At Emparion, we spend a lot of time talking with law firms (both large and small) about retirement planning. In many situations, law firms find themselves stuck making contributions only under a 401(k) profit sharing plan.
There is nothing wrong with a 401k plan. But the problem is they want to make larger contributions that are just not allowed under a 401k.
Another big concern of attorneys is their tax bracket. With the top tax rate still at 37% (plus state taxes) many attorneys find themselves giving a big chunk of their money to the government. Tax planning drives many law firms to research other available retirement planning strategies.
But when we take a look at retirement planning, there are many different options. Law firms with a few employees may find some solutions more beneficial than large law firms.
In either case, one solution we often look at is a defined benefit plan. This often comes in the form of a cash balance plan.
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Defined Benefit Plans for Law Firms
Company contributions to defined benefit plans are based on a variety of actuarial assumptions. As a result, each year an actuary is required to review plan investment returns, employee changes, and other data in order to ensure that the plan maintains compliance. In addition, the actuary examines contribution levels to ensure the plan will provide adequate benefits to plan participants upon retirement.
Cash balance plans technically fall under the defined benefit plan umbrella. The general rules and restrictions are governed by defined benefit plan limitations.
Cash balance plans though really function like a “hybrid” plan (which is what many people name them). This means that they have characteristics of both defined benefit plans and defined contribution plans (like 401ks).
With a cash balance plan, the contributions are put into a “hypothetical account” that is designated for the participants. The contributions are pooled together in one account for all participants. The third party administrator will track the account balance for each employee.
The law firm will typically credit the participant’s account with a specific percentage of his or her annual compensation. The company will also factor in an assumed interest credit which is then added to the account balance. Changes in the actual investment accounts will not impact final benefits, but will vary contributions made by the law firm. The firm itself bears the ultimate risk of the investment returns.
So once a law firm has selected to examine a defined benefit plan there are a variety of different options and pension rules. In a nutshell, in order to get large amounts in for partners and or owners there needs to be a contribution for certain other employees. But there are certain planning ideas and ways to structure the plan document to provide for benefits paid to the higher income partners.
Even though there are different ways to structure the plan, there may be different ways to compensate employees. For example, I’ve seen law firm’s that want no contribution if they could get away with it to staff other than the partners.
But I’ve also found other partners who want to give all employees a certain percent so they can treat it like a fringe benefit or bonus. They feel it helps their retention significantly.
In either event, it is our job to work with the firm to structure the plan that best suits their needs. And this post we’re going to take a look at a few different options that were selected by some of our law firm‘s.
Option#1: Solo Defined Benefit Plan for One Attorney
Single member firms who operate as sole proprietors (with no employees) can certainly set up and fund defined benefit plans. We call these plans “solo” or “one person” plans. The lawyer can set up the plan and provide funding for only himself or herself and may also contribute to a spouse that may be working in the firm. These can easily be added to a solo 401k plan which will make the testing and compliance that much easier.
One of our small laws practices primarily divorce law and his wife is the sole employee as the office manager. His plan worked like the following:
The above plan worked great for him. He and his wife were able to contribute $240,500 between the 401k profit sharing plan and the defined benefit plan. Note that a typical 401k plan will allow a profit sharing contribution of 25%. But when combined with a defined benefit plan it is limited to just 6% (unless other circumstances are met).
Option #2: Defined Benefit Plan for Small Law Firm
This next scenario gets a little more complex. It was a 10 employee law firm with an emphasis on bankruptcy, debt collection and estate planning. When you start adding employees you are able to exclude certain employees based on a variety of criteria. As such, the plan does not have to include all employees.
The IRS requires that 40% of employees are covered by the plan. There is a two part test that must be met. The two parts are as follows:
- The lower of 50 people or 40% of the employees must receive benefits under the plan; and
- The contributions must be what is called “meaningful.”
Because the plan is age weighted, a law firm can exclude some of the older employees. This can allow for an overall lower contribution for employees and still allow for a meaningful benefit. Of course, this is not applicable in the case of the solo defined benefit plan discussed above.
But back to the example. In this case, the owner attorney wanted to contribute to all employees and considered it a fringe benefit or bonus plan. He believed that by contributing to all qualifying employees this would reward them for their hard and help with the growth of the firm.
He was still able to contribute over $148k for himself which represented 86% of the entire contribution. The goal in this most situations is to get at least 85% of the contribution to the owner and still pass testing with the 401k plan. The result worked real well.
Option #3: Defined Benefit Plan for Large Law Firm
This last example is a rather large firm. We discussed previously the fact that the company must provide a meaningful benefit. This can be calculated actuarially for each employee. It can be a percentage of pay or it can be a flat dollar amount. The flat dollar amount is unusual, but it is a simple solution for many law firm.
In this example, the partners wanted to maximize contributions the partners of course. But they believed that it was best to offer a straight 6% of pay to each qualifying employee. Other than separating the partners into a separate, they wanted to treat all professional staff and admin staff with the percentage of pay.
As you can tell from the above examples, there is certainly a lot of flexibility when setting up a defined benefit plan for law firms. Just make sure that you define your goals up front and work closely with your defined benefit plan TPA.