404(a)(7)(C)(v)

– To PBGC plans post 2007• IRC §404(a)(7)(C)(iv)

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– What’s PBGC coverage?– DB plans exempt from PBGC coverage

• Plans of professional group if plan never covered more than 25 active participants

– Physicians, dentists, D.O.s, O.D.s, lawyers, CPAs, P.E.s, architects, actuaries, others where license requires advance study – (not RIAs, CLUs, etc.)

– ERISA §§4021(b)(13), 4021(c)(2)

• Plans covering only substantial (>10%) owners– Attribution rules of IRC §1563(e) apply– ERISA §§4021(b)(9), 4021(d)

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• IRS Notice 2007-28– Q&A 8 - where DC contributions exceed 6% of

comp, only DC contributions over 6% considered in determining 25% limit• Effectively translates to 31% limit

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Examples - census

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Compensation Age

HCE 1 – owner $ 255,000 60

HCE 2 – non owner 255,000 44

NHCE 1 30,000 30

NHCE 2 30,000 46

NHCE 3 30,000 60

NHCE 4 30,000 60

NHCE 5 30,000 44

NHCE 6 30,000 31

Total $ 690,000

Example – Uniform safe harbor PSP

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Compensation PS Allocation

HCE 1 – owner $ 260,000 $52,000

HCE 2 – non owner 260,000 52,000

NHCE 1 30,000 6,000

NHCE 2 30,000 6,000

NHCE 3 30,000 6,000

NHCE 4 30,000 6,000

NHCE 5 30,000 6,000

NHCE 6 30,000 6,000

Total $ 700,000 $140,000

Example – Uniform safe harbor PSP

• Allocation of 20% provided to each Participant to arrive at maximum ($52,000) for owner

• Cost for employees –– Non-owner Dr. $52,000– Other employees 36,000

• [Note that non-owner Dr likely pays for own benefits via eat what you kill formula]

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Example – PSP Permitted Disparity

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HCE 1 – owner $ 260,000 $52,000

HCE 2 – non owner 260,000 52,000

NHCE 1 30,000 5,060

NHCE 2 30,000 5,060

NHCE 3 30,000 5,060

NHCE 4 30,000 5,060

NHCE 5 30,000 5,060

NHCE 6 30,000 5,060

Total $ 700,000 $134,360

Example – PSPPermitted Disparity

• Allocate 5.7% of compensation above Social Security Wage Base ($117,000) plus 16.865% of total compensation

• Cost for employees –– Non-owner Dr. $52,000– Other employees 30,360– Cost for other employees $5,640 lower

than uniform allocation90

Example – Permitted Disparity with Safe Harbor 401(k)

91

Compensation

401(k) PS Allocation

HCE 1 – owner $ 260,000 $ 23,000 $ 34,500

HCE 2 – non owner

260,000 17,500 34,500

NHCE 1 30,000 3,040

NHCE 2 30,000 3,040

NHCE 3 30,000 3,040

NHCE 4 30,000 3,040

NHCE 5 30,000 3,040

NHCE 6 30,000 3,040

Total $ 700,000 $ 40,500

$ 87,240

Example – Permitted Disparity with Safe Harbor 401(k)

• Allocate 5.7% of compensation above Social Security Wage Base plus 9.979% of total compensation

• Cost for employees –– Non-owner Dr. $34,500– Other employees 18,240– Cost for other employees $17,760 lower than uniform

allocation [and $12,120 less than PD without 401(k)]

92

Example – PSP “New Comparability”

93


HCE 1 – owner $ 260,000 $52,000

HCE 2 – non owner 260,000 13,000

NHCE 1 30,000 1,500

NHCE 2 30,000 1,500

NHCE 3 30,000 1,500

NHCE 4 30,000 1,500

NHCE 5 30,000 1,500

NHCE 6 30,000 1,500

Total $ 700,000 $ 74,000


• Allocate 20% of compensation to owner and 5% of compensation to all other employees

• Cost for employees –– Non-owner Dr. $13,000– Other employees 9,000– Cost for other employees $27,000 lower

than uniform allocation [and $21,360 less than PD] 94


• Example of calculations• Owner (age 60):

