FLEISCHMAN, CPA, PhD, CMA, is assistant professor of
accounting at the University of Tennessee at Chattanooga. |
NERIMAN GUVEN, CPA, PFS, CFP, CEBS, is a sole practitioner in Lubbock, Texas, and adjunct professor of accounting at Texas Tech University in Lubbock.
Tax law changes in the 1990s have forced CPAs to make significant changes to the strategies they use in planning their clients retirement. The two most important tax acts—the Omnibus Budget Reconciliation Act of 1993 (OBRA 1993) and the Small Business Job Protection Act of 1996 (SBJPA 1996)—are pieces of legislation whose complexity offers additional tax planning opportunities for CPAs and their clients.
OBRA 1993 generally complicates matters for highly paid employees, while SBJPA attempts to simplify retirement plans for small business employees through the creation of the Savings Incentive Match Plan for Employees (SIMPLE). This new savings vehicle and the laws many other provisions have important ramifications for tax practitioners.
This article shows how CPAs can take advantage of planning techniques that help minimize the section 401(k) discrimination problems resulting from the lowering of the qualified plan compensation limit. It also offers tax planning techniques that can maximize qualified plan contributions to highly paid client employees.
LOWER LIMITS AND 401(k) TESTING
When OBRA raised the maximum individual marginal tax rate to 39.6%, retirement plan contributions became an even better deal, because the additional individual tax bite could be deferred until retirement, when the employee usually would have a lower marginal tax rate. Not all of the OBRA provisions encourage income postponement through retirement plan contributions, however. The Internal Revenue Code section 401(a)(17) limit on the amount of compensation that can be considered when computing contributions to retirement plans was lowered from $235,840 in 1993 to $150,000 in 1994 through 1996.
The $150,000 limit also affects the
- Actual contribution percentage and actual deferral percentage nondiscrimination testing for 401(k) plans. (Since 401(k) plans are so popular and are generally clearly understood, the 401(k) plan nondiscrimination rules are discussed in detail in order to illustrate for CPAs how the $150,000 limit works.)
- The deduction limits for defined contribution plans.
401(k) nondiscrimination rules. The maximum amount of compensation an employee can defer in a defined contribution plan such as a 401(k) plan is the lesser of a set percentage of salary or a statutory cap. The 1996 cap for 401(k) plans is $9,500, which provides the first limitation on the amount employees can put into their 401(k) accounts.
A second limitation results when the overall plan is deemed to discriminate against rank-and-file employees for the benefit of the companys highly paid employees. The nondiscrimination rules of section 401(k)(3)(A)(ii) and section 401(m)(2)(A) provide that deferral and contribution percentages of highly compensated employees may not exceed those of non-highly compensated employees beyond certain specific limits. Section 414(q) is generally used to determine whether an employee is highly compensated. Such employees, in 1996 and in 1997, are described in exhibit 1 .
Discriminatory tests. The 401(k) plan must meet two separate (although similar) tests in order to be considered nondiscriminatory:
- The actual deferral percentage test focuses on the employees actual deferral ratio (the deferral amount over the amount of compensation) of elective contributions made to the 401(k) plan. Elective contributions are the amounts the employee contributes to the plan instead of receiving a cash equivalent. The plan administrator separates employees into two categories: highly compensated employees and non-highly compensated employees. The administrator then compares the average percentage of compensation deferred in each category. Section 401(k)(3)(A)(ii) says one of the following requirements must be met for the actual deferral percentage test to be satisfied: The actual deferral percentage of highly compensated employees cannot exceed either 125% of the actual deferral percentage for non-highly compensated employees (the "125% test") or 200% of the actual deferral percentage for non-highly compensated employees, not to exceed two percentage points (the "two times/two plus" test).
- The actual contribution percentage test examines employer matching contributions made to the plan on behalf of the employee. For example, the employer may agree to match employee contributions dollar for dollar up to a certain limit. The actual deferral percentage computational requirements of section 401(m)(2)(A) are quite similar to the actual deferral percentage test above, as can be seen in exhibit 1 .
