Basic Types of Owner-Only Plans
Contributions to a SEP are limited to the lesser of 25% of current year compensation or $54,000. This means that an owner of a corporation must receive W-2 wages of $216,000 or more to reach the $54,000 maximum.
SEP contributions are subject to many of the same limits and restrictions as qualified plans. Therefore, a company should not make contributions to a SEP in addition to making contributions to a 401(k) or DB Plan.
Company contributions to a 401(k) Plan are also limited to 25% of current year compensation. However, salary deferrals of up to $18,000 may be made in addition to the company contributions (up to a combined total of the lesser of $54,000 or 100% of the owner’s compensation). This allows an owner of a corporation with W-2 wages of less than $216,000 to contribute more than they would have been able to using a SEP.
An owner age 50 or older may defer an additional $6,000, bringing the maximum up to $60,000.
The owner may characterize deferrals under the plan as after-tax Roth deferrals (rather than the traditional pretax deferrals). There is no compensation limit on the use of Roth deferrals in a 401(k) Plan, so highly paid owners can take advantage of this feature.
If the company meets the requirements of Form 5500-EZ, a 5500-EZ need not be filed with the government until assets exceed $250,000 (please note that this asset threshold includes rollovers and contributions receivable for that year). If the company does not meet the 5500-EZ requirements, the plan must file a full Form 5500 no matter the amount of plan assets (see 5500-EZ instructions for requirements).
Because a DB Plan funds for a benefit at retirement, the maximum contribution is not directly limited by the owner’s compensation in the current year. Rather, the benefit at retirement that the plan may promise the owner is limited. This retirement benefit cannot exceed the lesser of (i) 100% of the owner’s highest average compensation over three consecutive years, or (ii) the COLA-adjusted dollar limit (currently, the dollar limit on retirement benefits is $215,000 per year, for retirement ages between 62 and 65).
Once the plan has established an expected benefit for the owner to be paid at the plan’s retirement age, an annual contribution schedule is calculated that would allow the plan to be fully funded when the owner reaches that age. For this reason, the closer the owner is to the plan’s retirement age, the greater the annual contributions needed to fund that benefit (this is because there are fewer years to fund that benefit than would have been the case for a younger person).
Consider an owner, age 55 with W-2 wages of $195,000 or more, who intends to retire at age 65. These facts would allow first-year deductible contributions to the DB Plan of approximately $199,037, as follows:
- Compensation of $195,000 allows the plan to promise the owner-employee the maximum annual benefit payment beginning at retirement (in this case, $195,000 per year beginning at age 65).
- To fund this expected annual payment stream, a “lump sum” of more than $2 million is needed by age 65.
- In order to build this lump sum in ten years (given assumptions regarding rate of return, etc.), contributions of approximately $199,037 per year for ten years are needed.
- This process of valuing plan benefits and calculating contributions to fund those benefits is repeated each year, so contributions fluctuate from year to year based on the actual experience of the plan.
DB Plans have contribution requirements each year. The plan must maintain enough assets to fund promised future benefits to the owner. So an increase in benefit accrual for a year generally means some contribution will be required that year to fund the benefit increase.
This also means that investment performance affects required contributions to the plan. If the investments incur a substantial loss, an increase in future contributions may be required to make up the loss. Similarly, if actual investment return exceeds the assumed rate of return used to calculate funding obligations, required contributions in future years will tend to be reduced.
The plan may be amended to lower contributions for future years; however, benefits accrued during a plan year must be funded. Therefore, an owner considering adopting a DB Plan should assume that there will be required contributions to the plan in future years.
Under ERISA, a plan sponsor must intend the retirement plan to be “permanent.” Although the IRS does not give an explicit definition of “permanent,” it is clear that a Defined Benefit should not be setup if the company intends to fund the plan for only one or two years.
Add a 401(k) Plan to a DB Plan:
Owner-only DB Plan contributions are not affected by a 401(k) Plan, provided that contributions to the 401(k) Plan are limited to: (i) salary deferrals, and (ii) a profit sharing contribution that does not exceed 6% of the owner’s compensation. This allows the owner additional discretionary contributions of $18,000 salary deferral ($24,000 if the owner is age 50 or older), plus a 6% of compensation profit sharing contribution (not to exceed $15,800).