Change in Limits Increases Small Business Owner's Share of Pension Pie
"The Evolution of Plan Limits and Design from 2001 through 2005" - November 2, 2004
On October 20, 2004 the IRS announced the 2005 dollar limits on benefits and compensation for qualified retirement plans. Learn More
For very small employers (with 1-20 eligible employees and many larger ones too), the limit increases provide the opportunity for increased contributions for the business owner while either maintaining or even decreasing the cost to fund benefits for eligible employees.
If this statement seems to good to be true, it may be for those employers who are not taking advantage of currently available plan design, benefits and features ("optimal" plan design). But for those plans using "optimal" plan design, the 2005 increases provide yet another opportunity to increase contributions for the very small business owner while decreasing the cost to fund eligible employee benefits.
We consider the following limit increases in the plan design comparative analysis below:
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401(k) contribution limit from the lesser of 25% of compensation or $10,500 in 2001 to lesser of 100% of compensation or $14,000 in 2005 (as indexed);
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"Catch-up" contribution limit for those age 50+ from $0 in 2001 to $4,000 in 2005 (as indexed);
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Defined contribution maximum annual additions limit from the lesser of 25% of compensation or $35,000 in 2001 to the lesser of 100% of compensation or $42,000 in 2005 (as indexed);
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Maximum compensation limit from $170,000 in 2001 to $210,000 in 2005 (as indexed); and the
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Social Security Wage Base from $80,400 in 2001 to $90,000 in 2005 (as indexed)
Background
To appreciate the impact of the 2005 limit increases on plan design, let's look at where the limits have been in the recent past and where they are heading in the near future.
| 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | |
| 401(k) | $10,500 | $10,500 | $11,000 | $12,000 | $13,000 | $14,000 | $15,000* |
| "Catch-up" (50+) | N/A | N/A | $1,000 | $2,000 | $3,000 | $4,000 | $5,000* |
| Annual Additions | $30,000 | $35,000 | $40,000 | $40,000 | $41,000 | $42,000 | $43,000** |
| Compensation | $170,000 | $170,000 | $200,000 | $200,000 | $205,000 | $210,000 | $215,000** |
| Soc. Sec. Wage Base | $76,200 | $80,400 | $84,900 | $87,000 | $87,900 | $90,000 | $93,000** |
* Increase preset by EGTRRA law
**Projected increases subject to cost-of-living adjustment in minimum increments ($1,000 for Annual Additions Limit; $5,000 for Compensation Limit)
Case Study Profile
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Business Type: |
Professional Practice |
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Business Entity: |
Professional Corporation (P.C., Subchapter "C" Corporation) |
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Owner's Income: |
$300,000+ on W-2 as an employee of the P.C. |
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Owner's Age: |
55 in 200 5 |
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Employees: |
4 who are eligible to participate in the plan(s) |
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Plan Objective: |
Maximize contribution for business owner; minimize contributions to employees |
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This case study illustrates how changes in the limits impact the very small business owner's piece of the pension pie. It provides a comparison of "optimal" plan design features versus those conventional features typically used by employer's similar to the one featured in this case study. See Plan Design Analysis for background information and a discussion of available plan design features under prior versus current law. See Plan Design Information for specific features used in each plan design. The following is the employee census considered for the comparative plan design analysis shown below. For ease of illustration, employee salaries remain static for 2000-2004. Since the employee salaries are the same for both plan designs, the relative impact on the study is insignificant. |
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Employee Census |
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The below comparison illustrates how the change in limits effects the owner's share for a "conventional" plan design using the "integration w/Social Security" contribution allocation method versus the "optimal" plan design using the "cross-tested" contribution allocation method along with a "safe harbor" 401(k) feature. See Plan Design Information for specific features used in each plan design. |
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The Evolution of Plan Limits Conventional Plan Design versus "Optimal" Plan Design |
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Conventional Plan Design |
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"Optimal" Plan Design |
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Closing Commentary This case study demonstrates that the "optimal" plan design provides the very small business owner with a bigger piece of the pension pie (a higher percentage of the total employer contribution) regardless of the limits imposed by law. In fact, assuming that the employer uses the "optimal" plan design, the owner's piece of the pension pie will continue to increase in 2006 based on the increases resulting from cost-of-living adjustments to the defined contribution maximum annual additions limit and the annual compensation limit, and the preset increases to the 401(k) and catch-up limits. It should be noted that the results for the conventional plan design (using the integration with Social Security contribution allocation method) can be moderately improved by using a permitted disparity of 5.4% versus the 5.7% used in the case study. Also no salary increases are shown for the employees. This very slightly skews the results in favor of the business owner assuming that the employees actually received increases. Add Safe Harbor in any Event If the age differential between the employees and the business owner does not facilitate the use of the "cross-test" allocation method, the addition of the "Safe Harbor" 401(k) and "catch-up" features still dramatically improve the outcome for the small business owner for a plan using the integration with Social Security allocation method. Add Your Spouse to Your Plan If the business owner's spouse works for the employer, the "Safe Harbor" 401(k) and "catch-up" features will further enhance the plan design in favor of the business owner's family again whether or not the plan uses the "cross-test" or "integrated" contribution allocation method. Learn more about adding a working spouse to the employer's planFor plan year's 2001 through 2005, the "optimal" plan design provides the very small business owner with the maximum annual addition ($35,000-$42,000 plus $4,000 "catch-up") and the majority of total employer contribution while minimizing the contribution required to fund employee benefits. It is considered "tax-wise" since the tax savings on the total contribution far exceeds the plan's associated compliance fees and the cost to fund employee benefits. Bottom Line: The associated cost to hire a pension specialist to design, implement and administer the employer's plan is justified based on the benefit cost the employer saves for employees and the increase in contributions for the business owner.
