The goal of many small retirement plans sponsored by small businesses is to maximize benefits to the owner while minimizing the cost of employees. Since contributions are based on benefits, and benefits are based on compensation, contributions depend on compensation. If there are no employees, the question frequently boils down to "What is the minimum compensation to get the maximum contribution?"
The Tax Code imposes numerous limits on various aspects of retirement plans in order for them to qualify for special tax treatments. Some of the limits that impact the current discussion are:
the 415 %-limit that ties the maximum benefit level directly to a person's pay
the 415 $-limit that puts an absolute limit on a person's maximum benefit
For Defined Contribution plans, two basic limits are placed on the maximum allocation a participant can receive in their account, and these limits directly impact the contribution that the employer can make:
415 %-limit: the contribution cannot exceed 100% of Current Compensation.
However, only 25% of Covered Payroll can be deducted by the employer (this is the 404 limit), so for a small group of employees, the effective contribution limit for each individual is closer to 25% of current compensation.
415 $-limit: the contribution cannot exceed a specified dollar amount:
Effectively, then, for an entrepreneur without employees to contribute the maximum amount to a Defined Contribution Plan in 2005, he/she needs one of the following:
$28,000 (= $112,000 x 25%) as a Profit Sharing contribution
+ $14,000 401(k) deferral
= $42,000 total
If there are employees, the question of minimizing employee cost comes into play.
Defined Benefit Plans
For Defined Benefit plans the two basic 415 Limits are placed on the projected amount of benefit payable annually at retirement age, and so the effect on an employer's current contribution level is indirect:
actuarial reduction for retirement ages lower than 62
actuarial increase for retirement ages after 65
adjustment for certain forms of payment
Once the Maximum Benefit is determined based on the above limits, the Actuary determines the actual contribution required and/or deductible for the year.
Our calculator DBQuickQuote on our home page provides the Maximum Contribution to a Defined Benefit Plan for an individual at any given age, pay, and service.
The related question, "What is the minimum compensation to get the maximum contribution?" depends on the entrepreneur's age and how long they have been in business when they decide to establish the plan. The answer to this question has led to our highly referenced DBMinMax Table:
The columns in this table are as follows:
Rounded Starting Age - the entrepreneur's age at beginning of year
Retirement Age - the projected retirement age, chosen so as to produce the Maximum Contribution amount
Maximum Defined Benefit Contribution - this is the maximum possible contribution for the age, but is dependent on adequate compensation to support the benefit that is being projected
Minimum W-2 Compensation - the least amount of pay needed to support the contribution amount shown; but see discussion below regarding substitution of past pay history
if there is a significant past pay history, however, current compensation may not be needed
Contribution as % of W-2 - this percentage shows the potential power of Defined Benefit Plans: it is possible for an entrepreneur's plan contribution to exceed their compensation
Minimum Net Schedule C if Sole-Proprietor - for the Self-Employed, this amount applies instead of W-2 Compensation (see Compensation Used In Plans for more discussion)
Contribution as % of Net Schedule C - this percent shows the how much of current business earnings can be put into a Defined Benefit Plan; but see discussion below regarding substitution of past pay history
the remaining columns (not shown above) show a brief comparison of the maximum Profit Sharing Plan contribution based on the W-2 compensation discussed above.
Example: an individual age 50 can contribute $168,184 (2004 table) to a new plan if they have W-2 Compensation of at least $143,208 or Net Schedule C earnings of at least $321,142.
The specifics of this determination varies after the initial year, so w e also provide the answer to this question ("What is the minimum compensation to get the maximum contribution?") annually for our clients in their annual reports. This information enables our clients to manage their cash flow while still being able to make the maximum contribution to their plans.
Note that because Defined Benefit Plan formulas are generally based on 3-year average pay rather than just current pay, the discussion above needs to be modified. The article on 3-Year Average Pay Power discusses in greater detail how a person's past pay history can be substituted for current pay. This means that it is actually possible for a large retirement plan contribution to be made when W-2 compensation is $0.
Minimizing Cost of Employees
While there are various means by which employee costs can be minimized, many of which are discussed elsewhere (such as Integrated Formulas,New Comparability Plans, and General Nondiscrimination Tests), in almost every case the cost of employees can be reduced by increasing the compensation paid to the owner(s). T his is because nondiscrimination tests and requirements are based on percentages of pay. Hence, through proper plan design, the higher the entrepreneur's pay, the lower the cost of employees. There is, however, a maximum Considered Compensation limit above which pay cannot be counted, so it does not help to raise their pay any higher. For 2005 the compensation limit is $210,000.
All of this discussion is particularly relevant for an S-Corp, but also for other situations where some control can be exercised over compensation.
Profit Sharing Plans
If there are employees in the Profit Sharing Plan, they must receive a benefit that is proportionate to the owner's benefit. So, while $168,000 pay would permit the owner to make a $42,000 contribution to their own account in a Profit Sharing Plan, it would also require the maximum cost for each additional employee who participates in the plan. In order to minimize the employee costs, it is advisable for the owner to increase their own pay, if cash flow permits, up to $210,000 for 2005. This is because:
By increasing pay to $210,000, the percentage of their maximum contribution drops from 25% down to 20% (=$42,000/$210,000), so the percentage for employee contributions could similarly be reduced.
For the 401(k) Plan option, the owner should still increase their own pay up to $210,000 if cash flow permits. However, they cannot necessarily count on making the full $14,000 deferral, because 401(k) deferrals are subject to special nondiscrimination tests that compare the deferral for Highly Compensated Employees against the deferral rate for Non-Highly Compensated Employees. For the moment, suppose that the owner is permitted to make a $10,000 401(k) deferral, then a $32,000 Profit Sharing contribution would bring him/her up to the maximum total amount.
This $32,000 Profit Sharing allocation would be about 15.238% of pay (=$32,000/$210,000).
There are also other dynamics at play, such as matching contributions, which are considered in greater detail elsewhere.
Defined Benefit Plans
For Defined Benefit Plans, the same principle holds true. Suppose that the owner's Maximum Contribution level can be attained by a salary of $105,108. By instead taking a salary of $210,000, essentially doubling his/her pay, the plan formula can be cut in half and the savings in employee costs may also be cut in half. Specific illustrations can be run on our forthcoming DBIllustrator or by requesting them directly.
Special Limit for Sole-Proprietors
It is a general principle that no retirement plan contribution can put a Sole-Proprietor into a loss position with respect to his/her Schedule C earnings. That is, the contribution deducted is limited to the Net Schedule C earnings - 1/2 SE Tax. If this amount is actually deducted, it leaves the current Considered Compensation for the year equal to $0. This rule actually only comes into play with respect to Defined Benefit Plans.
After all, Defined Contribution Plans always needs current compenation to support the contribution, and no more than 25% of considered compensation can be deducted anyway. That means that the minimum taxable income after deducting the contribution is always at least 4 times the amount of the contribution that was deducted.
For a Defined Benefit Plan, however, if a high 3-year average pay has been established based on the owner's past pay history (see the article on 3-Year Average Pay Power), it is quite possible to generate a contribution requirement that exceeds the current Schedule C earnings. The amount that is to be deducted is the Net Schedule C earnings - 1/2 SE Tax.
The good news regarding this limitation is that, unlike the section 404 Limit on deductibility, if the Sole-Proprietor makes a required contribution that exceeds this secondary limit, no excise penalty tax applies to the nondeductible portion of the contribution.