Both investment and retirement plan specialists stress the need for young professionals to adopt a regular savings program early in their careers. For many professionals, the fact that contributions to a qualified plan become a forced savings mechanism is reason enough to merit their adoption. In addition, contributions to a qualified plan are tax deductible, and thus, afford a higher initial savings. Common sense seems to indicate that if a 40% bracket taxpayer had the choice of investing $20,000 and letting it grow on a tax-deferred basis, or paying taxes on the $20,000 and investing the net $12,000 on a taxable basis, he would be better off investing the $20,000 even recognizing that when the monies were eventually withdrawn, he would have to pay tax on it at that time. In fact, assuming an 11% return inside the qualified plan and an 8% after tax return outside the plan, after 30 years of annual $20,000 contributions to a qualified plan, one ends up after the payment of taxes with $2.8 million compared to $1.49 million if the initial tax had been paid and the net amount had been invested each year outside the plan.

Although the above example accurately reflects what happens if one has the choice of paying $20,000 into a qualified plan solely for oneself as opposed to receiving $20,000 in additional compensation, only in rare instances would this be the case since, in order to be qualified, a plan must also cover a percentage of one’s employees. Since the first qualified plan was established, owners have sought ways to exclude or limit their employees’ participation in their plans. Many of you have been approached with the idea of leasing your employees from a leasing organization. In most instances, this concept will not work and at least for federal income tax purposes, the leased employees are treated as yours.

In the past, we have attempted to determine how much of the contribution to the qualified plan must be allocated to you as the owner to put you in the same position as if you elected not to sponsor a qualified plan and paid the entire amount to yourself as additional compensation. The longer the period during which the money is invested in the qualified plan, the lower the percentage of the contribution which is necessary to be allocated to you in order for the qualified plan to make financial sense. Using the assumptions that one is in a 40% marginal federal and state income tax bracket and that money inside the plan returns 11% and outside the plan has an after-tax return of 8%, the break point at 10 years is 83%, 20 years is 65%, 30 years is 54%, and 40 years is 43%. Thus, a young lawyer with at least 30 years until retirement who is deciding on whether to establish a plan needs from an income tax standpoint to have at least 54% of the total plan contributions allocated to him.

With proper plan design, there are very few professionals who cannot achieve an allocation percentage higher than the break point described above. It is not uncommon to see 70%, 80%, and even 90% of plan contributions being allocated to the owner or owners. For a number of reasons, most lawyers have shied away from the sponsorship of defined benefit plans and have opted for the sponsorship of defined contribution plans (e.g., profit sharing, money purchase, or 401(k) plans). Traditionally, under defined contribution plans, a lawyer contributes a uniform percentage of both his and his employees’ compensation into the plan. In a professional corporation since only the first $170,000 in compensation may be utilized for qualified plan purposes, a lawyer with $170,000 or more in salary would have to make a contribution of 17.65% of his salary into a qualified plan to reach the current maximum $30,000 contribution. If one assumes this professional had three employees with an average salary of $19,333, the owner would be entitled to approximately 75% of the total contributions to the plan. Unfortunately, he would also be required to contribute $10,236 (17.65%) for his employees.

It would be possible to lessen this dollar amount by integrating the plan with Social Security, but even if this were done, his cost for his employees would be approximately 14.47% of his payroll. With this average payroll, the lawyer would see $8,392 going into the qualified plan for his employees. Frequently, employees do not appreciate their employer’s contributions to a qualified plan, and even though the lawyer might be paying his employees a premium when totaling both their actual salary and the contributions to the qualified plan, the lawyer might find himself losing employees to other employers who were willing to pay a larger salary and a lesser amount of contribution to a qualified plan.

