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Cross Tested Plans: The Small Business Tax Break
By John M. Barry II
How do you make your small business grow, but still be able to put away towards your own retirement with tax laws constantly changing? It’s not always easy, but there may be a pot of gold within reach. In 1993, the IRS added 401(a)4, better known as “Cross-Tested” plans to their Qualified Pension, Profit-Sharing and Stock Bonus plan section. To many small business owners, it’s the plan they’ve been looking for.
Though some experts may see it as discrimination, others see it as an equal and fair retirement plan for the business owner. To better understand, let’s look at a small business that has profits, where the owner is pouring the profits back into the firm. Being older than his/her employees, the employer does not have the luxury of time on his/her side, thus his retirement funding time is shorter. If the employer was using a traditional profit-sharing plan or simplified employee plan, “SEP”, the maximum the employer could put aside for top paid individuals would be $22,500, annually.
In a cross-tested plan, a company can contribute for an individual up to 25% of pay or up to $30,000 in the same time period. Remember, the actual amount depends on a few factors such as how much of the company’s profit goes into the plan, the number of employees, their age and salaries. Cross-testing allows employers to use similar allocation formulas that were once exclusive to pension plans. When looking at Pension formulas, older employees were given a larger investment amount due to less number of years left in the workforce. Now you ask where does fairness come into play? A dollar to an older owner and employees has less value than to someone younger who has investment time on their side.
Though cross-testing formulas were put in place to prevent retirement plans from discriminating in favor of older, higher compensated employees, the tax law keeps in consideration, the value of time left an older person has in the workforce. 401(a)4 does state you must divide employees into highly paid and lower-paid sections and you must keep in mind a cap on the spread with respect to the actual percentage. When you combine all of this, the owner and highly paid employees are able to keep a substantial amount. Most younger employees are not in the mindset to set aside a substantial amount towards retirement, but still have time on their side. Thus, “cross-testing” allows a section of highly compensated employees and business owners to place money aside for retirement at a faster rate. Though lower paid employees are included in the plan, they are all subject to a vesting schedule, usually six years and turnover of lower paid employees is usually sooner, leaving money in the plan to be reallocated to remaining members.
A trend today is to blend 401(a)4 plan with a 401(k) plan. 401(a)4, or a cross-tested plan, uses corporate dollars, solely. A 401(k) uses the employees pre-tax dollars and often a company match of corporate dollars. By using 401(a)4 with a 401(k), you change the discrimination testing by pulling out certain highly paid employees and owners, thus leaving the plan to pass discrimination tests, allowing the owner or shareholder to put away the maximum allowable, up to $30,000. Also allowing highly compensated employees who do not qualify for the top tier profit-sharing to defer the maximum into their 401(k), which is currently $10,000. Now, the owner still has the choice of offering a match to employees that are in the 401(k). This is a great way of utilizing both retirement plans and making everyone happy.
As is the trend with anything that even smells like a tax shelter, the IRS has strict rules governing these plans. However, the “kinder, gentler” IRS continues to make it easier to save for retirement by making the testing requirements for qualified plans easier to pass. Since the fate of Social Security is still being determined in Washington, any small business that can maximize the use of a 401(a)4 alone, or along side of their 401(k) would be smart to start now. Who knows how friendly the IRS will be tomorrow?
John Barry is a Vice President with Dodge, Warren and Peters Financial Services, Inc. and a Registered Principal with Associated Securities Corp. He can be reached at 310-542-7313 x208.