– Allocation $52,000– Grow at 8.5% to age 65 78,190– Annual annuity factor at age 65 7.9– Life annuity at age 65 9,897– Compensation 260,000– Benefit as % of comp. 3.81%

95


• Example of calculations• NHC 6 (age 31):

– Allocation $ 1,500– Grow at 8.5% to age 65 24,027– Annual annuity factor at age 65 7.9– Life annuity at age 65 3,041– Compensation 30,000– Benefit as % of comp. 10.14%

96

Example – “New Comparability” with Safe Harbor 401(k)

97

Compensation

401(k) PS Allocation

HCE 1 – owner $ 260,000 $ 23,000 $ 34,500

HCE 2 – non owner

260,000 17,500 11,500

NHCE 1 30,000 1,327

NHCE 2 30,000 1,327

NHCE 3 30,000 1,327

NHCE 4 30,000 1,327

NHCE 5 30,000 1,327

NHCE 6 30,000 1,327

Total $ 700,000 $ 40,500

$ 53,962

Example – “New Comparability” with Safe Harbor 401(k)

• Allocate 13.269% of compensation to owner and 4.423% of compensation to all other employees

• Cost for employees –– Non-owner Dr. $ 11,500– Other employees 7,962– $1,038 savings from “new comparability”

plan with no 401(k)– But gets owner extra $5,500 (401k catch-

up)98

Example – “Traditional” Defined Benefit Plan

99

Compensation DB Cost

HCE 1 – owner $ 260,000 $230,653

HCE 2 – non owner 260,000 95,696

NHCE 1 30,000 5,218

NHCE 2 30,000 12,290

NHCE 3 30,000 26,006

NHCE 4 30,000 26,006

NHCE 5 30,000 11,042

NHCE 6 30,000 5,505

Total $ 700,000 $412,416

Example – “Traditional” Defined Benefit Plan

• Benefit formula = 8.077% of compensation times years of participation in plan

• Cost for employees –– Non-owner Dr. $ 95,696– Other employees 86,067

• WAY TOO EXPENSIVE

100

Example – “Cash Balance” Defined Benefit Plan

101

Compensation DB Cost

HCE 1 – owner $ 260,000 $230,000

HCE 2 – non owner 260,000 20,000

NHCE 1 30,000 6,000

NHCE 2 30,000 6,000

NHCE 3 30,000 6,000

NHCE 4 30,000 6,000

NHCE 5 30,000 6,000

NHCE 6 30,000 6,000

Total $ 700,000 $280,000

Example – “Cash Balance” Defined Benefit Plan

• Contribution (pay) credit – Owner $230,000– Others 20% of compensation (Max $20,000)

• Cost for employees –– Non-owner Dr. $ 20,000– Other employees 36,000

• Over $50,000 savings on other employees vs. traditional DB– Testing would prove enough NHCs have benefits

comparable to HCEs• STILL TOO EXPENSIVE?

102

Example – “New Comparability” SH 401(k) and cash balance DB

103

PS/SHCash

BalanceTotal

Employer 401(k) Total

HCE 1 $ 34,500

$157,500

$ 192,000 $ 23,000

$ 215,000

HCE 2 7,800 -0- 7,800 17,500

25,300

NHCE 1

2,100 750 2,850 2,850

NHCE 2

2,100 750 2,850 2,850

NHCE 3

2,100 750 2,850 2,850

NHCE 4

2,100 750 2,850 2,850

NHCE 5

2,100 750 2,850 2,850

NHCE 6

2,100 750 2,850 2,850

Total $ 54,900

$162,000

$216,900 $ 40,500

$ 257,400


• DC plan: 3% non-elective safe harbor 401(k) + profit sharing as follows:

• Maximize Owner• No additional to non-owner HCE• 4% additional to NHCEs

• DB plan: Cash balance plan with contribution credits as follows:

• Owner - $157,500• Exclude non-owner HCE• NHCEs –$750

104


• Total for Dr./Owner $215,000• Cost for employees –• Non-owner Dr. 7,800• Other employees 17,100

– Almost $70,000 less than standalone traditional DB plan and less than half standalone cash balance

105


• Check deduction limit:– Plan compensation $ 700,000

X 31%Deduction limit 217,000Employer contributions 216,900

106

MORE EXAMPLES

107

Single Life 401(k) Plan(Catch-up eligible)

