DB Plan and SEP Contribution

[Guest lund]

I am trying to confirm what my DB plan admin and the Tax guy is telling me - as I think you guys here are much more knowledgeable in these types of issues. Sorry for taking some space here:

1. My DB Plan guys are telling me that my DB Plan is overfunded - by close to 15K for the year 2009. Which means I should not take a deduction this year and let the plan catch up. Looks like I have already tapped into future deductions.

2. I have a 401(k) and PS plan in place. Since I only draw a limited salary (say 50K) I will be able to defer 16500 (or whatever the exact limit is for 2009) for 401(K) salary deferal and an additional 6% PS of the 50K (which is 3K) paid by the business.

3. Spouse is also coowner of the business. She participated in the DB plan, she drew 3 years of salary in 00-02 and now just participates in the DB plan to maximize the benefits/deduction. So the high income for 3 years are enabled for her for the DB plan.

Now I understand may be I should let the DB plan catch up this year and not take a deduction (not fund the plan). However; if I am not putting any money in the BD plan, does it still perclude me from adding anything to a separate SEP IRA account as well? I know the limits include the combined DC contribution and DB contribution - but for the business, if in 2009 I am not putting any monry in the DB plan, I still cannot qualify for the 25% (49K or so for each one of us) DC contribution either?

Any help or pointers greatly appreciated. Sometimes bringing info to my Tax and DB plan admin attentions helps them see the light....

[AndyH]

First, having a SEP and a DB is most likely a problem - with the SEP document. Most require it to be the exclusive plan. You should check the language and wording of the plan document.

Is there a chance that you have a profit sharing/401(k) plan instead of a SEP? The distinction is important.

Once you have clarified that we can answer your question about what if you do not contribute to the DB.

Second, much more info would be needed to identify whether or not we might agree that you should not contribute to the DB plan. We'd need technical details, but to start with your DB plan's benefit formula, your accrued benefit, the plan's Normal Retirement Date, your age, and the value of plan assets might allow some insight.

[Guest lund]

THanks for the reply. You are correct, the SEP is kind of a different entity altogether.

The DB plan is a separate plan altogether. It was created in 2000. In 2008 we opted for a "S corp", DB plan was adopted by the S corp. Also in 2008 we added a separate 401(k) + PS plan. So it is my understanding that the DB plan and 401(K) + PS plan are being managed seperately.

My understanding is that as of end of 2009, the plan is overfunded by a mere 15K. Our ages are 40 & 32 (bummer.....)

Thanks

First, having a SEP and a DB is most likely a problem - with the SEP document. Most require it to be the exclusive plan. You should check the language and wording of the plan document.

Is there a chance that you have a profit sharing/401(k) plan instead of a SEP? The distinction is important.

Once you have clarified that we can answer your question about what if you do not contribute to the DB.

Second, much more info would be needed to identify whether or not we might agree that you should not contribute to the DB plan. We'd need technical details, but to start with your DB plan's benefit formula, your accrued benefit, the plan's Normal Retirement Date, your age, and the value of plan assets might allow some insight.

[AndyH]

So, are you saying that you have a:

1. DB

2. SEP; and

3. Profit sharing and 401(k) plan?

Or are you interchanging 2 and 3, and if so, which one is it?

[Guest lund]

Sorry for the confusion I am creating here:

1. DB exists. It is paid and managed by the business I and my wife own.

2. PS and 401(K) exists. Based on the salary of 50K for myself only, I defer the 401(K) deferrals from salary. Business puts in 6% as PS based on the 50K Salary.

3. The SEP is my personal account that I had prior to adopting the DB plan in 2000. And has nothing to do with the DB plan or the business. Before starting the DB Plan I used to contribute to the SEP plan ONLY. So the SEP predates the DB plan adoption in 2000. May be irrelevant for this discussion.

What I Was trying to find out that if I not contribute to DB plan in a year, can I instead contribute to a self standing (separate) SEP account for that year? Hence the mention of SEP...

Thanks

So, are you saying that you have a:

1. DB

2. SEP; and

3. Profit sharing and 401(k) plan?

Or are you interchanging 2 and 3, and if so, which one is it?

[AndyH]

If you don't fund the DB for a year, you can contribute 25% of pay to the profit sharing plan plus the 401(k) deferral. The SEP may be invalid because it may not be able to co-exist with either the DB or profit sharing/401(k) plan. Many SEPs have "exclusive plan" requirements, and others may not be viable when a DB plan exists.

[Mike Preston]

Forget the SEP. Anything you can contribute to a plan that is NOT the DB plan can be contributed to the PS/401(k) plan.

