The "Perfect" Retirement Plan for Small Businesses

For years I have advised clients they should be wary of adopting a "cookie-cutter" retirement plan. What a plan says or doesn’t say in the fine print can make a big difference in plan administration and cost. So, how can I now write about the “perfect” retirement plan for small business, as though one size fits all?

Notice the word perfect is in quotes. There really isn't a plan design that will fit every small business. However, I have concluded there is a basic plan format that meets the needs of small businesses most of the time.

A couple more points before I reveal the "perfect" plan. First, this doesn't include Defined Benefit Pension Plans or Employee Stock Ownership Plans. There certainly is a right time and place for those plans in some small businesses, but not in this article. Second, what I mean by "small business" is not based on the number of employees working for an enterprise. Instead, I am referring to a successful business with a working owner, no matter how many other employees are involved.

Working owners are very consistent in what they want from a retirement plan. First, they want to contribute larger amounts for themselves than for other employees. (There is absolutely nothing wrong with that. They have their capital invested in the business and they bear the financial risk, so they should also receive the highest reward.) Since the law requires a plan covering an owner to make nondiscriminatory contributions for other employees as well, let’s assume that a range of 3 percent to 5 percent of pay is an acceptable expense. Second, owners want a plan that allows contributions in good years, but does not require contributions when cash is unavailable. Third, they want a plan that is simple to administer. (Well, good luck! We are talking about tax laws regulated by the IRS.) The “perfect” plan design does allow simpler administration than some other plans, because it eliminates a few of the complicated testing requirements. Finally, they want the plan to be inexpensive. (Will you settle for three out of four?)

The "perfect" plan design can be implemented by using the Warner Norcross & Judd Volume Submitter Plan, which is a cost-effective way to provide an individually designed plan.

OK, now that I’ve built up the suspense, here is the "perfect" plan design for small business: A "Cross-Tested Safe Harbor 401(k) Profit-Sharing Plan." I know that's a mouthful, so I’ll break it down into its various parts. A few of you already have this design, but most of you do not. Let's examine why this is the "perfect" plan for small business.

Profit-Sharing Plan

I use a profit-sharing plan as the base for the "perfect" plan, because there is no obligation to make a contribution. Contributions are discretionary. When cash is available, the "perfect" plan will allow contributions for the owner up to $46,000 in 2008 ($51,000 if the owner is at least age 50). And, of course, all of the contributions are tax deductible to the business and tax deferred for the owner and other employees. (Notice the "perfect" plan is not based on a SEP, a SIMPLE or an IRA, which are "model" plans offered by Congress and touted by the IRS as "easy" and "cheap." If the IRS says something is good for you, you better start running!)

401(k) Plan

The profit-sharing plan in the "perfect" design is a 401(k) plan. (Let me stop for a moment and explain there is really no such thing as a "401(k) plan." This is a misnomer.) Section 401(k) of the tax law describes a special provision that may be added to a profit-sharing plan to allow participants to reduce their pay and have the reduction contributed to the plan on a pre-tax basis. Now that I've cleared that up, I will also refer to our "perfect" plan as a 401(k) plan, just like everyone else.

Safe Harbor Plan

Unlike a standard 401(k) plan, which limits the amount an owner can reduce his or her pay by looking at the amount contributed by other employees, the "perfect" plan ignores that comparison completely. Instead, in a year the owner wants to make contributions the employer will contribute 3 percent of pay to the plan for all participants. This 3 percent contribution is 100 percent vested, and is called a safe harbor contribution. The safe harbor contribution allows the owner to contribute the maximum amount to the 401(k) part of the plan ($15,500 for 2008, or $20,500 if the owner is at least age 50). This amount can be contributed by the owner even if the other employees contribute nothing. It just doesn't matter what they do. There are other types of safe harbor 401(k) plans, but the "perfect" plan uses the 3 percent safe harbor contribution because, as you will see later, the 3 percent can actually do triple duty under the "perfect" plan.