• SE income (after ½ SE tax deduction) $ 50,000

• Reduce by PS contribution (10,000)• Income for plan purposes 40,000• PS contribution

(deduction limit 25% of $40,000) 10,000• 401(k) contribution 23,000• Total plan contribution $ 33,000• Comp for plan purposes net of ½ SE

deduction & cont to plan [IRC 401(c)(2)] 108

Single Life DB Plan – Prior years define comp

• Example– Self-employed consultant, age 55– Prior to 2014 net Schedule C $100K annually (at least 3 years)– Retired from large company, spouse works, doesn’t need money– Incorporates in 2014– With average compensation of $100K, DB plan could easily create a

deduction of $100K• Prior employer earnings count where continuation of same employer

(Lear Eye Clinic TC 6/10/96; Reg. §§ 1.415(b)-1(g)(2)(ii)(B) & 1.415(f)-1(c)(2) )

– Reasonable compensation issue? – see Reg. §1.404(a)-1(b) – All SE and (current) income taxes on this income eliminated

109

Husband & Wife 401(k) Plan(Both Catch-up eligible)

110

Earn-ings

ProfitSharin

g401k

Catch-

upTotal

W $ 200K

$ 34.5K

$ 17.5K

$ 5.5K

$57.5K

H 76K 34.5K

17.5K

5.5K

57.5K

Tot $ 276K

$ 69K $ 35K $11K $115KPS deduction 25% of $276K = $69K; OK that H over 25%

Husband & Wife DB Plan

111

Age Earnin

gs

Age 62

Ben.LS Contributi

on

W 52 $ 200K $ 200K

$ 2,484K

$ 151K

H 55 76K 76K 921K

94K

Tot $ 276K $ 245K

Husband & Wife DB Planwith 401(k) Plan + 6% PS

Combined plan deduction limit? No, DC < 6% comp

112

Earnings

DBContributi

on401(k)

ProfitSharin

gTotal

W $ 200K

$ 151K

$ 23K $12K $186K

H 76K 94K

23K 4K 121K

Tot

$ 276K

$ 245K

$ 46.K

$16K $307K

Husband & Wife DB Planwith Employees

113

Age Earning

s

Age 62Ben. Cost

W 52 $ 200K $ 200K $ 151K

H 55 76K 76K 94K

E1 43 50K 50K 32K

E2 26 30K 30K 8K

Tot $ 356K

$ 285K

Husband & Wife DB PlanPSP for Employees

114

EarningsAge 62

Ben. DB Cost PS Total

W $ 200K $ 200K $ 151K $151K

H 76K 76K 94K 94K

E1 50K 5K 5K

E2 30K 3K 3K

Tot $ 356K $ 245K $ 8K $253K

Husband & Wife DB PlanPSP for Employees

• Saves $32,000 from DB only• 50% of employees covered by DB plan

– 40% participation rule of IRC §401(a)(26) passed• 100% of NHCs covered by combined plans

– Employer contributions under profit sharing plan and benefits provided under DB plan treated as though provided under single plan [Treas. Regs. §§1.410(b)-7(d) and 1.401(a)(4)-9(b)]

– Testing would prove NHCs have benefits comparable to HCEs

• 25% combined plan deduction limit under IRC §404(a)(7) applicable?– No; no common participation (i.e. no one benefits

in both)115

Retirement Planning Fun Facts

Kevin J. Donovan, CPA, EA, MSPA

[email protected]

116

mailto:[email protected]

Deductions / Funding• IRC §404(a)(6)

– “… a taxpayer shall be deemed to have made a payment on the last day of the preceding taxable year if the payment is on account of such taxable year and is made not later than the time prescribed by law for filing the return for such taxable year (including extensions thereof).”

– See also Revenue Ruling 76-28– Most of us know this rule – we have to deposit the money

before the due date of the tax return • Not before return filed - Revenue Rulings 66-144 / 84-18• Could even file before original due date if first extended• Useful e.g., where client wants to use tax refund to fund

117

Deductions / Funding

• IRC §430(j)(1)– “… the due date for any payment of any minimum

required contribution for any plan year shall be 8-1/2 months after the close of the plan year.”

