Qualified Retirement Plans

You’ve probably heard some version of this from your CPA: put money in your 401(k) or Profit Sharing Plan, pay tax on whatever’s left, and if you want to keep more, go earn more. I hear a version of that from nearly every client I meet. Most CPAs are genuinely good at their actual job, filing an accurate return for the year that already happened, but very few have the time or the mandate to build you a real income tax reduction strategy. That’s a different job entirely.

It’s generally assumed that funding a tax-deferred retirement plan is automatically the smart move. It isn’t always. You may have run into the question of whether it’s better to pay tax on the seed or the harvest: pay income tax now on what you earn today (the seed) and let that money grow, and eventually come out, completely tax-free, or defer the tax and pay income tax later on the full withdrawal (the harvest). For a lot of clients under 60, paying tax on the seed and letting the growth come out tax-free ends up beating the traditional approach of simply deferring everything.

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) lets an employee set aside part of their paycheck into a retirement account before it ever reaches their bank account, entirely voluntary, entirely their choice. Most employers add some form of match, commonly 50 cents on the dollar up to a set percentage of pay. The IRS sets annual limits on how much you can defer, plus a catch-up amount once you turn 50, and those limits typically rise most years. Ask me for the current numbers whenever you want them.

Profit-Sharing Plans

For a lot of small business owners, the profit-sharing plan is the workhorse of tax deferral. It’s a qualified plan with contribution limits set as a percentage of pay, also indexed each year. Pair it with a 401(k) and an owner or employee can max out combined pension contributions, though funding that fully for every single employee gets expensive fast.

To keep that cost under control, businesses lean on testing strategies that shift more of the contribution toward highly compensated employees, usually the owners: integrating with Social Security, weighting contributions by age, or structuring the plan under New Comparability rules. The New Comparability Profit Sharing Plan tends to be the most powerful of these. It lets a sponsor direct substantial contributions to a selected group of employees while keeping the cost down for everyone else, using an age-weighted formula to satisfy the IRS’s nondiscrimination testing. When the favored group is older on average than everyone else, this design can tilt benefits dramatically in their favor. A Double Advantage Safe Harbor 401(k), sometimes called a DASH plan, pairs a safe harbor 401(k) with a New Comparability profit-sharing structure, and the combined result can be significant.

Defined Benefit Plans

Most people assume Defined Benefit Plans are a relic nobody uses anymore. A tax law change brought them back, and for the right business owner, one might be exactly the tool you’re missing. Where a Defined Contribution Plan, like a 401(k) or profit-sharing plan, calculates and caps what you can put in each year, a Defined Benefit Plan works backward: it sets a benefit owed to you at a future date, then requires the employer to fund toward that benefit regardless of how large the annual contribution needs to be.

They’re especially powerful for late starters, business owners who got a late start on retirement saving, or who lost plan assets in a divorce or lawsuit, since a Defined Benefit Plan can allow for dramatically larger tax-deductible contributions than a profit-sharing plan alone ever could.

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 specific type of Defined Benefit Plan with one meaningful difference: the retirement benefit itself is guaranteed. It works by purchasing annuities directly from insurance companies at a guaranteed rate of return. Because that guaranteed rate runs lower than the assumed return in a regular Defined Benefit Plan, funding the same future benefit takes larger contributions, which translates into a meaningfully bigger tax deduction. The IRS has flagged past abuses of 412(e)3 Plans, so this is one where working with an advisor who actually understands the rules matters.

Cash Balance Plans

A Cash Balance Plan is technically a Defined Benefit Plan, but built with far more flexibility than a traditional one, since standard DB and 412(e)3 designs can be rigid and genuinely hard to follow. Each participant in a Cash Balance Plan has an account that looks and feels a lot like a 401(k) or profit-sharing balance, closer to a passbook savings account than the abstract formulas behind an old-school pension.

These plans stayed relatively obscure until the Pension Protection Act of 2006 reopened how they could be designed, and a lot of advisors still haven’t caught up. I have, and I’m glad to walk through whether one makes sense for your situation.

401(h) Plans

A 401(h) Plan is a medical expense account created under Code Section 401(h), built to cover the sickness, accident, hospitalization, and medical costs of retired employees, their spouses, and their dependents. Healthcare is one of the biggest expenses retirees face, and it’s usually paid straight out of savings or taxable income. A 401(h) Plan lets an employer take a full deduction to fund an account that retired employees can draw from tax-free for medical expenses, elective surgery included. It’s also one of the most overlooked tools in the industry, and it can meaningfully raise the total tax-deductible contribution otherwise available through a pension plan.

Example. Say a business owner has been funding a defined benefit plan every year and expects ongoing medical expenses in retirement while sitting in a high tax bracket. Instead of routing every dollar of that funding into the defined benefit plan alone, the business could direct a portion into a 401(h) Plan each year as an employee benefit, subject to the usual age, service, and salary nondiscrimination testing. That money grows and comes out entirely tax-free when it’s used for medical costs. Compare the two paths: a withdrawal from the 401(h) Plan for medical expenses is 100% tax-free, while the same withdrawal from a taxable pension plan is fully taxed, meaning you’d need a meaningfully larger gross withdrawal just to net the same amount. Over a long retirement, that gap compounds into a real difference.

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 401(h) expenses cover a lot of ground. This list isn’t exhaustive:

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) lives inside a regular 401(k) plan, but it’s funded with after-tax dollars, the same underlying idea as a Roth IRA, just with higher contribution limits and no income cap restricting who can participate. Money that goes into a Roth 401(k) grows tax-free and comes out tax-free.

So which builds more wealth: funding a Roth 401(k) now with after-tax money that comes out tax-free later, or deferring the tax into a traditional 401(k) where every withdrawal gets taxed at your future rate? Honestly, it depends. But more people come out ahead with a Roth than they’d expect. As a rough rule, if you’ll retire in the same bracket, a higher one, or within about 10 percentage points of where you are now, a Roth tends to win. Even someone sitting in a 40% bracket today who retires into a 30% bracket can still come out ahead choosing a Roth over a traditional tax-deferred plan.