By by Anna M. Hunter, CPA, CPC, QPA
Director, Witt Mares Pension Designs, LLC
As Published in the Oyster Pointer
Dr. Korgin has been in the dental practice for the last 25 years. In 1989, a profit sharing plan was set up for her practice by her investment advisor for a minimal annual fee, and it has been in place ever since. There has never been a reason to change what was working until now. The current economy has her patients putting off routine checkups and Dr. Korgin must start cutting costs. Is her retirement plan the place to do it? If things don’t improve soon, she is not going to make any profit sharing contribution this year.
Times are tight and employers everywhere are cutting costs to keep the bottom line where it belongs. A quick assessment of the company retirement plan may indicate it is costing a fortune! Is it time to drop the company retirement plan contribution entirely? Maybe not.
Many employers are stopping the employer contribution, when instead there may be real cost savings achieved by simply changing the retirement plan design. If you are still using a standard profit sharing or SEP plan to fund your retirement contribution, there are better retirement plan designs out now which can save thousands of dollars each year in pension expenses. Smaller companies, especially those with older owners, can often save money by changing the existing plan design to a cross-tested (or new comparability) formula. The standard profit sharing formula and SEP formulas are set up with either a “pro-rata” allocation, or “integrated” formula- which gives a slight advantage to those employees earning over the social security taxable wage base. Here are a few scenarios to consider:
Pro-Rata
| Owner | 10% contribution: $20,000 |
| 10 Eligible Employees | 10% contribution: $40,000 |
| Total contribution | $60,000 with 33% to owner |
Social Security Integrated
| Owner | 10% with 5.4% integration: $25,312 |
| 10 Eligible Employees | 10% contribution: $40,000 |
| Total contribution | $65,312 with 38.75% to owner |
Compare these percentages and contribution expenses to this cross tested formula:
Cross-tested
| Owner | 15% contribution: $30,000 |
| 10 Eligible Employees | 5% contribution: $20,000 |
| Total contribution | $50,000 with 60% to owner |
The cross-tested plan formula is permitted because contributions are analyzed on the future value of retirement benefit at normal retirement age instead of on the present value of the actual contribution. When owners have fewer years to normal retirement age than the majority of the other eligible employees, the cross-tested formula can save thousands of dollars in pension expense while still providing employees with a meaningful retirement benefit. Testing must be performed each year to determine the retirement benefit provided is not discriminatory in favor of the Highly Compensated Employees, as defined by the Internal Revenue Code. The cost of this additional testing tends to be minimal compared to the cost savings of the cross-tested formula. It is worth giving this plan design a look to determine if the cross-tested formula will provide a savings in pension expense without decreasing (and sometimes increasing) owner savings.
And what happened with Dr. Korgin? After determining the cross-tested plan would pass the mandatory discrimination testing, Dr. Korgin decided to change her pro-rata profit sharing formula to cross-tested. She changed the employee pension contribution to 5% which saved $10,000 that year. The result? The employees were happily surprised to receive a profit sharing contribution this year, it created a 2009 tax deduction for the company, and allowed Dr. Korgin to continue to save for her own retirement. Dr. Korgin was glad she took a closer look at her retirement plan design. Have you looked at your plan lately?