Can retirement plans provide tax relief?
If they can avoid the stigma of being categorized as exempt, business owners’ treatment of so-called pass-through income offered by the new tax bill creates a yawning window of opportunity to lop 20 percent right off the top of annual income.
The challenge, for those whose professions or businesses disqualify them from receiving the deduction, will be to dredge up a toehold of rationale for recasting themselves in a business that qualifies for the benefit. It will be a desperate search to recast themselves in the same image as, for example, owners and developers of commercial real estate.
Professionals who do qualify will be struggling to come to grips with the income levels above which the benefit grades down — $157,500 for singles and $315,000 for married couples. For these people, maybe I can help. They might want to consider beefing up their retirement plan with substantial contributions beyond what the typical 401(k) plan allows. These larger contributions would reduce taxable income and forestall the point at which the income breakpoints become a factor.
An “age weighted” retirement plan contribution allows a company to contribute an employer discretionary contribution into a 401(k) plan using formulas based on age. Selected older employees, typically company owners and key managers, may receive employer contributions above this year’s $18,500/$24,500 maximums they may already be contributing to their 401(k). Some professionals operate one-person 401(k) plans called “Solo-401(k)s.” These, too, could be expanded.
But beyond what the owner contributes to the 401(k), there can be an additional company discretionary contribution of up to $36,500. If there are employees in the company, they must be offered something, too, but the typical owner will enjoy a larger contribution percentage than the average employee covered under the plan. This is allowed because the average employee tends to be younger than the typical company owner.
What appears on the surface to be discriminatory is allowed because older employees are closer to retirement age and have less time to accumulate an adequate balance.
Plan design typically begins with determining the average age of the owners and compares this to the average age of all other employees. The difference is usually greater than 10 or 15 years. Younger employees with an average of 35 years to a hypothetical retirement age can accomplish with a small annual percent-of-salary contribution the same ending account balance as older employees receiving a percent that is three-times greater.
Nine percent contributed per year with just 15 years until retirement may generate the same proportionate-sized retirement nest egg as a 3 percent contribution per year for 30 years. The law recognizes what is, in effect, discrimination against older owners and allows a company to selectively pick and choose the older employees they may want to reward — starting with the owners, of course.
If the company makes, for
example, an annual contribution equal to 3 percent of compensation for all other employees, the owner/key managers can receive as much as a 9 percent contribution — up to a three-times multiple. If other employees receive 4 percent, key people could receive 12 percent, etc.
However, beyond 5 percent for non-key employees, there is no 3 times multiple limitation, and key employees could receive whatever percentage they needed to bring them to the dollar amount maximum of $55,000 (plus the $6,000 catch-up for those 50 and over). These “age weighted” plans are as simple as adding the feature to an existing 401(k). Beyond these plans are cash balance plans for small businesses, which offer contributions of as much as $200,000 per year for an older owner, but these are more complex and less flexible.
Depending on personal circumstances, many successful California professionals and successful business owners will be hammered as the new lax law limits their itemized deductions to $10,000. Those lucky enough to qualify for the 20 percent write-off are at least being thrown a bone.
For many, then, expanding the use of their qualified retirement plan offers the only relief. It reduces taxable income and, in some cases, brings their incomes down to below those breakpoints beyond which the deduction, if they have any at all, is snatched away.