This article appeared in Law Practice Advisor’s January 2015 newsletter.
Defined Benefit Pension Plans as well as Cash Balance Plans are generating a lot of interest with law practices, both large and small.
Law practices generally find that these retirement plans are a great way to increase retirement savings and reduce taxes at the same time. As an additional benefit, the plans provide a level of asset protection for attorneys. In addition to reducing income taxes, the significant contributions are a great way to catch up if you have not saved enough in the past or if your retirement account balances are still lagging after market losses during the recent economic turmoil.
Compared to 401(k)s and Profit-Sharing Plans
In 2015, an individual under 50 years old may defer $18,000 into his 401(k) account. With matching and Profit Sharing Plan contributions, the total may be increased to $53,000. If the individual is over 50, they may defer an additional $6,000.
In comparison, an attorney in his late 50’s could contribute and deduct nearly $210,000 in a properly designed Defined Benefit or Cash Balance Plan. This allows you to turbo-charge your retirement savings. You may accumulate close to $2.5 million in the plan by age 62, which is at least double what you would accumulate outside a tax-qualified plan. So if you plan to withdraw only the earnings each year after you retire, you’ll have twice the annual income.
| Company Name | ABC Company |
| First Plan Year End | 12/31/2015 |
| Normal Retirement | Age 62 |
| Income Tax Rate | 44.0% |
| Sex | Name | Age | Annual Salary |
| M | John Owner | 51 | $265,000 |
| F | Jane Spouse | 50 | $25,000 |
| F | Employee 1 | 28 | $57,446 |
| F | Employee 2 | 41 | $47,262 |
| F | Employee 3 | 48 | $65,495 |
| F | Employee 4 | 31 | $83,655 |
| F | Employee 5 | 28 | $37,891 |
| F | Employee 6 | 43 | $34,453 |
| F | Employee 7 | 24 | $17,120 |
Exhibit 1
Defined Benefit Pension Plan with 401(k)
Profit Sharing Plan – Cross Tested Design
| Participant Name | Plan Age | Ret Age | Total DB Plan Contribution | Total 401(k) Profit Sharing Contribution* | Grand Total Contribution | % of Total |
| John Owner | 51 | 62 | $153,000 | 38,550 | 191,550 | 74.46 |
| Jane Spouse | 50 | 62 | 15,000 | 24,100 | 39,100 | 15.20 |
| Sub-Total | 168,000 | 62,650 | 230,650 | 89.66 | ||
| Employee 1 | 28 | 62 | 500 | 3,906 | 4,406 | 1.71 |
| Employee 2 | 41 | 62 | 500 | 3,214 | 3,714 | 1.44 |
| Employee 3 | 48 | 62 | 500 | 4,454 | 4,954 | 1.93 |
| Employee 4 | 31 | 62 | 500 | 5,689 | 6,189 | 2.41 |
| Employee 5 | 28 | 62 | 500 | 2,577 | 3,077 | 1.20 |
| Employee 6 | 43 | 62 | 500 | 2,343 | 2,843 | 1.11 |
| Employee 7 | 24 | 62 | 257 | 1,164 | 1,421 | 0.55 |
| TOTALS | 171,257 | 85,996 | 257,254 | 100% |
Exhibit 2
*Combined plan tax deduction rules effectively limit employer contributions to defined contribution plan to 6% of total eligible payroll. To satisfy combined plan general nondiscrimination testing and other requirements, the exhibit shows employees receiving 3% safe harbor and about 4% profit sharing; the owner receives about 5% profit sharing. The owner’s contribution also includes a 401(k) deferral of $18,000 plus $6,000 catch up contribution. The spouse’s contribution includes this same generous deferral amount
Pension Protection Act of 2006
Defined Benefit and Cash Balance plans have become more popular since the Pension Protection Act of 2006. The Act made these plans more appealing in several ways. First, the Act clarified the legality of Cash Balance Plans. Second, the Pension Protection Act explained how a company, such as a law practice, might be able to sponsor both a 401(k) Profit Sharing and a Defined Benefit Plan to take advantage of the unique characteristics of each and benefit from the combination of the two. Third, the Pension Protection Act of 2006 (PPA) explained how to cross test the benefits from both types of plans and be able to weight the contributions more heavily toward the professionals/business owners if the demographics were right.
A sample case is provided showing a law practice where an attorney’s spouse is employed along with seven employees (Exhibit 1 above). When a Defined Benefit Plan is added to an existing Profit Sharing Plan, contributions can be significantly increased, while keeping financial obligations to non-owner employees to a minimum (Exhibit 2 above). A comparison of “before and after” is provided to illustrate improvement of plan design from one year to the next (Exhibit 3 below).
ABC Company – Comparison of Plan Designs
| Participant | Previous Year Design | Proposed New Design |
| John Owner | 57,500 | 191,550 |
| Jane Owner | 30,500 | 39,100 |
| Sub-Total | 87,000 | 230,650 |
| Employee 1 | 2,872 | 4,406 |
| Employee 2 | 2,363 | 3,714 |
| Employee 3 | 3,275 | 4,954 |
| Employee 4 | 4,183 | 6,189 |
| Employee 5 | 1,895 | 3,077 |
| Employee 6 | 1,723 | 2,843 |
| Employee 7 | 856 | 1,421 |
| Sub-Total | 17,167 | 26,604 |
| Grand Totals | 104,167 | 257,254 |
| Increase in contribution to John & Jane | 143,650 | |
| Increase in total contributions | 153,087 | |
| % of increase for John & Jane | 93.84 | |
Exhibit 3
Historically, Defined Benefit plans were thought to be fixed and inflexible. The PPA brought a funding method that gave rise to a range of funding options. The contributions in the range, from maximum to minimum, are all acceptable and income tax-deductible. With the proper plan design and the new funding method, there can be flexible year-to-year funding.
As a result of these changes, business owners, such as attorneys, can now have larger retirement plan contributions that are income tax-deductible. The plan designs are attorney friendly, allowing a contribution level that fits the needs of the business. This increased funding flexibility can also allow more predictable contribution totals from year to year.
Another important change brought about by the PPA is the Inherited IRA. Prior to the PPA, in the event of a participant’s death, a spouse beneficiary could roll the account into his own IRA, stretch the benefits over his lifetime and pass them on to future generations that provided for the deferral of the income tax for possibly decades. If the beneficiary was a non-spouse, the taxation was either in the year of death or no later than the end of the fifth year following. Taking a lifetime of accumulations and taxing them over a short time was not a good result.
The PPA changed this and allows a non-spouse beneficiary to receive this “Inherited IRA” and stretch out the payments in a similar fashion to a spouse, putting non-spouse beneficiaries on a more equal footing. With a high rate of divorce or the possibility that your spouse might predecease you, this is an important change.
Conclusion
If you want to find out if a Defined Benefit Pension Plan or a combination of plans is right for you or if your current plan provides for an Inherited IRA, call OJM Group and speak to one of their Retirement Plan Specialists. You might be very surprised at how a few changes can enhance your retirement and income tax planning.