– minimum required contribution is the amount that needs to be funded into a pension plan for a plan year [IRC §430(a)]

• defined benefit or money purchase plans – There is no weekend relief for this rule

• i.e. if 15th on weekend then deposit still due on 15th • or in reality previous Friday

118

Deductions / Funding

• IRC §§4971(a)(1) / 4971(c)(4)– “… there is hereby imposed for the taxable year a tax equal to …10

percent of the aggregate unpaid minimum required contributions for all plan years remaining unpaid as of the end of any plan year …”

– “The term unpaid minimum required contribution means … any minimum required contribution … not paid on or before the due date (as determined under section 430(j)(1)) …”

• Sole props– Return can be extended to 10/15– Minimum required contribution still due 9/15!!

119

DC Plans / Maximum contribution• IRC §415(a)(1)(B)

– “A trust which is a part of a … plan shall not constitute a qualified trust … if … (B) in the case of a defined contribution plan, contributions … with respect to any participant … exceed the limitation of subsection (c)”

• IRC §415(c)(1)– “Contributions … with respect to a participant exceed the limitation of this

subsection if … greater than the lesser of (A) $40,000 or (B) 100 percent of the participant's compensation”

– Includes SEP contributions; Reg. §1.415(c)-1(a)(2)(i)(c)• IRC §415(d)(1)(B)

– “The Secretary shall adjust annually … (B) the ... amount in subsection (c)(1) ..”– $52,000 for 2014

• IRC §415(f)(1)(B)– “For purposes of applying the limitations of subsection … (c) … (B) all defined

contribution plans … of an employer are to be treated as one … plan”• So this a plan/employer limit not an individual’s limit

– Dr leaves group A and joins Group B – as long as they’re not related Dr can maximize his/her 415(c) limit in both plans

120

Simplified Employee Pensions (SEPs)• IRC §402(h)(2)

– “Contributions made by an employer to a simplified employee pension with respect to an employee … shall be treated as distributed … to such employee … to the extent such contributions exceed the lesser of - (A) 25 percent of … compensation … or (B) the limitation in effect under section 415(c) …”

• IRC §404(h)(1); (B) / (C)– “Employer contributions to a simplified employee pension shall be

treated as if they are made to a plan subject to the requirements of this section. Employer contributions to a simplified employee pension are subject to the following limitations …

– (B) Contributions shall be treated for purposes of this subsection as if they were made for a taxable year if … made not later than the time prescribed by law for filing the return … (including extensions thereof)

– (C) The amount deductible in a taxable year for a simplified employee pension shall not exceed 25 percent of the compensation paid to the employees …”

121

Self-employed Persons• IRC §401(c)(1)(A)

– “The term "employee" includes, for any taxable year, an individual who is a self-employed individual for such taxable year.”

– So, e.g., a plan (including a SEP or a SIMPLE) covering a partner must be sponsored by the entity, not the partner

• So your client can’t take his/her K-1 and do a SEP without considering the rest of the partners/employees of the partnership

• IRC §401(c)(2)(A)– “The term “earned income” means the net earnings from self-

employment … but such net earnings shall be determined …• (v) with regard to the deductions allowed by section 404 to

the taxpayer, and • (vi) with regard to the deduction allowed to the taxpayer by

section 164(f).”– Earned income is basis for deductions for SE persons; (v)

effectively reduces the 25% to 20% of pre-plan SE income122

Related Employers• IRC §414(b)

– “… all employees of all corporations which are members of a controlled group of corporations (within the meaning of section 1563(a) …) shall be treated as employed by a single employer…”

• Similar rules apply under IRC §§414(c) and 414(m) for unincorporated entities and certain service entities– So, e.g., multiple 415(c) limits discussed above won’t apply if a

physician leaves one group and joins another if the two groups are related under these sections – e.g., where two groups merge

– SIMPLE or SEP plans maintained by any member of a related group of employers must be maintained by all members

• Likely but not necessarily the case with other qualified plans

123

Contact Us

Beth A. Cooper, CRPS®Strategic Development [email protected](520) 906-4821

Beth A. Cooper, CRPS®Strategic Development [email protected](520) 906-4821

www.pinnacle-plan.com

http://www.pinnacle-plan.com/

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