Deferral Portion Contributions
It is important that you distinguish the deferral of salary compared to the amount put into the plan by the employer. The deferral portion is the amount that the employee defers into the investment plan and doesn’t have to pay taxes on currently. For example, if the employee had a gross salary of $47,000 and put $5,000 of that into the 401(k) plan her W-2 at the end of the year would show $42,000 and she would not have to pay taxes on the $5,000 deferred. At retirement the deferred amount is taxed when withdrawn. This salary deferral doesn’t cost the business any additional funds because it’s taken from the employees’ salaries. Offering a 401(k) plan to employees is proven to be a welcome perk and boost loyalty.

Matching Plans and Safe Harbor 401(k)s
When employees and their employers contribute to a worker’s plan it’s commonly referred to as matching. With matching plans, small business owners have the ability to contribute a much larger portion from their business to themselves than to their employees. This can be done by using a Safe Harbor 401(k) plan. If the small business owner contributes the amount equal to 3 percent of the salary for the employees — known as the Safe Harbor contribution — the law then allows the owner to put a larger percentage into his or her own 401(k). In my example below you’ll see that by making the 3 percent Safe Harbor contribution and an additional 2 percent Profit Sharing contribution, the small business owner can put in the maximum $29,000 allowable by the IRS for 2006.

Unlike defined contribution plans, these plans can be somewhat complicated to set up and maintain. So, it’s important to enlist the right pros. Use a great CPA who understands your current tax situation and can look ahead to your financial future. Hire an actuary to run calculations and valuations on a regular basis to ensure the required investments are being made and the promised benefits are adequately funded. And rely on an investment advisor who has a proven track record of providing acceptable investment returns to keep you and your employees on track. Your CPA can also make sure the Pension Benefit Guaranty Corporation (PBGC), a federal agency, insures the plan benefits, and makes sure all required paper work is handled and the annual premiums are paid. While these financial pros may sound costly, their fees can be minor compared to the wealth you can build quickly for yourself and your employees all while relieving a substantial tax burden for your business.

In this example you, the owner, are deferring $20,000 in salary, the company is contributing $36,900 ($11,340 + $25,560) and you are getting $49,000 of retirement plan benefit.
On your W-2 you are deferring $20,000 and not paying taxes on that, while the $36,900 is an expense that you get to deduct from your revenues on your business tax return. If your business is a Partnership, LLC or S-Corporation the tax savings would be around $25,000 as the example shows.

Employee Salary Deferrals
What would happen if the other employees also made deferred salary contributions into the 401(k) plan? They could contribute the maximum and it would not have any effect on the small business owner. This can be accomplished because of the contributions you made for your employees. Also note that this plan usually has vesting, but it works a little differently than the defined benefit plan. The amount in the Safe Harbor column in the illustration above immediately vests to the employee, as does their salary deferral contribution, if any, as well. However, the amount where we gave the employee the additional matching contribution 2 percent in profit sharing is subject to vesting. So, for example, if Employee 1 left after two years he would get all of his safe harbor contributions that she made but only around 40 percent of the amount of the profit sharing part of the contributions made for her. The 60 percent of the amount of her profit sharing forfeiture —monies to which she is not entitled — would go back in the plan for later distribution among the other participants, or to reduce the business owner’s funding requirements for future years.

Some Final Consideration
These strategies are somewhat similar to those I used in my previous column about defined benefit plans, but on a smaller scale. In this example you can put away $49,000 in a pension plan for yourself and have the government “pay” $17,705 of that as a result of your tax savings. Importantly, this is $17,705 of profits you created without having to generate more sales or work more hours. The 401(k) plan is less costly to administer than the defined benefit plan—and the administration costs are also tax deductible.

Some of you may say, “I have a 401(k) now but I am not able to put away nearly as much as this illustration.” That may be due to a problem I’ve mentioned before: You may have gotten yourself a “canned” plan. Off-the-shelf or prototype plans are massed produced. They are not tailored to your individual business. So, you’ll need to find yourself a good 401(k) administrator who can tailor this type of plan for your business so you can get the maximum deduction as illustrated.

Keep in mind that if you are planning to start a new plan or enhance one you have established, you need talk to a plan administrator regarding IRS deadlines so you can take advantage of tax deductions for the current or following year.

Find yourself a great CPA to run your numbers and see what type of retirement plan is right for your business. Get a sophisticated plan administrator who can structure a plan tailored for your specific needs. Then find an investment advisor who can help you put that money to work in the most efficient matter for prudent growth.

Guy McPhail, CPA, CFP®, is president of Zdenek Financial Planning, LLC.

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