T or F: For 2015 and 2016, everyone can contribute up to $18,000 to their 401K, and those aged 50 or older can contribute up to $24,000. FALSE
“In a lot of cases, we see situations where the (401K) plans are not designed in a way where more highly compensated individuals can take full advantage of the benefits,” said Steven Glasgow, a senior vice president with Avondale Partners’ Wealth & Asset Management Group, which serves clients across the country.
When 401K plans were being created, Glasgow continued, they were designed with certain tests in place to ensure a company’s plan didn’t intentionally discriminate against employees at lower income levels. “If they have a population of employees who are not contributing enough as a percentage of their total income, then you have a testing issue,” Glasgow said, adding that could block higher earners from being allowed to fully contribute. “It’s an incentive to design plans to encourage participation by the non-highly compensated employees, and if they don’t do so, it limits the ability of everyone else to use the plan.”
Typically, administrators will run year-end test calculations to ascertain whether the plan met its threshold or whether highly compensated employees have contributed too much. If some employees are found to have excess contributions, Glasgow said, “then they have to file an amended tax return and take the money back out. That’s never a happy moment for anybody.”
Avoiding the Amended Tax Return
Glasgow, who has 20 years of experience working with individual and institutional investors, focuses his expertise in the areas of defined contribution plans, defined benefit plans, endowments and foundations. He said there are ways to address the funding issue and help high income individuals adequately save for retirement.
The first option, he noted, is to change the plan design so that it becomes more generous for non-highly compensated individuals. Switching to a safe harbor plan allows companies to eliminate testing. However, it does cost more from the company, health system or practice perspective.
“So it raises the question, ‘does it make more sense to increase your benefit plan?’ Most often, the answer is ‘yes.’” Glasgow said. He added a qualified financial advisor could put pencil to paper to help an employer weigh the costs and benefits of such a plan. In addition to some long-term financial advantages to the decision, Glasgow added a richer benefit plan could also help attract and retain talent in a competitive marketplace.
“The other thing you can do in some cases … not all … is to put a non-qualified plan in place to supplement the 401K,” he continued. “It’s a plan specifically designed for highly compensated people.”
In this scenario, the higher income earner could take excess contributions and put the money in the non-qualified plan. In fact, it can be set up so that excess contributions automatically spill over into the non-qualified plan, eliminating the need to file an amended tax return. In addition, the company is free to add ‘bells and whistles’ such as contributing on an employees’ behalf to sweeten the pot.
“It can be structured in a lot of ways,” noted Glasgow, “but it’s not governed by the Department of Labor and ERISA law like your 401K is.”
The downside of that is money in a non-qualified plan is an asset on the corporate balance sheet. If creditors come after the company or health system, money in the non-qualified plan is fair game so employees could lose their contributions.
“That can’t happen in a 401K,” Glasgow stressed. “It’s absolutely free and clear from the company balance sheet.”
Profit Sharing
“With a physician practice, you have an interesting situation where you have a high concentration of high income earners,” Glasgow said.
In the case of professional services groups – which could include attorneys and accounts, in addition to physicians – Glasgow said it’s common to have a profit sharing plan as the second part of the overall retirement benefit. In combination with a 401K plan, individuals could defer up to $53,000 in income (for 2015 and 2016) to lessen their current tax burden.
“For those profit sharing plans to pass muster, the owners actually have to contribute additional money on behalf of the non-highly compensated employees,” Glasgow added, noting hourly employees must have access to the profit sharing plan, as well.
Defined Benefit
“If you really want to turbo charge your contributions, there is something called a cash balance defined benefit plan,” Glasgow said. “In this case, in addition to the $53,000 you’ve already put away (through 401K and profit sharing), you could … depending on your age and income … put away an additional $294,000 pre-tax.”
The closer to retirement, the more an individual is allowed to contribute. Glasgow said it isn’t unusual to see a 68-year-old put in the max amount. “You can use this as a way to manage your adjusted gross income,” he pointed out, adding minimizing tax liability and building a nest egg is often more important than take-home pay as retirement nears. Like a 401K, the cash balance defined plan is very safe and is kept in a segregated trust governed by ERISA laws.
While this plan could work for any size practice, Glasgow said it is particularly interesting for larger practices. “It’s worth exploring and having a conversation about,” he noted. However, Glasgow cautioned, setting it up is tricky so those considering the option should consult with a qualified financial advisor.
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