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Qualified plans can be the best way for clients to save tens of thousands in taxes every year — except when they wind up costing even more in taxes they don’t have to pay!
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Tricks and Traps with Qualified Plans

Life is full of tradeoffs that require us to weigh costs and benefits to arrive at the “right” decision. This is just as true with taxes as anything else. Sometimes, the costs of implementing a tax strategy are insignificant relative to the overall benefit. For example, establishing an S corporation often means smaller social security benefits down the road. However, that long-term cost is far less than the savings you can create today, and most clients will do far better investing the savings on their own than if they paid the extra tax.

Other times, weighing the costs and benefits are a bit harder. This is especially true with “timing” strategies, like qualified plans or monetized installment sales, that push tax bills decades into the future. For starters, we don’t know what tax rates will be that far down the road. And second, we don’t know how much money will be worth when the tax bill finally comes due.

I’ve seen a fair amount of discussion on the TMN Facebook group that touches on this question, particularly with qualified plans. At first glance, recommending a big qualified plan contribution – a defined benefit or cash-balance plan – looks like a home run. “Look, I just saved you $80,000 in tax!” But at that point you haven’t “saved” your client anything. You’ve just deferred the $80,000. How much will the client wind up paying down the road? Less than $80,000? Maybe even more? Let’s walk through a case study to identify the issues that can turn a qualified plan contribution into a ticking tax time bomb.

Qualified Plans

We’re all familiar with the core qualified plan concept. Contributing gives clients an up-front tax break they can use to put more money in the plan or take the family to Disney for spring break. Tax is deferred until the money comes out of the plan. All other things being equal, the client comes out ahead by investing what would have gone to taxes before withdrawing those funds from the account. They come out even further ahead if there’s employer matching money going into the account, or they find themselves in a lower tax bracket in retirement.

But things aren’t always equal. So, let’s take a closer look at some of the less obvious costs to develop a framework for avoiding mistakes that make us look great now but wind up costing the client big-time down the road.

First, how much will your client really save up front? If their income puts them $100k into the 35% bracket, and they contribute $50k to a 401(k), they’ll save 35% of their contribution. If they’re $25k into the 35% bracket, that same contribution saves them just 33.5% (35% of $25k and 32% of $25k).

But we can’t stop there. We have to look at two more factors: 1) the cost of administering the plan; and 2) the cost of contributing on behalf of employees. If your client is looking to establish a plan specifically or primarily as an employee benefit, those are part of the cost of doing business. But if they’re establishing a plan primarily as a tax-saving strategy for themselves, that really throws off the up-front savings.

Example: Clyde Consultant’s taxable income is well into the 37% bracket. You recommend a defined benefit plan that lets him put away $200,000 for himself with a $20,000 employee contribution and $3,000 annual admin cost. The gross tax savings on the $200,000 contribution is $74k, which sounds great. However, the net savings, considering the after-tax cost of the employee contribution and admin fee, is just $59,510, or 29.8%.

There’s one more factor that applies when you’re looking to maximize a client’s qualified plan contribution: if you raise their salary to make bigger contributions, you’ll have to consider the extra FICA tax involved in the higher pay. This can be devastating when the extra salary is below the social security wage base, thus subject to the full 15.3% FICA tax.

Example: Rhonda Realtor grosses $250k in her S corporation, deducts $50k in expenses, and pays herself a salary of $100k. Her husband Roger stays home with the kids. Now she wants to start stuffing money into a 401(k). So she hires her husband and pays him $25k so he can put $19,500 in the plan, too. Together, they save 22% on his deferral, or $4,290. BUT, they pay $3,750 in FICA on that wage, which cuts their actual savings to roughly 7%. (They’ll get an income tax savings on the employer half of the FICA that Rhonda’s corporation pays, and some additional income tax savings if she makes a profit-sharing contribution based on that $25k salary.)

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Of course, sometimes the collateral consequences of deferring income into a qualified plan help the client. Cutting taxable income can open up qualified business income deductions, restore lost credits and deductions subject to phaseouts, open up the rental real estate loss allowance, and create other collateral savings. (At this point, you’re probably wondering if TMN has an Excel spreadsheet or other software to help you run the numbers. The answer is no: the data entry necessary to be that precise would simply be too burdensome. Use the projection module in your tax-prep software for this sort of number crunching.)