If you are NOT contributing the DB plan for the year, your contribution to the PS plan can be greater than 6%.

You really need to have this discussion with the entity that helps you with your PS/401(k) plan. They should know the rules and be willing to discuss them with you.

[Guest lund]

My 401(K) and PS admin guys are telling me that there is no restriction - the PS component can be deposited upto 25% of compensation limited to 49K.

But it seems that:

1. Business can put upto 25% os salary in PS not to exceed 49K (as long as I do not put in any money in the DB plan for this year). My salary is lot less than the profit. Another decent chunk flows to each of us under schedule K-1 as profits, but I am the only one who draws the 50K salary. Is the 25% limit for PS only uses the salary drawn from the business and not the profits, right? Again I have less salary and more profits...

2. I will still defer the max 401(K) deferral (16.5K) from the salary for 2009.

I have another question: Does it make sense to over fund some what the DB plan and eat into future contributions or is it better to stay at par? I know the taxes will most likely be higher down the road...

The DB Plan guys were telling me that I can fund half of what I am used to funding the DB Plan for 2009, but it will really be eating into the future contributions. They are saying one way or the other I will have to not fund for a year or two for it to catch up and normalize. I guess our ages does cripple us to max out in the contribution.

If each one of us can amass 2.2M in lump sum retirement value, we are way way far away from that in our account and I do not see us working in this or any other business longer than say 10 years that generates this kind of money.

THanks for all your help...

[AndyH]

My 401(K) and PS admin guys are telling me that there is no restriction - the PS component can be deposited upto 25% of compensation limited to 49K.

But it seems that:

1. Business can put upto 25% os salary in PS not to exceed 49K (as long as I do not put in any money in the DB plan for this year). My salary is lot less than the profit. Another decent chunk flows to each of us under schedule K-1 as profits, but I am the only one who draws the 50K salary. Is the 25% limit for PS only uses the salary drawn from the business and not the profits, right? Again I have less salary and more profits...

2. I will still defer the max 401(K) deferral (16.5K) from the salary for 2009.

I have another question: Does it make sense to over fund some what the DB plan and eat into future contributions or is it better to stay at par? I know the taxes will most likely be higher down the road...

The DB Plan guys were telling me that I can fund half of what I am used to funding the DB Plan for 2009, but it will really be eating into the future contributions. They are saying one way or the other I will have to not fund for a year or two for it to catch up and normalize. I guess our ages does cripple us to max out in the contribution.

If each one of us can amass 2.2M in lump sum retirement value, we are way way far away from that in our account and I do not see us working in this or any other business longer than say 10 years that generates this kind of money.

THanks for all your help...

1. The 49K is an individual limit, not a total limit. (If your wife has no compensation the two are the same but the 25% will apply).

2.Profits don't count as compensation. Convert some of it to salary or bonus - especially for your wife to use 401(k) provision and to get DB service credit.

3. The rest of your comments may be debatable - not enough information. if your income will increase in the future, your limits will grow in the future, not be used up now.

You were too young to have a DB when you set it up IMHO. Did you get sold a bad deal?

Hope this helps.

[Guest lund]

Got it.

I think in the hindsight, so far a bunch has been put away in the DB plan that I would not have been able to otherwise. We never knew if the business would survive or not, it still can go under any year.

The money is self directed, so NO crazy 412(i) stuff either. The only issue is ongoing yearly costs roughly around $1400. Not sure if this much yearl costs is reasonable or not. I checked couple places and found to be the case. $1400 is for the yeraly DB plan administration.

Just so that I know - for a 40 year and 33 year old couple, what would be the Flat NORMAL (no catch up, no accelerated) DB plan contribution yearly? assuming the business was making unlimited money....

Thanks

[Mike Preston]

Andy, one of the criteria that I use to determine whether a DB plan makes sense for a prospective client is the answer to this question:

Are you in the last 10 or 11 years of a business where your income generation will be such that you will want to save more than 20% of income?

If that can be predicted with any degree of certainty, then doesn't it make sense for anybody, no matter how young?

[AndyH]

Mike, I'm always interested in your opinion, but I don't understand your question. What do you mean by "in the last 10 or 11 years of a business". He's only 40, and perhaps had the plan start when he was 35 or so (just guessing). And he's only showing $50K of salary, now, so are you suggesting he wants to retire at age 45?

Five years ago he could have deferred $26,500 in a DC plan. I bet he did not. I wonder how much he saved in a DB plan above $26,500, net of fees.

Why not max out a DC until age 40 or so, then establish a DB, especially with a shaky business?

