Executive benefits design and savings capacity

In a previous article, we discussed the employee census and the importance of this report for a business owner in terms of its impact on plan design. Now, we want to educate you on qualified plans and how they can be designed to benefit the business owner and drive capacity for alternative investments in a tax-favored environment.

Remember as we lay out these options that a sole proprietorship, single-member LLC and contract worker all qualify for most of these benefits. There are many savings plans allowed by the IRS, and this article will focus on each one and its potential savings capacity. In future articles, we will highlight the specific details of each plan.

First, let's begin with the two types of savings plan chassis. Retirement savings plans typically are designed as a defined contribution plan (DC plan) or a defined benefit plan (DB plan).

A DC plan has limits on the contributions that can be saved on an annual basis. While DC plans are the most common type of retirement savings vehicle, they also may have lower savings thresholds than a DB plan can offer.

Meanwhile, a DB plan has a specific benefit or income goal that will determine the funding amount, based on factors like age, income, benefit target and duration. These plans can allow for significant tax deferral amounts – often exceeding six figures.

Now, let’s highlight the types of plans that fall into each of these two categories.

Defined contribution (DC) plans

401(k) and solo 401(k) plans quickly have become the most popular retirement plans. There are many benefits to this type of plan, including increasing savings capacity. The maximum amount that can be personally deferred inside a 401(k) for 2020 is $19,500 for individuals under age 50 and $26,000 for individuals 50 and older. These plans often are combined with profit-sharing plans to drive the annual capacity to $57,000 for participants under age 50 and $63,500 for participants 50 and older.

Simplified employee pension (SEP-IRA) plans still are a popular plan type, given their low administrative costs. However, they lack the flexibility and features of the 401(k) and become more expensive as you add employees to your plan. Still, a SEP does have the potential to allow for significant savings. The contributions made to a SEP-IRA each year cannot exceed the lesser of the following: 1) 25% of compensation; or 2) $57,000 (for 2020; subject to annual cost of living adjustments for later years).

Savings incentive match plans for employees (SIMPLE IRAs) are exactly as their name implies: Simple to set up and manage. There is no cost to implement a SIMPLE IRA, and it can be done quickly, with no annual administrative costs. However, SIMPLE IRAs also have the lowest funding limits of all the DC plans. Salary contributions cannot exceed $13,500 for individuals under age 50 and $16,500 for individuals 50 and over. The company also is required to contribute fully vested matching funds, dollar for dollar, on the first 3% of compensation deferred or a 2% flat contribution for all eligible participants across the board.

Profit-sharing and money purchase plans both are add-on plans that complement a 401(k) to help increase contribution limits. Profit-sharing plans are more flexible and can be funded in profitable years and shut off after a nonprofitable year. Contribution amounts depend on profitability but cannot exceed the lesser of the following: 1) 25% of an individual’s compensation; or 2) $57,000 (for 2020). A money purchase plan has a more rigid set of rules. Contributions are required every year, regardless of profitability, and the contributions are a fixed percentage that is determined when the plan is implemented. As with a profit-sharing plan, money purchase plan contributions cannot exceed the lesser of the following: 1) 25% of an individual’s compensation; or 2) $57,000 (for 2020).

Defined benefit (DB) plans

Plan contributions are made by the employer and are determined by the retirement benefit target for each employee at a future date. This often allows for much larger contribution levels, dictated by the plan assumptions, plan census and funding vehicles. These plans also can be combined effectively with defined contribution plans, driving overall contributions to the business owner’s account into the mid-six figures with regularity. The guarantee of a monetary benefit in either a lump sum or annual income makes the underlying asset options an important choice. Many plans use a guaranteed asset to move the risk of funding a benefit away from the business and onto the investment firm. Though rare in our current times, these plans quickly are becoming popular once again and are a great option for the right business profile.

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Brickhouse Consulting (brickhouse-consulting.com) is a fee-only consulting firm with expertise in advanced financial planning strategies for business owners and sole practitioners. We focus our financial expertise on educating clients about opportunities for tax-efficient retirement savings and income plans and how those plans integrate into their exit or succession plan. As part of our services, we mathematically model scenarios to demonstrate the effects of varying strategies and help clients select a strategy for implementation. For information or to schedule a free videoconference introduction, send an email to info@brickhouse-consulting.com.