Qualified Retirement Plans

If the following comment from your CPA sounds familiar, your CPA is similar to most clients we talk with: "Put money in your 401(k)/Profit Sharing Plan and pay taxes on the rest. If you want to take home more money, you need to make more money." We have found that very few CPAs are proactive when it comes to saving their clients money on taxes — most simply process tax returns and don't have time to build a true income tax reduction plan with individual clients.

While it's generally assumed that funding a tax-deferred qualified retirement plan is a good idea, that's not always the case. You may have heard the question: is it better to pay taxes on the harvest, or the seed? That is, is it better to pay income taxes now on your current income (the seed) and let that money grow — and come out — tax-free later, or to let your money grow tax-deferred and pay income taxes on all of it when it's withdrawn (the harvest)? For many clients under 60, paying taxes on the seed and letting the money grow and come out tax-free can outperform simply deferring taxes the traditional way.

Information provided is not intended as tax or legal advice and should not be relied on as such. You are encouraged to seek tax or legal advice from an independent professional.

401(k) Plans

A 401(k) Plan is a qualified retirement plan in which an employer permits an employee to defer receipt of part of their compensation by contributing that part to their account in the plan. This is a paycheck deduction for the employee and is completely voluntary. Companies typically offer some kind of matching contribution, often 50 cents on the dollar up to a percentage of pay. Annual deferral limits (and catch-up amounts for those 50 and older) are set by the IRS and typically increase most years — ask us for the current-year numbers.

Profit-Sharing Plans

The bread-and-butter income tax deferral tool for many small business owners is the profit-sharing plan — a qualified retirement plan with contribution limits set as a percentage of pay (also indexed annually). A combined 401(k)/Profit-Sharing Plan lets an employee/owner "max out" pension plan contributions, though funding it fully for every employee can get expensive.

To limit that cost, businesses use testing options to skew contributions in favor of highly compensated employees (usually the owners) — integration with Social Security, age-weighting the contribution, or New Comparability classification plans. Perhaps the most compelling of these is the "New Comparability" Profit Sharing Plan: it allows the sponsor to make substantial contributions to selected groups of employees while limiting the cost for other groups, using an age-weighted mechanism to satisfy nondiscrimination testing. If the preferred employees are older than the average age of the non-preferred employees, this design can dramatically skew benefits in their favor. A Double Advantage Safe Harbor (DASH) 401(k) plan combines a "safe harbor" 401(k) with a New Comparability profit-sharing feature — the results are often dramatic.

Defined Benefit Plans

Most people think of Defined Benefit Plans as old-school and no longer relevant. Thanks to a tax law change, they're back — and may be exactly what you're looking for to build wealth for retirement. Unlike Defined Contribution Plans (401(k) and Profit-Sharing Plans), which calculate and cap how much you can contribute each year, a Defined Benefit Plan calculates a benefit owed to employees at a future date and lets the employer fund toward that benefit — regardless of how large the required contribution is.

Defined Benefit Plans can be especially powerful for late starters — business owners getting a late start on retirement saving (or who lost plan assets in a divorce or lawsuit) can often make dramatically larger tax-deductible contributions than a profit-sharing plan alone would allow.

Example figures used to illustrate these plans are for illustrative purposes only and do not take into account your particular investment objectives, financial situation, or needs. They are not intended to project the performance of any specific investment and are not a solicitation or recommendation of any investment strategy.

412(e)3 Defined Benefit Plans

A 412(e)3 Plan is a special type of Defined Benefit Plan that works almost exactly like a typical one, with one important twist: the benefit in retirement is guaranteed. A 412(e)3 Plan purchases annuities from insurance companies offering a guaranteed rate of return, and because that guaranteed rate is lower than the non-guaranteed return assumed by a regular Defined Benefit Plan, more contributions are required to reach the same future benefit — creating a meaningfully larger tax deduction. The IRS has commented on past abuses of 412(e)3 Plans, so it's worth working with an experienced advisor to navigate them correctly.

