Designing a tax-saving retirement plan

Of the many changes anticipated from health care reform, one comes to the fore for America’s affluent: Increased taxes may make it harder to retire.

The enactment of the Patient Protection and Affordable Care Act of 2010 means that individuals earning $200,000 or more annually will be subject to new Medicare taxes on both earned and unearned income. Those taxes can amount to thousands of dollars annually, and are in addition to the probability that the Bush tax cuts for capital gains and earned income will expire.

Higher taxes, when combined with strict limits on how much individuals can contribute to a defined-contribution retirement plan, can pose a serious challenge for high-income earners who want to continue their lifestyles in retirement.

What many professionals and business owners don’t realize, however, is that there are time-tested strategies available to help overcome the double whammy of higher taxes and limits on retirement-plan contributions. These strategies can help them set aside significant assets for retirement while providing their firms with valuable tax deductions. The deductions, in turn, can actually become a source of additional dollars to be contributed to retirement funds, potentially mitigating the impact of the new Medicare taxes.

What makes these strategies work is the design of the retirement plan. Many professionals and business owners currently rely on plain-vanilla profit-sharing plans. These typically require owners and employees to be treated alike, meaning that the percentage contributed by the employer must be the same for everyone. If an owner wants to increase the firm’s contributions on his or her behalf, all boats must rise proportionately.

In today’s arduous tax and business climate, few business owners can afford to enhance retirement-plan contributions for all employees. But with the right advanced plan design, an owner can set sail on a faster course while still helping employees navigate toward a meaningful retirement benefit.

Any one of several advanced plan designs can permit business owners to boost their annual retirement contribution to as much as $49,000 (plus an additional $5,500 for those ages 50 and older) while providing a lesser contribution for other employees. Those designs can include age-weighted, integrated or new comparability plans. A complementary cash balance plan — a type of defined-benefit pension — may allow an affluent owner to multiply contributions by several times above what would be allowed under a defined-contribution plan alone.

The most basic of advanced designs — an integrated plan — enables a business to make more generous retirement-plan contributions on behalf of employees who earn above the $106,800 Social Security wage base for 2010. Integration with Social Security is based on the principle of permitted disparity, taking into consideration the fact that Social Security replaces a lower percentage of income in retirement for highly compensated employees than it does for less highly compensated workers.

Because business owners tend to be older and more highly compensated than their employees, many firms gravitate to age-weighted plans that base retirement contributions on the age of each plan participant. Higher contributions can be made on behalf of older employees, who typically have less time than younger employees to accumulate retirement savings.

Another effective way to boost contributions for owners and key employees is to establish a comparability plan. These qualified plans divide employees into different group, split based upon rational characteristics. While the groups cannot be based directly on compensation, the choice of characteristics (age, service, class, etc.) can often translate into distinctions that may favor the business owner.

For well-established firms whose owners want to boost retirement savings past the limits allowed by DC plans, cash balance plans may be the answer. These may provide higher tax deductions than a 401(k) and allow annual contributions totaling many times above what DC plans permit. Because cash balance plans require an annual commitment for funding, they are appropriate for only the most stable companies.

As taxes for the affluent climb higher, financial advisers who learn more about the benefits of advanced plan designs will ultimately be in a better position to help their clients reach their retirement goals.

E. Thomas Foster Jr. is the national spokesman for The Hartford Financial Services Group Inc.’s qualified retirement plans.