At one time, operating pension and profit sharing plans was expensive and burdensome for entrepreneurs and owners of small businesses. No more. The employer no longer needs multiple plans to maximize his retirement contributions.
The Safe Harbor 401k. Employers looking to maximize their own contributions while minimizing the expense of running a plan, needn’t look further than the Safe Harbor 401k. The name refers to a feature that allows employers maximum salary deferral without fear the plan will be disqualified because it unduly favors highly compensated employees.
The Safe Harbor 401k is actually two plans in one—a salary deferral plan (401k) and a profit sharing plan. Assuming the employer chooses one of three safe harbor matching options, the employer can defer the maximum out of the first compensation he receives. Thus, in 2008, the first $15,500 earned by each owner or highly compensated employee ($20,500 for those over age 50) can be deferred into the plan. Later in the year, the employer can make contributions for all employees at a given percentage of salary.
In 2008, the maximum contribution for each employee from all plans is $46,000, or $51,000 for those over age 50.
The minimum cost approach. Let’s assume a husband and wife who own a business together and expect to have $400,000 available for their compensation in 2008. They have three eligible full-time employees whose salaries total $150,000 (excluding payroll taxes in both instances). The three safe harbor options require our owners to either: match one-for-one each dollar deferred by an employee up to 4 percent of salary; match 100 percent of the first 3 percent of salary and 50 percent of the next 2 percent of salary; or contribute 3 percent of salary for all eligible employees, whether or not they defer.
Whichever option our owners choose, the cost to match the employees contributions will be no greater than 4 percent of $150,000, or $6,000. If fewer than all employees elect to defer salary, or defer less than 4 percent, the cost of the match will be less. Employees under age 21 can be excluded, as well as part-timers working fewer than 1,000 hours per year. Under the first two options, no match is required for eligible employees who elect not to defer a portion of their salaries.
As for administrative costs, it’s reasonable to expect to pay about $1,500 to a third-party administrator (“TPA”) to set up the Safe Harbor 401k plan and perhaps $1,500 a year to handle the plan’s annual paperwork. Thus, after getting the plan up and running, the owners will pay about $7,500 a year to maintain it, $6,000 in employee matching contributions and $1,500 to the TPA. Of the funds remaining for owners’ compensation, the owners will each defer $21,500 for a total of $41,000. The business will then match these deferrals dollar-for-dollar up to a total of 4 percent of salary, or $15,700.
The owners’ deferred salary is free of income taxes. The matching contributions are free of current income taxes and payroll taxes. (Employer and employee must pay FICA and Medicare taxes on salary deferred into the plan). Let’s look at the math:
Administrative expense: $1,500
Employee deferral match: $6,000
Deferred owners’ salaries: $41,000
Owners’ deferral match: $15,700
Taxable owners’ income: $335,800
If our owners have a combined state and federal marginal tax rate of 35 percent, their deferrals and the plan expenses will lower their 2008 income tax bill by almost $22,500—three times the amount the plan reduces their potential compensation. And they’ll have put aside $56,700 to grow, tax-deferred until retirement.
Going to the max. How much more would it cost the owners to make the maximum contributions to their Safe Harbor 401k, assuming they’re both over age 50? In addition to the maximum deferral and the one-for-one match, they must use the plan’s profit sharing feature. But unlike the initial deferral and match, they don’t have to commit to the profit sharing contribution until late in the year when it’s clear there will be sufficient profits.
Our owners must put another $45,300 of their potential compensation into the plan to reach the maximum. To do this, they’ll cause the business to contribute a like percentage of salary for all plan participants, deferring or not. It turns out in our example that the profit sharing contribution rate for 2008 will be 12.1 percent of salary.
Let’s look at the math again.
Administrative expense: $1,500
Employee deferral match: $6,000
Employee profit sharing: $18,150
Deferred owners’ salaries: $41,000
Owners’ deferral match: $15,700
Owners’ profit sharing: $45,300
Taxable owners’ income: $272,350
Assuming the same 35 percent marginal tax rate, this will reduce the owners’ income tax by $44,600 compared to no plan, or $22,100 greater tax savings than the minimum cost approach. And the owners will have squirreled away $102,000 for the future.
So far, we’ve only looked at the owners’ direct self-interest. Salary deferral plans can also be popular with employees. While the safe harbor match vests immediately to each deferring employee, the owners can establish a multiyear vesting schedule for elective profit sharing contributions. Combine the deferral, matches and contributions, add in running the plan as a pooled investment with professional investment management paid for by the employer, and you have a powerful employee retention tool.