Cash Balance Plans

Cash Balance Plans are a special kind of Defined Benefit Plan — you get all the benefits of a Defined Benefit Plan or 412(e)3 Plan, but with much more flexibility (traditional DB and 412(e)3 plans can be somewhat inflexible and hard to understand). In a Cash Balance Plan, each participant has an account that resembles those in a 401(k) or profit-sharing plan — to many, it feels like a passbook savings account.

Cash Balance Plans weren't widely used until the Pension Protection Act of 2006 opened new doors for how they can be designed. Most advisors still aren't familiar with how that changed things — our firm is, and we welcome the opportunity to help you determine if one is right for your situation.

401(h) Plans

A 401(h) Plan is a medical expense account under Code Section 401(h) that pays for costs associated with sickness, accidents, hospitalization, and medical expenses of retired employees, their spouses, and dependents. One of the largest expenses retirees face is healthcare — typically paid from savings or taxable income. With a 401(h) Plan, an employer can take a full deduction to fund a tax-free account that retired employees can draw from for medical expenses entirely income-tax-free. It's one of the most overlooked and underutilized plan benefits in the industry — and can meaningfully increase the otherwise-maximum tax-deductible contribution of a pension plan.

Example. Assume a business owner has been funding a defined benefit plan every year and, on average, will incur ongoing medical expenses in retirement while in a high income tax bracket. Instead of directing all of that funding into the defined benefit plan alone, the business could allocate a portion into a 401(h) Plan each year as an employee benefit (with standard age, years-of-service, and salary nondiscrimination testing). That money grows tax-free and comes out tax-free when used for medical expenses — including elective surgery. Comparing the two: money withdrawn from the 401(h) Plan for medical costs is 100% tax-free, while the equivalent withdrawal from a taxable pension plan is fully taxable, meaning a meaningfully larger gross withdrawal is needed to net the same after-tax dollars. Over a long retirement, that difference compounds into a substantial net benefit.

This example is for illustrative purposes only and does not take into account your particular investment objectives, financial situation, or needs and may not be suitable for all investors.

Eligible expenses under a 401(h) Plan are broad, and not limited to the list below:

Acupuncture, hospitalization insurance, ADD counseling and assistance, hospital bills, air lift transportation, insulin, alcoholism treatment, laboratory fees, alternative healthcare and medicines, Lasik eye surgery, ambulance hire, artificial limbs and teeth, assisted living facilities, long-term care/nursing homes, asthma and allergy treatment, birth control, braces, membership fees for medical services, Braille books and magazines, chiropractors, Christian Science practitioners' fees, contact lenses (including exam fee), co-pays, cosmetic surgery, operations, orthopedic shoes, out-of-country care, counseling, physical therapy, crutches, physician fees, deductibles, LTC premiums, dental fees and dentures, dependent care, dermatologist care, diagnostic fees, prosthetics, drugs, psychiatric and psychological care, electrolysis, specially equipped cars, experimental care, special care costs for disabled dependents, eyeglasses, special diets, fees of practical nurses, sterilization fees, fees for fitness programs and facilities, support groups, fees of licensed osteopaths, surgical fees, flu shots, therapy treatments, hair transplants, transport expenses for medical services, health insurance premiums, tuition at special schools for the handicapped, hearing devices and batteries, vitamins, hospice care, wheelchairs, in home care, weight loss programs, and X-rays.

Roth 401(k) Plans

A Roth 401(k) is a component of a "regular" 401(k) plan funded with after-tax dollars — similar to a Roth IRA, but with higher funding limits and no earnings cap on who can contribute. Money contributed to a Roth 401(k) grows without tax and is distributed without tax.

Will you grow more wealth funding a Roth 401(k) with after-tax dollars where the money later comes out income-tax-free, or deferring income tax into a traditional 401(k) where withdrawals are fully taxable at your future income tax bracket? The honest answer is: it depends — but many people are better off with a Roth than they assume. As a rule of thumb, anyone retiring in the same bracket, a higher bracket, or within about 10 percentage points of their current bracket, tends to come out ahead with a Roth. For example, someone in a 40% bracket today who retires in a 30% bracket can still come out ahead using a Roth over a traditional tax-deferred plan.

Frequently Asked Questions