Cross-Tested Plan

OK, this is the one part of the “perfect” plan design that gets a bit complicated. With a typical profit-sharing plan each eligible participant gets a contribution equal to the same percentage of pay. For example, if the employer contributes 5 percent of pay, that is what each eligible participant receives. A $25,000 employee gets $1,250. A $230,000 (or more) employee (which is the maximum compensation that can be considered by a plan for 2008) gets $11,500. However, if a profit-sharing plan is "cross-tested," it is very possible the owner will receive a much larger contribution. I won't try to describe how cross-testing is accomplished, but it does work and the IRS has approved it.

Generally, if the owner is older than the average age of other employees in the plan, which is typical, cross-testing will allow a larger contribution for the owner. The more difference in age, the greater the disparity in contributions can be.

A few years ago the IRS issued a rule requiring a minimum contribution for employees if cross-testing is used to increase the owner's contribution. This rule requires that employees receive at least the smaller of one-third the percentage of pay contributed as a profit-sharing contribution for the owner, or 5 percent of pay.

Remember our 3 percent safe harbor contribution? Well, you can count that as a profit-sharing contribution for the employees in a cross-tested plan. So now that 3 percent has done double duty. First, it allows the owner to contribute the maximum 401(k) amount for the year. Second, it counts as a 3 percent profit-sharing contribution. In our "perfect" plan, the profit-sharing contribution for the owner (assuming the age difference is present) can be 9 percent of pay. The 3 percent contribution for employees is one-third of the 9 percent for the owner, so the minimum cross-tested contribution rule is met.

Under the "perfect" plan, our owner has made the maximum 401(k) contribution of $15,500 (or $20,500) and has received a profit-sharing contribution of $20,700 (9 percent of $230,000). This is a total of $36,200 (or $41,200) for the owner, at a cost of only 3 percent of pay for other employees.

If the owner wants to reach the maximum $46,000 (or $51,000), an additional contribution of $9,800 will be necessary. This would give the owner a profit-sharing contribution of $30,500, or approximately 13.26 percent of $230,000. To meet the one-third rule, the profit-sharing contribution for employees would need to be about 4.42 percent. Since they've already received 3 percent of pay, only an additional 1.42 percent is required. Our owner now has made a 401(k) contribution of $15,500 (or $20,500), and received a profit-sharing contribution of $30,500, for a total of $46,000 (or $51,000). The cost for employees is only about 4.42 percent, and that amount is tax deductible so the after-tax cost is even less.

If we are piling up cash for the owner at this rate, won't the plan be "top-heavy?" (A plan is top-heavy if more than 60 percent of the benefits are held for key employees). I certainly hope so! That's exactly what we are trying to achieve. Under the "perfect" plan design, it doesn’t matter. If the plan is top-heavy the employer must make a minimum 3 percent contribution for employees. Does that amount sound familiar? Yep, you got it. The same 3 percent that allowed the owner to contribute the maximum 401(k) contribution, and allowed the owner to make a substantial profit-sharing contribution using cross-testing, can also be used as the minimum top-heavy contribution. Now the 3 percent has done triple duty. That's a lot of mileage from a single contribution of 3 percent of pay.

Is this really a "perfect" plan design for small business? In many if not most cases, the answer is yes. However, not in every situation. There are many variables. For example, instead of one owner, what if there are two or more? What if the ages of the multiple owners are substantially different? What if the owner's spouse or kids also work in the business? These are facts that may require us to alter the design a bit, but the "perfect" plan design is still available in these situations.

So how can you establish the "perfect" plan? Well, one way is by using the Warner Norcross & Judd Volume Submitter Plan. We have received IRS approval of our Volume Submitter Plan, and it is flexible enough to install a "perfect" plan. Over the next two years our clients will need to update their profit-sharing plans and 401(k) plans by adopting the Volume Submitter Plan. This may be the "perfect" time to consider a "perfect" plan for your small business.