RSM Resources

Many owners of small and midsized businesses, as well as professional practices, face a dilemma as they prepare for retirement: They need to make larger contributions to their tax-qualified retirement plan to meet their future retirement objectives.

Traditional retirement plans seem unaffordable because the contribution costs to cover other eligible employees can be relatively high. Fortunately, tax-qualified retirement plans can be customized to maximize contributions and benefits for owners while controlling the cost of covering other eligible employees.

To illustrate some plan design ideas let’s look at ABC Radiologists, a small, closely held professional corporation owned by doctors Adams, Baker and Cox. The practice comprises of the three doctors and 23 additional employees, ranging from ages 21 to 60. The doctors, ages 50, 49 and 40, each receive a base salary of $250,000. ABC Radiologists usually realizes a large profit at the end of the year, which can be used for partner bonuses and retirement plan contributions. Total annual compensation for staff is $827,000.

ABC Radiologists has a traditional profit sharing plan and a safe harbor 401(k) plan. Under the terms of the profit sharing plan, the company decides annually what amount, if any, to contribute to the plan. The employer contribution is allocated among all participants in proportion to their pay. Due to IRS limitations, the plan can only recognize $230,000 of each partner’s compensation when calculating contributions and retirement benefits in 2008. Therefore, total annual compensation of all plan participants, including $690,000 in partner compensation, is $1,517,000.

A class-based profit sharing plan and a safe harbor 401(k) plan
This allocation method works only with certain group demographics. Highly compensated employees targeted for higher profit sharing contribution rates must be older, on average, than other participants. The demographics of ABC Radiologists make it possible to provide the partners with the maximum $46,000 annual contribution through 401(k) salary deferrals and profit sharing contributions. This design reduces the contribution rate for staff from as much as $165,400 (20 percent of pay) to $41,350 (5.0 percent of pay), a savings of $124,050. As with any allocation method, the determination of contributions cannot discriminate in favor of highly compensated employees.

This plan design illustrates customizing contribution rates under 401(k) and profit sharing defined contribution plans. The maximum total annual contribution for defined contribution plans is $46,000 for those under age 50 and $51,000 (including catch-up contributions) for those ages 50 or older. Based on current salaries, these amounts would probably not meet the partners’ retirement needs, even with possible future cost of living increases.

Increasing partner contributions by adding a defined benefit pension plan
ABC Radiologists could adopt a defined benefit pension plan in addition to the 401(k) and profit sharing plans. The new plan design would provide maximum allowable benefits for the partners while providing modest benefits to all other staff members. The 401(k) and profit sharing plans provide salary deferral contributions for the partners and the staff, plus a profit sharing contribution for the staff of 5 percent of pay. By adding the defined benefit plan, partner contributions total $330,500, compared to $143,000 under the original profit sharing plan, an increase of $207,300. The cost of covering the staff in both plans is 9.0 percent of staff payroll, or $74,000. Adding a defined benefit plan increases the total amount of tax deductible contributions and provides greater leverage for the owners. This tax savings would more than offset the cost of additional contributions for the staff.

The defined benefit plan is structured to provide each partner with the maximum allowable benefit at age 62, currently a life annuity of $185,000 payable each year. The benefit would be equivalent to a lump sum of about $2,100,000 at age 62 and the doctors would continue to make contributions to their 401(k) and profit sharing plans. IRS regulations for combining a defined benefit and defined contribution plan also deem that contributions or benefits provided under the plans must not discriminate in favor of higher paid employees.

Daniel Long, QPFC, is a director with RSM McGladrey Retirement Resources. For more information, contact him at daniel.long@rsmi.com.