Over the last few decades, 401(k) plans have become the primary pre-tax retirement vehicle. These balances, used in conjunction with personal savings and Social Security, are the foundation for post-retirement cash flow and sustainability for most employees.
When factoring Social Security benefits into a post-retirement equation however, it matters to know that there are limits to the monthly income available through the Social Security Administration. For 2020, that maximum is just over $3000 for those taking Social Security at Full Retirement Age, or FRA, and almost $3800 for those taking Social Security at age 70.
For company owners, the challenges of preparing well are more complex. Their income is typically greater, as are the demands on cash flow. Building a strong financial statement as an owner includes decisions around cash reserves for the business and income tax exposure, as well as prudent allocation of available resources, among others. With the diminishing impact of Social Security on their post-retirement cash flow, they are largely responsible for preparing for their own retirement or financial independence.
Retirement plan law acknowledges these challenges through flexibility in plan design, and by allowing combination plans. Plans can use Social Security Integration and New Comparability, among other design features, as a way to address the needs of owners. Owners can also establish combination plans, which fall into the broad categories of defined contribution plans, and defined benefit plans. To some definitions.
A defined contribution plan includes most of the types of retirement plans with which most of us are familiar. 401(k)’s, which are profit-sharing plans which allow employees to add their own funds, SEP IRAs, Money Purchase Plans, SIMPLE IRAs, and so on, are all defined contribution plans. The contribution is defined as a percentage of something, typically compensation or payroll, up to an overall dollar limit. There are no promises of future benefits, simply the option of making contributions now, and in a way that allows participants to know their account value on a daily basis. The adoption of a defined contribution plan does not create a future liability for an employer, although there is significant liability regarding prudent plan management.
A defined benefit plan, by contrast, is completely employer funded, has no daily valuation feature, and promises certain future income benefits to qualifying employees, based primarily on compensation and length of service to the employer. Think of the classic pension plan. The adoption of a defined benefit plan does create a future liability for the employer, as by adoption of the plan, the employer is promising certain income amounts to qualifying employees, at some point in the future, typically Normal Retirement Age, or NRA. For most plans, this is age 65.
A defined benefit plan uses the services of an actuary. The actuary will calculate, based on census data (age and length of service of employees), plan formulas and mortality, morbidity, and interest rate assumptions, the range of contributions or deposits needed in a given year, to fund the future liability. The older the employee population, the greater the current tax-deductible contribution needed to fund the future liability.
Retirement plan law allows employers to adopt both a defined contribution and a defined benefit plan. What seems to work best is a profit-sharing plan with a 401(k) feature, combined with a defined benefit plan. In order for the combination plan to work well, the employer needs to be committed to either a generous match, or a discretionary profit-sharing plan contribution, or both. When this is the case, we have found that very high percentages of the defined benefit, sometimes as much as 95%, accrue for benefit of company owners.
The integration formulas between match, discretionary profit-sharing, and defined benefit contribution ranges very greatly, based on the specific census demographics of the company or sponsoring employer. Therefore, any attempt at an example would be misleading, in our opinion.
Experience tells us that a best fit for a combination plan is a company with recurring revenue from installed service agreements. This revenue is often referred to as Monthly Recurring Revenue, or MRR. We have found it in firms as diverse as engineering services, public relations, and IT Managed Service Providers, or MSPs, among others. It is best if owners are at or over 50 years old. It is also ideal if they have the flexibility to assign themselves earned income of up to $285,000, which is the current earned income limit which can be taken into account for retirement plan design purposes.
Medical practices often use combination plans. We are aware of one medical practice who has a 401(k) match for employees and makes an annual discretionary profit-sharing contribution. In each of the last two years, contributions to the defined benefit plan have been more than $500,000, 95% of which benefit accrues to the doctor who owns the practice.
Combination plans aren’t for every company. However, in the right circumstances, they can reduce tax burdens significantly, allow owners to prepare well for their own future, and give employees a generous retirement benefit. We have significant experience in complex plan design and would be pleased to discuss options with you, if you would like to explore these ideas.