Let me tell you a little story of three law firms, one big bad wolf (IRS), and the house that protected them (their 401k plan). As you may or may not know, I specialize in working with business owners private wealth management and employer retirement plans, and in a very unfortunate finding, I’ve noticed that many law firms suffer from having a poorly built ‘houses’. It has been so common that I had to shed light on the subject so everyone can be better educated.
Many companies these days have an established retirement plan, some more recent than others, but most law firms benefit significantly by the tax sheltering ability they provide. Now I’m reasonably certain most firms will agree with me when I say that your company’s income, taxes, and profits look much different than when the company was initially established. Does your retirement plan? You’ve likely hired on additional staff, created partnerships, and expanded ownership within the company to accommodate growth. With that growth comes extra income, which increases taxes. I’m sure your CPA is excellent, but there is only so much they can do to provide write-offs and try to keep your tax liability down. A far overlooked space to help is within your retirement plan. As your company grew, you may have updated your systems, improved your technology, and potentially even found some cost-cutting strategies. If you’re correctly reviewing your 401k annually, then you’ll be achieving all three of these things while seeing the opportunity to lower the companies tax liability. Today we'll be reviewing the first case study of three so I hope you enjoy!
17 Employee Law Firm
A 401k is set up for an employee benefit, and if it’s not set up correctly, it can be benefit that may hinder the savings ability to the owner, partners, and other employees that are considered highly compensated (Earning $120K+/year). In this case study, our client and their partners were upset with the fact they were limited to $10,000 a year for their contributions. That’s because the other employees that are considered non-highly compensated were not contributing enough to satisfy an IRS ratio. This is maddening for partners who are earning over 400k per year and only deferring 10k from their taxable income.
The plan documents needed to be amended to add a Safe Harbor provision. What this does is it eliminates the IRS ratio testing because the company is providing a 3% non-elective match or 4% elective match to employees.
- Non-elective: offered to all eligible employees regardless of if they participate in the plan or not
- Elective: Matches only participants that are contributing to their retirement and requires the employee to meet a certain percentage to access the full company match
This feature will allow all employees, partners, and owners to take full advantage of the tax-saving possibilities through the company retirement plan at 19,000 for 2019 and an additional 6,000 catch up for those over the age of 50.
While that’s almost double what they were able to put in previously, it still doesn’t help someone with a 400k salary quite as much.
This specific client really hates taxes, as most people do. So in addition to adding Safe Harbor to the plan, they were open to adding Profit Sharing. This allows the company to look at their financials year to year and decide whether or not they want to share some of the profits with the employees. The amount they chose to share with employees will be sheltered from taxes whereas if this wasn’t done would be taxed as the company’s profit. Profit-Sharing can be granted to employees in several different formulas so it’s best to look to a professional to help establish in whatever way makes the most sense for your company. But at the end of the day, this is able to potentially boost an owner's personal tax savings from 19,000 to $56,000 for 2019 and $62,000 for those over 50 if you include the catch-up.
Now that’s a significant difference from where we started at 10K a year but with the recent tax changes last year, this attorney was really looking to lower his income below 300k, so we still had some work to do.
After adding the Safe Harbor and Profit Sharing to the plan, the company was still be looking at a significant six-digit profit, which was going to equate to a six-digit tax bill, according to their CPA. We proceeded to evaluate the option to add a Cash Balance (pension) option to the plan. Without going into the specifics of how they work, know that you can set aside a considerably more substantial amount than everything else we discussed. These are very complicated plans and require the skills of an actuary to determine the appropriate amounts. For this specific case study, we were able to take that significant tax liability in what would have been paid to the IRS on company profits and redirect to key employees and others within the company. In doing this, it allowed for partner deferrals of $280k for the year.
Your hard-earned profit dollars are going to go somewhere; they can either go to the IRS, or to those that have helped you earn them while a large portion stays in your pocket.
I hope you found this information helpful, and if you’re in a situation similar to this scenario, please reach out so we can help educate and guide you on what will be most appropriate for your company. We do not charge for consultations, reviews, or proposals. We only get paid if you decide to hire us after evaluating your options.
Stay tuned for the next two scenarios in this 3 part series…
Case studies may not be representative of the results of all clients and are not indicative of future performance or success.
This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.