So, our up-front benefit, in many cases, is far different than merely multiplying the client’s contribution by their marginal tax rate – and far less than the client realizes.

Now let’s look at the cost of pulling the money out of the plan.

The first factor is unknowable: what will the client’s tax rate be on the income they draw from the plan. This will depend on how much the client is earning before qualified plan withdrawals and what the average rate is on that income.

This is obviously uncertain for younger clients who may be decades away from retirement. But it’s true for older clients as well. Consider that Washington may (or may not) raise rates based on President Biden’s campaign proposals. Consider that Washington may (or may not) extend the current rates in the Tax Cuts and Jobs Act when they expire at the end of 2025. For that matter, consider that on December 19, 2017 – the day before that act passed – we didn’t know what rates would be when 2018 started in less than two weeks!

Having said that, when you look at current tax rates in the context of history, we’re still at historical lows. Odds are good that if your client is a decade or more away from starting withdrawals, the general rate environment will be higher. And most clients will agree with you.

Now let’s consider three more issues:

  • Money coming out of a qualified plan gets taxed as ordinary income – even if the underlying income would have been taxed as lower-taxed qualified corporate dividends or long-term capital gains had it not been invested in a taxable account. Millions of Americans are happily buying and holding stocks and stock mutual funds (ugh) in their retirement plans, not realizing they’re converting long-term capital gains into ordinary income all the while. Centuries ago, alchemists worked in the earliest laboratories to spin base metals like lead into precious gold. Buying equities in a qualified plan is the complete opposite of that classic path to riches.
  • Qualified plans are designed to provide retirement income, not “just” tax shelter. At some point, the tax code requires your client to start taking required minimum distributions. That age has gone up from 70½ to 72, and may go up even further to 75. But those rules will force many clients to take withdrawals they don’t otherwise need and pay tax on it.
  • Taxpayers can build absolutely gorgeous, fully-taxable portfolios full of stocks, SPACs, bitcoin, and NFTs – hold those portfolios until they die – and avoid tax entirely on their gains. (Well, at least they can now, under current law.) But if they build those same portfolios in a qualified plan, their heirs will lose the “stepped-up basis” they would enjoy with taxable assets and wind up paying tax on those gains. Adding insult to injury, they’ll pay tax on that lifetime of gains at ordinary income rates.

Take a look at all these factors, and suddenly the qualified plan decision looks a lot less cut-and-dried, doesn’t it? Here are a few useful rules-of-thumb to start making decisions easier:

  • If your client is an employee and there’s employer money on the table, take it. Contribute as much as it takes to maximize that free employer money.
  • If your client is young or just starting out in a new job, Roth accounts are probably the best option. Why should a 24-year-old just starting out in her first job sacrifice to save today at a 12% or even 22% rate when her tax in retirement will probably be higher?
  • If your client is currently in the top bracket, and their income and/or net worth are high enough that they’re always going to be in the top bracket, qualified plans are a wash, at best. If making qualified plan contributions will require employee contributions, then it’s not an employer tax-saving play, period. This can be a hard pill to swallow for those of us who love the fat up-front deferral we get from defined benefit or cash-balance plans. (Of course, if your client is stacking paper now, but expecting to retire in a significantly lower bracket, it can still be a great play as long as no significant employee contributions are required.)

What if all this analysis shows that qualified plans aren’t the right answer? We’ll discuss that in our next column.

Edward Lyon

Edward Lyon

Edward A. Lyon is CEO of the Tax Master Network, where he's coached tax professionals to add planning and financial services to their business since 2005. Go here to join the network. Go here to upgrade your membership or discuss opportunities in financial services.
Edward Lyon

Edward Lyon

Edward A. Lyon is CEO of the Tax Master Network, where he's coached tax professionals to add planning and financial services to their business since 2005. Go here to join the network. Go here to upgrade your membership or discuss opportunities in financial services.

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