This obstacle led pension professionals to design defined contribution plans which allow the owner to contribute a significantly higher percentage contribution for himself than for his rank-and-file employees. This is accomplished through what is referred to as "cross-testing." Cross-testing does not work in every instance, but can be quite successful where the average age of the rank-and-file employees is less than that of the average age of the owners. Cross-tested plans work because the Internal Revenue Service’s regulations are quite liberal - as a starting point, the regulations only require that the benefits of the rank-and-file employees be equivalent to 70% of the benefits being provided to the highly-compensated employees. In addition, in a cross-tested plan, one projects what the dollar contribution made in the current year will purchase as a monthly retirement benefit at normal retirement age. Thus, the younger the participant, the smaller the amount which is needed to be allocated to him in order to provide a specific retirement benefit at age 65.

In a typical cross-tested plan, the incorporated owner is able to place $30,000 into the plans with a contribution rate of 4% of each of his employee’s compensation. By utilizing cross-testing, the employer can reduce his required contribution for rank-and-file employees by as much as 74% from what might be required in a noncross-tested plan.

In our experience, very few lawyers were sponsoring plans in which they were placing 15% to 17% of their employees’ compensation into the plan. Rather, they had plans in which they placed anywhere from 5% to 10% of both their and their employees’ compensation. Thus, the owner might be making a contribution of between $8,000 to $16,000 on his own behalf when a maximum contribution could have been $30,000. For many lawyers and law firms, utilization of cross-testing will allow them to place up to $30,000 into the plan for themselves without increasing the payroll cost for their employees.

A single cross-tested money purchase pension plan creates few complications for the solo practitioner. However, as the number of lawyers in the firm increase, the higher the probability that each has differing abilities to currently save for retirement. Thus, while senior lawyers of the firm are quite anxious to place $30,000 a year into a qualified plan, younger lawyers often struggle with any percentage contribution approaching double digits. It is possible to base contributions to a cross-tested plan based upon employee classes and professional status. Thus, a plan might provide for a $30,000 contribution for attorneys with 20 or more years of practice, a $20,000 required contribution for attorneys with less than 20 years of practice, and a flat 7% contribution for all other employees.

Another approach is to utilize a section 401(k) plan in the retirement plan design. Traditionally, owners and small employers have not benefitted by section 401(k) plans since the amount which they can voluntarily elect to defer into the plan depends upon the deferral percentage of their nonhighly-compensated employees. Typically, these deferral percentages are quite small. However, commencing in 1999, the Internal Revenue Code has been amended to allow the adoption of "safe harbor" section 401(k) plans. In a safe harbor 401(k) plan, if an employer makes either a required fully-vested contribution for all employees or a fully-vested matching contribution, then the deferral percentage test will automatically be met.

In the simplest form of safe harbor plan, if an employer makes a fully-vested 3% contribution for all eligible employees, then each highly-compensated employee may elect a salary deferral contribution of up to the maximum $10,500. Thus, in a safe harbor section 401(k) plan design which provided for a 3% fully-vested contribution for all employees (both lawyer and nonlawyer), all employees (including lawyers) would have the option to make additional salary deferral contribution of up to $10,500. If this type of plan were coupled with a money purchase pension plan which utilized cross-testing, shareholder- employees could have a combined required contribution of $19,500. Those desiring to maximize their contributions could, on an individual basis, elect to place an additional $10,500 into the section 401(k) plan through salary reduction. Depending upon the average ages of the employees, employer contributions for the rank-and-file employee could be as low as the 3% safe harbor contribution. Often, employers in the past have had contribution levels in the 6% to 7% range and elect to continue this contribution level by amending their plans to provide for a 3% fully-vested safe harbor contribution with the balance of the contribution being made subject to a graded vesting schedule.

If you are not currently sponsoring a section 401(k) plan, it would still be possible to adopt a cross-tested plan for 2000. However, in the case of safe harbor section 401(k) plans, advance notice must be given to employees for the implementation of such a plan. For new plans, this notice must be given by May 1, 2000. In the case of calendar year employers who already have section 401(k) plans, the safe harbor provisions could not be elected until the year 2001 and again advance notice would be required.