Retirement plan design for the new tax regime

Abram Claude, Vice President, Columbia Management Learning Center | November 12, 2014

  • Small business owners can potentially mitigate the effect of the new 3.8% net investment income tax (NIIT) by establishing or updating a retirement plan for their business.
  • Strategic use of tax-advantaged retirement plans may prevent one from breaking through the MAGI income threshold for the NIIT strategy.
  • The Columbia Management Learning Center is dedicating a series of blog articles to this important and timely “Navigating the New Tax Regime” topic.

According to 2012 data from the Bureau of Labor Statistics, only 41% of businesses with fewer than 50 employees offer a defined contribution plan, and only 7% offer a defined benefit plan. Not only are the majority of small businesses missing out on the retirement savings benefits these plans can offer, they are forgoing an opportunity to potentially reduce the effect of the NIIT. And for those small businesses that do have a retirement plan, more often than not, the plan could benefit from a design upgrade, which could further enhance the owner’s ability to accumulate tax-deferred and/or tax-free growth.

You may recall that the 3.8% NIIT applies to the lesser of the amount of:

  • Modified adjusted gross income (MAGI) that exceeds an income threshold based on tax-filing status


  • Net investment income (NII).

Therefore, steps that may prevent one from breaking through the MAGI income threshold merit consideration as a NIIT strategy — and tax-advantaged retirement plans are great vehicles to facilitate the moves. Common tax-favored retirement plan types for small business owners include savings incentive match plans for employees (SIMPLE) IRA plans, simplified employee pension (SEP) plans and 401(k)/profit sharing plans.

Pretax contributions to qualified retirement plans lower MAGI upfront, and the earnings they may generate while held in the plan grow tax-deferred. Any future distributions of pretax dollars from a plan would be taxable as ordinary income, and therefore would increase MAGI, but the distributions do not count under NII. 401(k) plans not only allow for pretax contributions, but, if designed properly, could also permit after-tax contributions (either designated Roth contributions or standard after-tax contributions). Although after-tax contributions are included in MAGI, they are not counted as NII. If they grow while held in the 401(k), any gain is tax-deferred and excluded from NII. When withdrawn, only the earnings on standard after-tax contributions are considered MAGI, not the principal. And, qualified distributions of designated Roth contributions (principal and earnings) are completely tax-free, meaning they are not included in NII or MAGI.

Let’s say Jordan, a 53-year-old unincorporated small business owner currently has a SIMPLE IRA plan and the level of her earned income makes it possible for her to contribute the maximum amount allowed ($29,000). If she were to “upgrade” her plan to a 401(k)/profit sharing plan, she could nearly double her contributions ($56,500) to a tax-favored account.

Retirement plan maximum contribution chart


Or consider Lou who doesn’t have a retirement plan for his business, even though the business has the cash flow to support one. Lou has been reluctant to set up a plan because, beyond his key employees, he experiences high employee turnover. A potentially appealing plan for Lou could be a profit sharing plan with a new comparability allocation formula, because it would allow Lou and other plan-defined key participants to maximize their contributions, while rank-and-file employees receive smaller contributions on a percentage basis. The result is that Lou and the key participants receive a greater share of the overall contribution as compared to other participants, more dollars are directed to a tax-deferred account and Lou’s business receives a tax break for the contributions. This experience might lead him to consider adding a cash balance defined benefit plan using a new comparability model as well. Of course before implementing any plan, Lou would want to discuss plan design strategies with his tax professional, taking into consideration employee demographics, as well as the costs of maintaining a workplace retirement plan.

Related reading: Strategies for business owners to reduce net investment income tax

Next in this series:

  • Trust accounts and net investment income tax

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This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Management does not provide tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.