Pension
Trends Volume I, No. 3, August 2000
Pension
Trends Volume I, No. 3, August 2000
In this issue...
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Utilizing the Combined Plan Limit Repeal
The year 2000 repeal of the limit on an
individual with benefits in both a Defined Benefit (DB) plan and a Defined
Contribution (DC) plan had many pension professionals eager to utilize these new
expanded limits for their clients. However, for small employers (those with few
or no employees) looking to maximize their qualified plan deductions, the
combined plan maximum deduction of 25% of compensation seemed to eliminate the
advantage of having both a DB and DC plan. As a result, an owner too young
(under 45) to have a DB contribution in excess of 25% of compensation would
typically just have a DC plan.
One fact that is often overlooked in this analysis is that for
an owner with pay at the compensation limit ($170,000 for 2000), 25% of
compensation is $12,500 more than the individual DC contribution limit of
$30,000. So an owner old enough to generate a $12,500 DB contribution (29 or
older) can raise his/her deduction by 42%, from $30,000 to $42,500 For the owner who starts a plan at age 40, a DB plan alone
produces about $150,000 more in retirement funds after 15 years than a DC plan
alone. A DB/DC combination adds another $140,000. However, because as the owner
ages the DB contribution eventually becomes much larger than 25% of
compensation, the optimal scenario is one in which the DB/DC combination is used
until the DB contribution alone is significantly above 25% of compensation. At
this point the DC plan is terminated and only the DB plan continues. This
optimal scenario adds another $240,000 to the qualified retirement funds of the
owner who started at age 40 and retires at 55, or a total of $530,000 in
additional qualified funds at retirement compared to the DC plan alone. The owner who started contributing at age 45 is better off with
just a DB plan compared to a DC plan alone or even a DB/DC combination run for
all 15 years. However, if the DB/DC combination is used just for the first 5
years the owner can add almost $400,000 more to the qualified funds at age 60
with little impact on current deductions levels. Owners who start contributing to DB plan alone at 50 or older
can probably already get a deduction significantly in excess of 25% of pay. As a
result, a DB/DC strategy is not likely to be advantageous for them. However,
owners as young as 30 can benefit substantially through a DB/DC plan
combination. This scenario works best when there are no employees. However,
depending on the age differences between the owner and the employees, there are
DB/DC plan designs (discussed in this issue) that can be used to control the
employee benefit cost.
The
graph at right shows the accumulation of 15 years of maximum qualified plan
contributions for an owner who starts to contribute at age 40 and one who starts
at age 45. The funds are accumulated at 7% per year and all IRS benefit and
compensation limits are anticipated to increase by 3% per year.
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