Plan Design Analysis Prior to 2002, very small business owners with a desire to contribute the maximum contribution to a retirement plan typically sponsored two qualified retirement plans. A defined contribution pension plan (money purchase pension) that required an annual contribution of 10% and a profit sharing plan that allowed the discretion to contribute from 0% to 15% in any given year. The two plan approach permits the business owner to contribute the law's maximum deductible contribution equal to 25% of eligible employee compensation. However, the business owner was only obligated to contribute 10% of compensation to the pension plan in any given year since the profit sharing plan permits the discretion to contribute 0-15%. Employers with eligible employees also typically used the conventional plan design technique commonly referred to as "integration with Social Security." This technique permits the employer to allocate a higher percent contribution to those individuals whose compensation is in excess of the Social Security wage base. However, the "optimal" plan design prior to 2002 for many very small employers (with owners that were 5-10 years older than their employees) used a "cross-tested" or "new comparability" allocation method based on the proposed regulations for defined contribution plans that test non discrimination on a benefits basis (IRC §401(a)(4)). Also prior to 2002, the individual contribution allocation limit was the lesser of 25% of compensation or $35,000 in 200 and the compensation limit considered in determining the contribution was $170,000. Starting in 2002, the revised pension law and regulations provide the following:
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Plan Design Information 2001 Pension and Profit Sharing Plans - Conventional
2001 Pension and Profit Sharing w/"Safe Harbor" 401(k) Plans - "Optimal"
2002 Profit Sharing Plan - Conventional
New law $200,000 compensation
limit
New law 25% Profit Sharing maximum deduction
facilitates new law $40,000 annual additions limit absent Pension Plan
Profit Sharing is
"cross-tested" to provide owner only with 14.5% First 3% of Profit Sharing is 100% vested and triple counted as "Safe Harbor" 401(k); therefore, owner contributes $11,000 401(k) limit since no "ADP" test. New law $1,000 “Catch-up” 401(k) limit for those age 50+
New law $200,000 compensation limit
2003 Profit Sharing Plan
- Conventional
Profit Sharing $40,000 annual additions and $200,000 compensation limits 2003 Profit Sharing Plan w/"Safe Harbor" 401(k) - "Optimal"
2004 Profit Sharing Plan - Conventional
2004 Profit Sharing Plan w/"Safe Harbor" 401(k) - "Optimal"
First 3% of Profit Sharing is 100% vested and triple counted as "Safe Harbor" 401(k); therefore, owner contributes $13,000 401(k) limit since no "ADP" test. $3,000 “Catch-up” 401(k) limit for those age 50+ Annual additions limit subject to COLA increases to $41,000 Compensation limit subject to COLA increases to $205,000 2005 Profit Sharing Plan - Conventional
Annual additions limit subject to COLA increases to $42,000 Compensation limit subject to COLA increases to $210,000 2005 Profit Sharing Plan w/"Safe Harbor" 401(k) - "Optimal"
First 3% of Profit Sharing is 100% vested and triple counted as "Safe Harbor" 401(k); therefore, owner contributes $14,000 401(k) limit since no "ADP" test. $4,000 “Catch-up” 401(k) limit for those age 50+ Annual additions limit subject to COLA increases to $42,000 Compensation limit subject to COLA increases to $210,000 |
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© 2004 Milberg Consulting LLC All Rights Reserved We intend the information in this publication as a general resource, not as legal or plan compliance advice or counsel. If you consider any actions illustrated in this case study, we suggest that you consult a tax or ERISA professional. Milberg Consulting LLC and Barry R. Milberg do not warrant and are not responsible for any errors and omissions from this case study. |
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