We work with a lot of solo professionals who are looking to add their spouses to their retirement plans. While this can be very tax advantageous, there are a few pitfalls to consider.
If your spouse works for your business (even in a limited capacity, like as a bookkeeper, scheduler, or administrative assistant), you can add them to your payroll. As a result, you can make a contribution to a cash balance or define benefit plan for them.
But there are several issues to consider. In this article, will discuss what you need to do if you’re considering adding your spouse to your plan. Let’s jump in.
Some Background
Many small business owners and professionals have their spouse help out in their business. Sometimes they’re actually on payroll, but often they are not.
If they are technically working for your business, then they should be compensated just like any employee would be. This is typically by issuing them a W-2 for the services they perform.
Two downsides of adding your spouse to your plans is the added payroll complexity and the additional payroll taxes. You will pay approximately 15% of their gross payroll in payroll taxes. So, if your pay your spouse $30,000 this would cost you approximately $4,500 in payroll taxes.
Why would you want to pay this extra payroll taxes? Well, first of all, it’s the law if your spouse works for you. But second of all, it will allow your spouse to make a 401(k) deferral (assuming he or she is not covered under another job), a profit-sharing contribution, and most importantly, a contribution to a defined benefit plan.
In fact, you get a lot of bang for your buck when you add your spouse to a plan. Assuming they are not a high-income employee, a low salary will allow you to minimize payroll taxes and make a substantial overall retirement plan.
For example, if you hired your 50-year-old spouse to work for you and paid them $35,000, here’s how the numbers would look:
| Gross Payroll | $35,000 |
| Payroll Taxes (15%) | $5,250 |
| Retirement Contributions: | |
| 401(k) deferral | $31,000 |
| 401(k) profit sharing (6%) | $2,100 |
| Defined Benefit Contribution | $25,000 |
| Total Contribution | $58,100 |
As you can see from the table above, a $35,000 W2 will cost you approximately $5,250 in payroll taxes. However, you will get a contribution of approximately $58,000. If you were in a 40% tax bracket that will save you $23,000 in tax. Not a bad deal.
The economics work pretty good in this scenario. This is especially true if you’re looking to maximize your total retirement contribution. However, there are a few other issues you must consider.
Step #1: Review and Determine Spousal Compensation
Assuming you want to add your spouse, you have to review and determine the compensation. Remember that the IRS requires you to pay your spouse “reasonable compensation” for the services they provide to your company. The higher the wage, the higher the potential contribution to a cash balance or defined benefit plan.
If they are simply providing administrative tasks, then most likely a low salary is acceptable. However, if they are providing a higher level of professional services, then likely their compensation should be higher. You would also want to consider the number of hours they work for your business. You should document services performed and hours worked.
Your spouse must receive compensation that is subject to payroll taxes. It is not acceptable to simply “add” your spouse to a plan without having them on payroll. They must be a bona fide employee subject to Social Security and Medicare taxes. Retirement contributions are only for actual employees and are not allowed if a spouse works off the books.
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If you are an S-corporation or C-corporation, it is usually relatively easy to just add your spouse to payroll. However, if your structure is a sole proprietor or partnership, then you are not typically issuing a W2 for the services you provide. It might be more challenging for you to set up payroll and add your spouse.
You may be able to your spouse as an independent contractor. But just make sure that their income is subject to payroll taxes. Your CPA can likely help you with this analysis.
Step #2: Determine Contribution Levels
Once you determine reasonable compensation, then you would want to determine how much you can contribute to the defined benefit plan based on this compensation.
Contributions to a cash balance or defined benefit plan are primarily based on age, compensation, and actuarial calculations. A higher-earning spouse can receive a larger tax-deferred contribution.
Your current plan administrator should be able to run you an illustration to determine funding amounts. You may also realize that if your plan is overfunded, adding your spouse would allow you to build up an accrued benefit that can reduce the overfunding. In either case, make sure you agree with the funding amounts and the ramifications of allowing them into the plan.
Step #3: Ensure Your Plan Allows Spousal Eligibility
When your plan was initially established, there were often restrictions placed into the plan for eligibility purposes. These restrictions are typically the following:
- Working for the business for at least 1 year.
- Meeting minimum age requirements (typically 21 years old).
- Working at least 1,000 hours.
These restrictions are generally not applicable for a solo plan. However, they are designed so that if you happen to add an employee to your business (even in a part-time capacity), that you can exclude them from the plan.
Is a Cash Balance or Defined Benefit Plan Right For You?
While these exclusions operate as protection for you, they will hinder adding your spouse to a plan. For example, if you have a one-year entry date restriction, even though your spouse might be on payroll this year, they would not be allowed to enter the plan until next year. This will obviously not accomplish what you’re looking to do.
The good news is the above eligibility restrictions can be eliminated or reduced. You could allow immediate entry for everybody. You may want to keep the minimum age restriction in place, but reduce the hours worked or entry date restriction. This will allow your spouse to enter the plan in the current year.
Make sure you check with your administrator to determine if you have any current plan restrictions that would limit your spouse’s entry into the plan. This should only be a simple document review.
Step #4: Amend the Plan Document (if Necessary)
if your plan document allows immediate eligibility for your spouse, then you’re all set, and you typically don’t have to do anything else. However, if you want to reduce the eligibility restrictions, so your spouse can get an immediate contribution, then you’ll have to make a plan amendment.
Plan amendments are usually relatively straightforward. You are merely amending or revising the plan to change these specific criteria. All other plan provisions will remain in effect.
Your plan administrator will prepare the amendment, and you must sign it for it to take effect. Most plan administrators will charge an amendment fee, but typically it is very nominal. You should also consider that you will have extra participant fees each year to calculate the spousal contribution and provide the participant statement.
Step #5: Submit Employee Census and Fund Plan
Once you have finalized the details above, you are almost finished. For the plan administration after year-end, you will need to submit not only your compensation, but also your spouse’s compensation to the actuary. The actuary will then finalize the contribution amounts.
Remember that when you fund your plan, you are given minimum, target and maximum amounts for all employees in TOTAL. So, you will not necessarily see a breakout for your spouse. However, you should see an increased contribution amount as a result of the new accrued benefit.
The higher funding amount reflects the fact that the company is now contributing for two eligible employees. When the actuary reviews and calculates these new numbers, they will confirm a few details and make sure the amendment is completed accurately and completely.
Bottom Line
Adding a spouse to a cash balance or defined benefit plan can provide tax advantages and increase retirement savings but must be structured correctly to comply with IRS rules. Whether the goal is to maximize retirement benefits, optimize tax advantages, or ensure spousal protection, the process involves several key steps.
