Evaluating a Plan for Tax Efficiency

[austin3515]

When calculating for owners the tax benefit of their plan, do we include 401(k) in that analysis? I've always said "no" because more likely than not there is some level of 401k that can be done with no employer contribution at all. But if the Plan is top-heavy, I suppose the 3% is the cost of doing the 401k quite literally.

But it also occurs to me that I'll bet someone has done quite a bit of research on this analysis. I wouldn't be surprised if one of the large accounting firms has written something about this. If not, they should, because I have this conversation with clients all the time.

Does anyone have any info they can share?

[Bird]

I'm not sure exactly what calculation you are doing, but when I do a proposal I usually include something that shows what percentage of the contributions the owners are getting, and I definitely include 401(k) in that. I suppose they could maybe do an IRA if they didn't have a plan, but I don't think it's my job to get into those details. As you note, for smaller companies, a TH contribution is probably required, so it's generally an all-or-nothing deal (i.e. a plan with employer contributions or no plan at all) so I think it is totally appropriate to include 401(k) contributions when you are looking at the "all" scenario.

[austin3515]

The calculation is essentially "what does the employer get for a tax deduction compared to employer contributions allocated to participants."

[mbozek]

If you want to know what % of the contributions are allocated to the employer then just multiply the % of the contributions allocated to the employer/owner's account. E.g., 100,000 deduction for contributions to the plan of which 90,000 is allocated to employer's account. Employer gets 90% of the deduction.

[chc93]

If you want to know what % of the contributions are allocated to the employer then just multiply the % of the contributions allocated to the employer/owner's account. E.g., 100,000 deduction for contributions to the plan of which 90,000 is allocated to employer's account. Employer gets 90% of the deduction.

This is how some CPA's view the employer contributions in discussions we have with them. In fact, when they say "what percentage is the contribution", while I think of percentage of compensation for the owner, they think of percentage of the total contribution paid to the plan and deducted.

[austin3515]

Yes, but do you include 401k in the "deduction"?

[chc93]

Yes, the 401k is discussed, but separate from the "company contribution" and associated "percentage". And we don't discuss the splitting of 401k and company contributions and tax implications.

[austin3515]

That's what I do too. I'm surprised no tax firms have made something like this available.

I've always said total deduction x tax rate - employee contributions to figure the tax savings. I think ESPECIALLY when you're talking about profit sharing that is the analysis for sure because the SHNEC already paid for the deferrals. If anyone took finance in college that is referred to as a "sunk cost" that should not be taken into account when deciding whether or not to fund the profit sharing. Of course in the plan design phase (or before the beginning of a plan year it is relevant.

Geeze, maybe I just answered my own question

[John Feldt ERPA CPC QPA]

Why not show the efficiency of just the employer dollars as your first total, then on separate line below that include an efficiency with the owner deferrals included. You can explain that the actual efficiency lies somewhere in between but is based on the owners' individual tax situations.

[austin3515]

Well now we're talkin...

[Bird]

I've always said total deduction x tax rate - employee contributions to figure the tax savings. I think ESPECIALLY when you're talking about profit sharing that is the analysis for sure because the SHNEC already paid for the deferrals. If anyone took finance in college that is referred to as a "sunk cost" that should not be taken into account when deciding whether or not to fund the profit sharing. Of course in the plan design phase (or before the beginning of a plan year it is relevant.

Humor me for a moment...I've seen accountants do this and never quite understood what they were getting at. You're saying that if a company can make a $100K contribution, and $20K goes to employees and $80K goes to owners, and the tax rate is 45%, the calculation is: 100X.45 = 45000 that they would have paid in taxes, minus the 20000 that goes to employees, equals a $25000 "tax savings"? I guess that means something; maybe depends on the audience.

I always preferred to think of it as: you can pay 45000 in taxes and keep 55000 in your pocket, that's 55%. Or you can put 100000 in the plan and get 80000. That's 80%. 80% is better than 55% (ignoring future taxation of course). And I (sometimes) break it down further, pointing out that there are inflection points - on the first 3% (SH), you (owner) get 60% (or whatever, I'm changing from the example), but that allows you to defer the maximum, and 100% of that is yours, then you can put in another 6% PS (maybe) that's 100% yours, then maybe the last tier of PS would be 80% or whatever.

All the same stuff said a different way I think.

fwiw

[austin3515]

All the same stuff said a different way I think.

Bingo, with one exception, and that is, unless you do a calc based on dollars instead of percentages it's hard to determine the value. What if 70% of the total goes to the owners? Is there net tax savings? Hard to say...

But if $100K went in, you saved $45,000 in taxes and gave $30,000 to the employees (i.e., 70%), you saved $15,000.

[austin3515]

hey I just realized something fun - you should be able to come up with a formula to calculate the break-even percentage based on the marginal tax rate! Have to work on that one!