The purpose of the tests is to ensure that employers do not target highly compensated employees for 401(k) benefits to the exclusion of non-highly compensated employees. Since highly compensated employees already have a higher wage base, a contribution based on a fixed percentage of compensation will be higher for them than for non-highly compensated employees. If no limit is placed on the disparity between the contribution percentage rates of the two groups, the contribution gap is even greater. The rules attempt to minimize this disparity.
The following example illustrates how the $150,000 compensation limit will affect the 401(k) nondiscrimination rules. (Because the two testing procedures are so similar, only the actual deferral percentage test is used in this example.)
Best Corp. example. Assume Best Corp. has five unrelated employees who have, in 1996, the characteristics noted in exhibit 2 , above. A comparison of the test computed under pre- and post-OBRA 1993 rules follows in exhibit 2 .
Under this set of facts, the plan meets the test under the pre-OBRA 1993 law since the percentage point spread is less than 2%. The plan fails the test, however, under the new law since there is greater than a 125% difference or 2% differential between the highly compensated employee and non-highly compensated employee. If a plan fails to pass the ADP test (and is thus deemed to be discriminatory), significant qualified plan tax benefits may be lost.
Even though the plan initially fails the actual deferral percentage nondiscrimination test because of the section 401(a)(17) restrictions, Best Corp.s CPAs can encourage the company that all is not necessarily lost. CPAs can help plan administrators try to meet the requirements by decreasing the benefits of the highly compensated employee with the highest deferral percentage while still trying to minimize lost tax benefits. This procedure is commonly referred to as "leveling." Although the details of leveling are beyond the scope of this discussion, the process requires the CPAs to assist the plan administrator in reducing the deferral of Jill, because she has the highest actual deferral percentage, 14.62%.
Note, however, that the plan fails the actual deferral percentage test because Jacks deferral percentage increased to 6.33% from 4.31% using the lower $150,000 limit placed on his compensation for testing purposes. Jills contributions must be reduced so the highly compensated employees will no longer have an actual deferral percentage of over 2% in excess of the non-highly compensated employees. (This result is not optimal from an equity standpoint, because an upper middle class employee, Jill, is being hurt rather than Jack, who clearly qualifies as a member of the group the rules attempted to target.)
SBJPA modifies the two tests by using prior-year data. Permitted actual deferral percentage and actual contribution percentage amounts for highly compensated employees in the current year will be based on non-highly compensated employees previous-year actual deferral percentage and actual contribution percentage tests. This provision is effective starting in 1997.
TAX PLANNING AND DISCRIMINATION ISSUES
CPAs can use the following tax planning ideas to help client businesses meet the qualified plan nondiscrimination requirements in order to salvage significant qualified plan tax benefits.
Increase non-highly compensated employee 401(k) plan participation. This will decrease the disparity between highly compensated employee and non-highly compensated employee actual contribution percentages and actual deferral percentages. Businesses usually can increase non-highly compensated employee participation by promoting the benefits of participating in the plan through increased employeremployee communication:
- Carefully plan and design a communication document based on the objectives and strategy developed to stimulate employee participation. Consider media options, such as handbooks and booklets. Show a short video to reinforce the written material.
- Target a specific employee audience and make it clear why the plan is beneficial to the employees.
- Ensure that communication is regular and ongoing.
Add or increase employer matching. CPAs can advise clients to narrow the highly compensated employee vs. non-highly compensated employee 401(k) contribution gap by increasing employer matches of non-highly compensated employee contributions. As an example, employers may wish to raise their matching rate from $0.50 for each dollar contributed by employees up to $0.75 for each dollar, up to a specified ceiling amount.
