Each year around Halloween time,
the IRS announces what I call the "Pretend Salary" maximum". For 2015 the amount is $265,000. Government regulators must be so jealous of those in private enterprises that have figured out how to make a pot full of money each year, that they have decided to pretend that nobody makes more than $265,000 per year. That way, the person who actually makes $530,000 will be treated as if they make half that amount for all retirement plan purposes.
the IRS announces what I call the "Pretend Salary" maximum". For 2015 the amount is $265,000. Government regulators must be so jealous of those in private enterprises that have figured out how to make a pot full of money each year, that they have decided to pretend that nobody makes more than $265,000 per year. That way, the person who actually makes $530,000 will be treated as if they make half that amount for all retirement plan purposes.
"So what?", you may ask! (You did ask that, right?) Well, when you take their desired salary deferrals of $24,000 divided by their Pretend Salary maximum of $265,000, the Deferral Percentage is a fictitious 9.06% instead of the actual much lower salary deferral of 4.53% ($24,000 / $530,000). The name of that game is that you cannot do that much (the fictitious 9.06%) unless the Plan Sponsor is providing a Safe Harbor Plan or the rank-in-file employees are saving a ton, which isn't likely. Once again, the problem is the infamous ADP test (average actual deferral percentages of the Non-HCEs as compared with the average actual deferral percentages of the HCEs - normally, a 2% spread is all that is allowed). The Pretend Salary maximum also comes into play, if the business owner wants to max out for the year (2015) at the $59,000 overall limit.
Let's do a little Common Core Math word problem, shall we?
Suppose a business owner has a corporate salary of $700,000 and wants to get a Profit Sharing allocation of $35,000 added to his or her retirement plan account, then what percentage of Profit Sharing must be made by his or her company for the the staff? [Note that the salary deferral limit of $24,000 (over age 50) plus the $35,000 of Profit Sharing would get the business owner to the total limit of $59,000]. Your very bright 6th grader studying California Common Core Math would say to you "Well, that's easy! On a salary of $700,000, the $35,000 of Profit Sharing would represent a 5% of salary contribution for the owner. I got that using the "Ladder Method" instead of the "Standard Algorithm Method". So the Profit Sharing percentage for everyone would have to be 5% of their pay, right?
Not wanting to admit that you have no idea what the "Ladder Method" or the "Standard Algorithm Method" is that your 6th grader is referring to, even though you have an MBA, you meekly respond "Yes, Sweetie, that would seem to make sense normally, but you see, we cannot use the business owner's real salary. We have to use his or her Pretend Salary of $265,000, so we have to pretend the business owner is getting a 13.21% Profit Sharing allocation even though they are not. If we have a straight "Pro Rata Profit Sharing Allocation Method" called for in the plan document, then the business must contribute 13.21% for everyone!"
"No way, Dude!" your kid exclaims. "That's just crazy!" To which you respond, "Welcome to my world!"
Just so you know, with a Safe Harbor Cross Tested 401(k) Plan (wow, that is a mouthful!) for a successful small business, the contribution for the employees could be as low as approximately 4.40% (3% Safe Harbor plus 1.4% Profit Sharing) assuming the business owners are somewhat older than approximately 50% of the support staff.
For a nice handy, dandy chart of all of the 2015 retirement plan limitations including the Pretend Salary limit, go to this link: http://401kacademy.com/materials/ and then click on the Retirement Plans Limitation Chart.
