This page describes a composite hypothetical. It is not a real client or a real result. All numbers are assumptions, and actual plan design requires an actuary, so nothing here is a quote or a recommendation.
The Scenario in Brief
The owner of a small engineering firm is 58 and has six employees. The firm has had strong profit for several years, and the owner wants to accelerate retirement savings. The owner's advisor suggests exploring a defined benefit plan with a 401(k) profit sharing plan. The owner asks how to think about the employee cost and the risks before asking an actuary for illustrations.
Assumptions Used
- Preliminary actuarial illustration, assumed for this scenario, shows a target annual funding for the owner of 150,000 dollars.
- The six employees have combined pay of 300,000 dollars and are assumed eligible.
- To meet plan requirements, the design includes an employee benefit accrual costing an assumed 3 percent of staff pay and a 401(k) profit sharing contribution costing an assumed 5 percent of staff pay.
- Annual actuarial and administration fees are assumed at 8,000 dollars.
- Firm profit before owner pay and retirement contributions is assumed at 700,000 dollars in the current year.
Worked Arithmetic: The Full Cost
| Item | Annual amount |
|---|---|
| Owner funding target | 150,000 dollars |
| Employee benefit cost: 3 percent of 300,000 | 9,000 dollars |
| Employee profit sharing: 5 percent of 300,000 | 15,000 dollars |
| Fees | 8,000 dollars |
| Total annual cost | 182,000 dollars |
| Share attributable to the owner | about 82 percent |
The owner would compare this cost with the potential deduction and with the value of the retirement savings. Contributions to a qualified plan are generally deductible, so the tax reduction depends on the owner's marginal rate. At an assumed 35 percent rate, a deduction of 174,000 dollars in contributions would reduce federal tax by about 60,900 dollars in the year, an amount that ignores the qualified business income deduction and state tax. The owner would consider the whole picture, including the fact that contributions are cash the firm does not keep.
Downturn Testing
The advisor would ask the owner to test the plan against a weaker year. Suppose profit drops by 30 percent to 490,000 dollars. The required contributions would generally remain the same, so the plan cost as a share of profit would rise.
| Scenario | Profit before plan | Plan cost | Cost as a share of profit |
|---|---|---|---|
| Current year | 700,000 dollars | 182,000 dollars | about 26 percent |
| Profit down 30 percent | 490,000 dollars | 182,000 dollars | about 37 percent |
The owner would decide whether a plan cost of that size would be sustainable in a weaker year. The advisor would remind the owner that defined benefit plans have required contributions, and that reducing or freezing a plan involves rules and possibly costs.
Employee Considerations
The employees benefit from the plan. That may improve retention and morale, and it is part of the cost. The advisor would ask how the employees would view the plan and whether the plan's vesting schedule and benefit formula suit the workforce. The advisor would also ask about anticipated turnover and any plans to add staff, since a growing staff raises cost.
Fiduciary and Administrative Duties
The owner would become a fiduciary for the plans, responsible for selecting and monitoring providers, funding on time, and following plan terms. The advisor would suggest documenting decisions, reviewing the plan annually, and using experienced administrators.
Exit
The advisor would ask about the owner's exit plan. If the owner intends to sell the firm in a few years, the plan may be terminated before the sale, and the buyer may prefer that the plan does not continue. Termination has costs and steps, including actuarial calculations and distribution of assets. Alternatively, the plan could continue if the buyer assumes it, which is uncommon. The advisor would suggest that the exit plan be discussed at the design stage.
Scenario Variations Worth Considering
If the firm had two employees instead of six, the employee share of cost would be smaller. If the owner were younger, the target funding might be lower. If the firm's profit were irregular, a smaller plan or a different design might fit better. If employee turnover were high, forfeitures could affect cost.
Risks and Limits
- Required contributions apply even in a lean year.
- Employee costs can be large.
- Plan design rules are technical.
- The numbers here are illustrative only.
What This Scenario Teaches
Plans with employees are business decisions as well as tax decisions. The total cost, the ability to fund in a downturn, and the exit plan matter more than the size of the deduction.
Questions to Bring to Your Advisor
- What is the total cost including employees and fees?
- Can the firm sustain the funding in a weak year?
- How would the plan be terminated?
- What are my fiduciary responsibilities?
Frequently Asked Questions
Do defined benefit contributions have to be paid every year?
Generally required contributions must be made, though there are rules for adjusting or freezing plans.
Is the owner share in this scenario typical?
No. It is an assumption for arithmetic.
Want to Talk Through Your Own Situation?
These scenarios are illustrations only. Book a discovery call with AE Tax Advisors to discuss the facts of your own business or portfolio.
Book a Discovery CallEducational purposes only. This page is an illustrative educational scenario, not tax, legal, or accounting advice, and it does not describe a real client or a real result. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.