In addition, a plan may have a better chance of passing the 401(k) discrimination tests if qualifying nonelective contributions (QNECs) are used. A QNEC is an employer contribution that is permitted to one or more non-highly compensated employees for the sole purpose of ensuring that their overall average deferral percentage is increased. This strategy may be very inexpensive, since the 401(k) nondiscriminatory test, in certain circumstances, may be passed if only the lowest paid non-highly compensated employee is allocated the QNEC contribution. This is especially true if QNECs are made to a terminated non-highly compensated employee who had very low gross earnings. The plan document must provide for how these QNEC contributions are to be allocated. QNECs could be used when the client is very close to passing the tests.
Consider using a new SIMPLE retirement plan. SIMPLE plans can be used by employers that do not already maintain another employer-sponsored retirement plan. Some of the plan requirements and characteristics are as follows:
- The sponsoring employer may have no more than 100 employees earning at least $5,000.
- SIMPLE plans can be set up either as individual retirement accounts or part of a 401(k) plan.
- Contributions cannot exceed $6,000 per employee per year (indexed for inflation).
- Contributions are not taxable until withdrawn.
If a SIMPLE plan is part of a 401(k) plan, the detailed nondiscrimination tests discussed earlier do not apply. Instead, SIMPLE 401(k) plans must meet a safe-harbor test that requires the employer to do one of the following:
- Match employees elective deferrals up to 3% of compensation.
- Make a 2% of compensation nonelective contribution to all employees earning at least $5,000.
In addition to these two rules, all contributions must be vested immediately.
CPAs can use certain tax planning strategies to assist clients that are not eligible for SIMPLE plans in maximizing qualified plan contributions to highly paid employees. OBRA 1993 made it more difficult for such employees (from exhibit 2 ) to maximize their contributions not only to 401(k) plans but also to other qualified defined contribution plans such as profit-sharing plans. Lowering the compensation limit to $150,000 has made it more difficult for qualified plans to pass the nondiscrimination test requirements. In addition, the lower limit may also minimize the amount that a highly paid employee can contribute to a basic profit-sharing plan. CPAs can advise their business clients to increase highly compensated individuals qualified plan contributions in the following three ways.
- Add a second qualified plan (such as a money purchase plan). Section 404(a)(3)(A)(i) allows employee/employer contributions to a profit-sharing plan of up to 15% of the employees wages capped by a total contribution limit of $30,000. In 1993, an employee could contribute the $30,000 maximum into the plan with less than a 13% contribution since the old compensation limit was $235,840. Now that the compensation limit has been reduced to $150,000, however, a full 15% contribution will amount to only $22,500. If, for example, Best Corp. wishes to allow for the maximum $30,000 contribution for Jack, it should consider adding to the existing profit-sharing plan a money purchase plan, which is similar to a defined contribution plan because it is often based on compensation and usually credited directly to an employees account. Money purchase plans also are representative of defined benefit plans because the employer must make contributions each year on behalf of the employee. The money purchase plan can be used to raise the contribution rate from 15% to 20% so the full $30,000 maximum contribution may be made by employees with compensation of at least $150,000. Allowing for increased retirement benefits may provide additional incentives for companies to retain their key employees.
- Provide an age-weighted profit-sharing plan. Most profit-sharing plans allocate the corporations contributions only on the basis of compensation. Companies also may offer profit-sharing plans, however, that consider the participating employees age in the computation of allowed contributions. This permits older employees to receive significantly larger contributions than those of younger employees. These age-weighted plans are becoming more popular because the retirement security of older workers is not being effectively administered by most defined contribution plans, which generally benefit younger employees.
- Provide a profit-sharing plan integrated with Social Security. Qualified plans also may be integrated with Social Security benefits under section 401(l). Under these "permitted disparity" rules, plans may allow participants an additional contribution or benefit based on compensation that is above a particular level (known as the base integration level) without violating qualified plan nondiscrimination rules. For 1996, the maximum Social Security base (other than the 1.45% unlimited hospital insurance portion) is $62,700.
The complex issues raised by OBRA 1993 and SBJPA 1996 create a demand for advice and planning. CPAs, whether they serve large or small clients, need to be aware of these rules and limitations and should investigate each clients situation on a case-by-case basis. Although nonqualified plans are outside the scope of this article, they, too, should be part of the analysis.