Plan advisers have a new arrow in their quiver when it comes to wooing new employer clients: plan designs aimed at helping highly-paid personnel save even more for retirement.
These days, taxes are tougher for highly compensated individuals, due to the American Taxpayer Relief Act of 2012. Those
details bear repeating: If you are single and earn taxable income over $400,000 (or married-filing-jointly with more than $450,000), you'll be subject to a top marginal income tax rate of 39.6%, plus a top marginal tax rate of 20% for long-term capital gains, a 0.9% Medicare tax on wages and 3.8% levy on net investment income.
But there's a silver lining for business owners hitting that threshold: their 401(k) adviser can help craft additional retirement savings strategies within their company's retirement plan.
What's good for those highly paid employees is also good for the plan adviser. “The adviser is looking like a hero for bringing in the ability, if they can, to accelerate funding and reduce tax liabilities,” said Tom Zgainer, chief executive of America's Best 401(k).
Enter the cash balance pension plan and the profit-sharing plan, which can work alongside a 401(k). Tommy Horst, vice president of ERISA Services Inc., a fee-based third-party administrator, said that while 18 months ago only 1% of the plans his firm had worked with implemented cash balance plans as an additional savings vehicle, that number is now closer to 10% to 15%.
“The conversation is becoming more prevalent because of taxes,” Mr. Horst said.
Cash balance plans are defined benefit plans, meaning the investment risk is borne by the employer and not the participant. Employers make contributions that are based on the worker's age, tenure at the firm and pay. Participants are assigned a hypothetical account that receives an annual pay credit that's representative of a percentage of the worker's compensation, as well as an interest credit that can be linked to an index. When the worker is eligible to receive the benefit of the cash balance plan, he or she may receive a lump sum distribution, which can be rolled over elsewhere, or an annuity based on the account balance.
The older the participant, the more money can be stashed into the cash balance plan on his or her behalf.
From a tax perspective, business owners and highly-compensated individuals will find these plans interesting because they're allowed to save even more money on a pre-tax basis, which translates into lower income taxes today.
In 2014, the
IRS caps employee contributions to a 401(k) at $17,500 and defined contribution limits — the total of all contributions to DC plans, including profit-sharing — at $52,000. Supposing a 55-year-old is able to contribute the full $52,000, plus a cash balance contribution in 2014 of $179,338 and a catch-up contribution of $5,500, he or she could be saving as much as $236,838 with an additional tax savings of nearly $95,000, according to Mr. Zgainer.
There are also profit sharing plans, namely the cross-tested profit-sharing plan, which is engineered by an actuary to calculate a higher contribution percentage for older key employees, according to Samuel Brandwein, vice president and corporate client group director at Morgan Stanley. Profit sharing plans permit employers to kick in annual contributions on the behalf of workers; the choice of making the contribution is up to the employer and can hinge on the company's annual results.
“The cross-tested profit sharing plan is a well-known strategy for allocating profit-sharing contributions in a fashion that's other than pro rata,” Mr. Brandwein said. For example, under a pro rata profit-sharing plan, all of the workers might get a 5% contribution, but if it's cross-tested, key workers who are closer to retirement may receive contributions that are as much as three times the allocation for the group of workers who aren't receiving the higher benefit.
Often, these cross-tested profit sharing plans appear alongside safe harbor 401(k) plans, according to Mr. Brandwein. Those plans aren't subject to annual contribution testing, but they do require workers to receive a certain amount of employer contributions and these contributions must be fully vested when they're made.
Indeed, advisers can help employers come up with vesting schedules for profit-sharing plans, rewarding the best employees for sticking around. “It looks great on paper [the profit-sharing contribution], but you have to be there for five years to get the money,” said Mr. Zgainer. “If you stay, you've earned the money and you're materially contributing to the growth of the practice.”
As impressive as these additional savings vehicles can be for employers, advisers need to do a good bit of homework before they can start talking about them with clients. For instance, start off with an examination of the plan's demographics. Since these strategies skew benefits toward older and highly-compensated employees, younger rank-and-file workers can receive smaller contributions, according to Richard W. Rausser, senior vice president of Pentegra Retirement Services.
The best prospects for these add-ons are medical specialists, attorneys and other professionals. “It's a different kind of employer, an '-ologist,'” said Mr. Horst. “The difference is income spread: a general practitioner will make $300,000, but a medical specialist will make $400,000-plus; they're in a higher bracket, they have more taxes and more disposable income.” A true high-earner can afford the additional outlay of saving more money.
Advisers need to be aware of Internal Revenue Service's nondiscrimination tests, ensuring that the 401(k) itself isn't built to unfairly benefit the highly compensated personnel. This will require advisers to step up the quality of the retirement plan itself. “You can boost the non-highly compensated employees with auto-deferral increases and auto enrollment,” said Mr. Brandwein. “You improve the average deferral rate for the non-highly compensated, and this may improve the testing results.”
Finding ways to boost the savings rate for highly paid personnel will likely require a team effort, plus plenty of research on the part of the adviser. “Study the types of plans out there,” said Mr. Zgainer. “The shortest way to do that for most advisers is to find a great local [third-party administrator] that's been in the business a long time.”