I think I know where you're going with this, but some clarification of your criteria would be appreciated.

[Mike Preston]

Well, I did say it was *ONE* of the criteria, not the sole criteria.

Judging from the tone of the message, my guess is that he has a significant chunk of change passing through on his K-1.

My calculations yield a DB accrual for somebody age 30 in 2009 which exceeds the DC max (excluding catchup). So, a DB plan really does make sense for a relatively young person if the other criteria line up.

Keep in mind that a DB plan put in 10 years ago at the youngest age where the benefit accrued was the DC 415 $ limit at that time ($30,000), which was 35 or so, would have a 415 dollar limit associated with that first year of $100,000 now, which is 1/10th the dollar limit payable at age 45. You have to assume a constant rate of return of nearly 13% to pretend that there wouldn't be additional contributions beyond that initial $30,000 just to use 1/10th of the dollar limit in effect 10 years later.

So, I submit that it is not merely the contribution for the year in question, but also the contributions for future years which will pyramid that must be taken into account.

It is an interesting trade-off in the sense that the DC contribution itself can be viewed as a "use it or lose it" kind of thing, since there is no making up for missed contributions in the DC plan. But in a DB plan you can take the opposite approach and claim that the DB plan provides the ultimate in establishing the potential for large future contributions. Certainly until the IRS comes out with regulations that implement 415(b)(5) [the 10 year phase in of the 415$ limit], you are establishing a very large potential, even if you put in what I call a "placeholder" plan at a modest level, well below the 415 $ limit at the outset.

Whether that potential can ever be realized usually revolves around the answer to the question I initially posed:

Are you in the last 10 or 11 years of a business where your income generation will be such that you will want to save more than 20% of income?

If the answer is yes, it hardly seems wrong to implement the DB plan, because after the 10 years has run, since the answer to the question itself means that a DC plan can adequately serve the client's needs after that point.

As you know, it is very difficult to predict when those 10 years actually take place. My experience has been that when people think they have a fixed horizon income opportunity, they establish themselves as competent business people during that time period and the income continues on long after they thought it would end.

If so, they probably would have been better off with putting in a DC plan until, .... untill... when? Well, go back to the question: Are you in the last 10 or 11 years of a business where your income generation will be such that you will want to save more than 20% of income?

It is definitely not an exact science.

Combine all this with the fact that deferrals no longer reduce 415 compensation (which always argues for layering a DB on top of a 401(k) plan), and the 404a7 limitation affecting the maximum that can go into a PS plan in many cases and you have all the criteria you need to do a great plan design!

[Below Ground]

Just as a note from the "peanut gallery".

Lund really needs to find someone to work directly with his issues. If I hear him right, his wife is, or could be on payroll, and he is limited to $15K with a DB, and for some strange reason he has this SEP which he doesn't think has impact.

May I suggest that if the DBP is "tapped out", leave it alone. Pay your wife enough so that you can both do maximum deferrals (16.5K or 22K) EACH, with another 25% on top from employer contribution under the 401(k) Plan. Oh, and lest I forget, that SEP could be a ticking time bomb.

Of course, whether or not this is right depends upon the details; hence, the need to talk to someone who knows what he/she is doing in this area of expertise; discussing the specific of his situation.

[AndyH]

Well, I did say it was *ONE* of the criteria, not the sole criteria.

Judging from the tone of the message, my guess is that he has a significant chunk of change passing through on his K-1.

My calculations yield a DB accrual for somebody age 30 in 2009 which exceeds the DC max (excluding catchup). So, a DB plan really does make sense for a relatively young person if the other criteria line up.

Keep in mind that a DB plan put in 10 years ago at the youngest age where the benefit accrued was the DC 415 $ limit at that time ($30,000), which was 35 or so, would have a 415 dollar limit associated with that first year of $100,000 now, which is 1/10th the dollar limit payable at age 45. You have to assume a constant rate of return of nearly 13% to pretend that there wouldn't be additional contributions beyond that initial $30,000 just to use 1/10th of the dollar limit in effect 10 years later.

So, I submit that it is not merely the contribution for the year in question, but also the contributions for future years which will pyramid that must be taken into account.

It is an interesting trade-off in the sense that the DC contribution itself can be viewed as a "use it or lose it" kind of thing, since there is no making up for missed contributions in the DC plan. But in a DB plan you can take the opposite approach and claim that the DB plan provides the ultimate in establishing the potential for large future contributions. Certainly until the IRS comes out with regulations that implement 415(b)(5) [the 10 year phase in of the 415$ limit], you are establishing a very large potential, even if you put in what I call a "placeholder" plan at a modest level, well below the 415 $ limit at the outset.

