Strategy: Integrate your company’s profit-sharing contributions with Social Security tax payments. That effectively reduces the amount the company must contribute on behalf of the rank and file.
As a result, highly compensated employees — including you — will be entitled to a larger slice of the pie.
Is it legal? Absolutely. An integrated retirement plan qualifies as a “permitted disparity” under a special exception in the tax law. The plan is not considered discriminatory even though only a select few might benefit from it.
Here’s the whole story: Employers are required to pay their share of FICA tax (both Social Security and Medicare) for each employee.
-Social Security tax = 6.2 percent of each employee’s Social Security “wage base” for the year (the first $94,200 of the employee’s wages for 2006, the first $97,500 for 2007).
-Medicare tax = 1.45 percent of the employee’s wages.
The employee’s Social Security tax wage base equals the “integration level.”
Under an integrated plan, the Social Security tax payments the employer makes are “credited” against the plan contributions it must make on behalf of employees. Once the combined contributions reach the integration level for each employee, the credit against Social Security tax contributions disappears.
Thus, there are two effective contribution rates for plan participants:
1. The “minimum base contribution” rate for wages up to the integration level.
2. An “excess contribution rate” for wages above it.
The catch: The maximum annual compensation that qualifies for this purpose in 2006 is limited to $220,000 ($225,000 in 2007). That figure is also indexed annually (see the chart below for new retirement-plan thresholds).
So, you can’t go hog-wild in favor of highly compensated employees, but they can still reap the lion’s share of plan contributions.
Example: Permitted disparity pays off big
Say you earn $250,000 a year. Your company integrates its defined-contribution plan with its Social Security tax payments, and the base contribution to the plan equals 5 percent of each employee’s salary.
When an employee’s salary exceeds the integration level, a 10 percent contribution kicks in.
Since your compensation for this purpose is limited to $220,000 (see “The catch” above), your annual contribution equals $17,290:
$ 4,710 ($94,200 x 5 percent)
+ $12,580 ($125,800 x 10 percent)
In comparison, someone earning $40,000 receives a contribution of only $2,000 ($40,000 x 5 percent). Lower-paid employees don’t reap the benefit of the higher 10 percent contribution rate.
Caution: Don’t go overboard with this technique. The excess contribution rate can’t be more than double the minimum base rate or 5.7 percent higher than the base rate.
Furthermore, if the company is “top-heavy” (i.e., more than 60 percent of the benefits go to key employees), it must make a minimum contribution of 3 percent that can’t be integrated with Social Security tax payments.
Usually, employers use this technique in conjunction with a defined-contribution plan. The integration must meet several special requirements.
You can use the same idea for a defined-benefit pension plan, but the calculations are even more complex than they are for defined-contribution plans. You’ll need an actuary to do the grunt work.
Tip: Even if you’re integrating a defined-contribution plan, let a tax pro handle the particulars. This is not a do-it-yourself proposition.
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