Whether that potential can ever be realized usually revolves around the answer to the question I initially posed:

Are you in the last 10 or 11 years of a business where your income generation will be such that you will want to save more than 20% of income?

If the answer is yes, it hardly seems wrong to implement the DB plan, because after the 10 years has run, since the answer to the question itself means that a DC plan can adequately serve the client's needs after that point.

As you know, it is very difficult to predict when those 10 years actually take place. My experience has been that when people think they have a fixed horizon income opportunity, they establish themselves as competent business people during that time period and the income continues on long after they thought it would end.

If so, they probably would have been better off with putting in a DC plan until, .... untill... when? Well, go back to the question: Are you in the last 10 or 11 years of a business where your income generation will be such that you will want to save more than 20% of income?

It is definitely not an exact science.

Combine all this with the fact that deferrals no longer reduce 415 compensation (which always argues for layering a DB on top of a 401(k) plan), and the 404a7 limitation affecting the maximum that can go into a PS plan in many cases and you have all the criteria you need to do a great plan design!

Well, no disagreement with any of your main points. I agree it comes down to a comparison of the "Use it or lose it" rule versus the "placeholder" rule. My unscientific break point might be just before 40. I'm considering the fixed versus flexible contribution aspect and the need for cash for life events at this age. So, yes the K1 is an important consideration.

[Guest lund]

To keep all the correct info in there - Before the DB plan being out in place I was running as Schedule "C" (sole prop) and funded my IRA for couple years into the SEP-IRA account. I may be using an incorrect name for this type of account, this is where as a Sole Prop I was able to put away 20-30K per year for retirement. Once the DB plan was put in, that account has seen no additional contribution activity since then.

[Guest lund]

On another note - I am also consiedring termintating this current Plan. Take the money, invest in the market (at some point) and let it grow outside of the plan. If business continues, may be I will pick up the plan again in the next 3-4 years. This way I will have more years behind me w/o contribution into the DB plan and would allow for some decent contributions yet again.

My DB Plan guys are telling me that I am not overfunded, so excise tax or anuthing on temrination this year.

My question though - If I terminate the plan, roll over the money into an IRA and agressively grow it, the growth of this money does not bite into the future DB contributions (once I restart the DB plan 4-5 years later). Of course this assumes that the money grows. However; if I keep the DB plan active, and try to grow the money within the plan then it eats into my future contributions...this all sounds rubbish to me, may be I am missing something basic here.

If I am right, it should always make sense to termiante, roll over, grow and pickup again in few years.....as long as the growth does not eat into the original basis and stays where the plan was terminated....

Thanks

[Mike Preston]

lund, your basic understanding and your instincts are correct. In an economic environment where significant growth in the underlying investment fund takes place, it will definitely be better for somebody to see that growth take place in an IRA, rather than in a db plan, for just the reasons that you mentioned.

Taken to its ultimate extreme, the monies to fund a DB plan are deposited annually, then immediately withdrawn and rolled over to an IRA. If you do that for 10 years, the total funds in the IRA will dwarf whatever might have been accumulated in a DB plan that didn't employ this "strategy". The problem is that the IRS doesn't like this strategy at all, and those who practiced it (and there were more doing this than many people imagine) were recently told to cut it out or their plans would be disqualified.

I'm not suggesting that you follow that strategy. Quite the opposite. All I'm doing by relating that story is to show you that your understanding of the financial ramifications is correct.

Of course, the whole thing falls apart in years where the investment return is lower than what is expected. In those years, the above mentioned "strategy" will end up reducing the total funds available at retirement. I'm sure this makes sense to you given your grasp of the investment issues.

But if you do this precisely once, by terminating your existing plan now, sitting on the sidelines for a few years, and then starting up another DB plan when the economy turns around, the IRS is not likely to claim you are employing the "strategy" described above and if the rates of return you can engineer in the funds is indeed significant, you will be ahead of where you would have been had you merely left the funds in the existing DB plan and invested similarly there.

Of course, there are all sorts of "ifs" that go along with the conclusion that you will be ahead in the long run and you should go over them with the folks that currently have your DB plan. Paying now for a little consulting will go a long way to ensuring you are on the right track.

[Guest lund]

Mike thanks for your words of wisdom.

If I terminate and restart after few years, would I need to re-establish my High 3 years of income for maximum DB plan contributions? IN other words do I loose the high-3 income year numbers I currently am using? That would be a bummer.

THanks

[Mike Preston]

The way the law is written now, you do NOT lose your high 3 average. I know of no movement afoot to modify this.