FIN 422 Week 3 Contribution Limits and Tax Deductions Example

How Much Can Go In and What It Saves: 2025 Limits, a Safe Harbor Match, Profit Sharing, Startup Credits and the Tax Effects for Ridgeline Design's Partners and Staff

[Student Name]

University of Phoenix

FIN/422: Retirement and Benefit Planning

Week 3 Assignment

[Instructor Name]

[Date]

Ridgeline Design and all figures are composites written for a model paper; limits are the 2025 figures published by the IRS, credits are summarized generally from the sources listed and both change.

Ridgeline Design, the composite Denver firm, has settled on a safe harbor 401(k) that matches deferrals dollar for dollar on the first 4 percent of pay, automatic enrollment at 4 percent and graded vesting for any profit sharing. Its eligible payroll is about $1.68 million for 24 employees plus $500,000 for the two partners, each paid $250,000. The partners asked how much they could save, what the plan would cost and what tax help was available. Contribution limits decide what the plan can do for the partners, while payroll and credits decide what it costs the firm, so both have to be worked out together. This paper does both.

The 2025 Limits

For 2025, the IRS set the elective deferral limit for 401(k) plans at $23,500, with a catch-up contribution of $7,500 for participants aged 50 and over and a higher catch-up of $11,250 for those aged 60 through 63 (Internal Revenue Service, 2024). The overall limit on annual additions, combining employee deferrals and employer contributions but excluding catch-up contributions, is $70,000, and compensation above $350,000 cannot be counted. The IRA limit is $7,000, and the SIMPLE IRA deferral limit is $16,500.

The Partners' Maximum

Each partner, aged 52 and 54, can defer $23,500 plus a $7,500 catch-up, for $31,000. The safe harbor match adds 4 percent of $250,000, or $10,000. Under the annual additions limit, profit sharing could add up to $36,500 more, since $23,500 of deferrals plus $10,000 of match plus $36,500 reaches $70,000, with the catch-up on top, for a total of $77,500 each.

The Cost of Staff Contributions

The match costs the firm 4 percent of the pay of each employee who defers at least 4 percent. With automatic enrollment at 4 percent and an expected 80 percent of staff staying in, the staff match costs about $54,000 a year, and the partners' match $20,000.

Profit sharing raises the question of fairness among employees. A uniform allocation, the same percentage of pay for everyone, is simplest. To give the partners the full $36,500 each, 14.6 percent of their pay, a uniform allocation would cost about $245,000 for staff, far more than the firm can afford. A cross-tested design, which allocates different percentages to different groups while passing nondiscrimination tests based on projected benefits, could give staff a minimum of 5 percent while the partners receive more, costing about $84,000 for staff. A modest uniform contribution of 3 percent would cost about $50,000 for staff and $15,000 for the partners.

Pricing Three Options

Option one, the match only, costs about $74,000 a year. Option two, the match plus a 3 percent uniform profit-sharing contribution, costs about $139,000. Option three, the match plus a cross-tested allocation maximizing the partners, costs about $231,000. Employer contributions are deductible up to 25 percent of eligible compensation, about $545,000 here, so all three are fully deductible.

Credits for Starting a Plan

Federal law provides credits for small employers starting a plan. Employers with up to 50 employees can claim a credit for 100 percent of startup and administrative costs, up to a cap that is the lesser of $250 per eligible non-highly compensated employee or $5,000, for three years. With 24 such employees and about $4,500 of annual costs, the credit covers those costs. A separate credit covers employer contributions of up to $1,000 per employee earning under an indexed pay limit near $100,000, at 100 percent in the first two years and declining after; with about 20 qualifying employees, that is worth up to $20,000 a year at first. Adding automatic enrollment earns another $500 a year for three years. In the first year, credits could total about $25,000, offsetting a large part of the plan's cost.

The Partners' Tax Savings

The partners, taxed on the firm's income as pass-through owners, face a combined federal and state marginal rate near 39 percent. Each partner's $31,000 of pre-tax deferrals saves about $12,000 of income tax now. Employer contributions, including the partners' own match and profit sharing, reduce the firm's taxable income passed through to them.

Pre-Tax or Roth for Employees

Employees can choose pre-tax deferrals, which reduce income tax now and are taxed when withdrawn, or Roth deferrals, taxed now and tax free later. Neither saves Social Security or Medicare taxes. An office coordinator earning $42,000, in the 12 percent federal bracket, may well face a similar or higher rate in retirement, which favors Roth. A senior architect in the 24 percent bracket who expects a lower rate later may favor pre-tax. The plan offers both.

Do Tax Incentives Change Saving?

Chetty et al. (2014) used Danish data to show that most workers are passive savers who do not respond to changes in tax incentives, while automatic employer contributions raise total saving substantially; they estimated that each dollar of tax subsidy raised total saving by only about one cent. Engelhardt and Kumar (2007) found that matching contributions modestly increase participation and saving in the United States. For Ridgeline, the evidence suggests that automatic enrollment and the match will do more than the tax deduction to raise employees' saving.

What Happens When the Credits End

The contribution credit falls to 75 percent in year three, 50 percent in year four and 25 percent in year five, then ends, and the startup credit ends after year three. By year six, option two will cost the full $139,000 a year plus payroll growth. The partners set aside part of the early credits in a reserve so the plan's cost does not jump suddenly in their budget.

Recommendation for Year One

The firm should begin with option two: the safe harbor match plus a 3 percent profit-sharing contribution for everyone, costing about $139,000 before credits and about $114,000 after the first-year credits, with each partner saving $48,500. Once the plan's cost and the firm's cash flow are known, the partners can consider a cross-tested design or a cash balance plan.

Conclusion

The 2025 limits allow each partner up to $77,500, but providing that through profit sharing would cost far more than the firm can bear. A match plus modest profit sharing, offset by small-employer credits, gives the partners meaningful savings, gives staff a strong benefit and fits the budget.

References

Chetty, R., Friedman, J. N., Leth-Petersen, S., Nielsen, T. H., & Olsen, T. (2014). Active vs. passive decisions and crowd-out in retirement savings accounts: Evidence from Denmark. The Quarterly Journal of Economics, 129(3), 1141-1219. https://doi.org/10.1093/qje/qju013

Engelhardt, G. V., & Kumar, A. (2007). Employer matching and 401(k) saving: Evidence from the Health and Retirement Study. Journal of Public Economics, 91(10), 1920-1943. https://doi.org/10.1016/j.jpubeco.2007.02.009

Internal Revenue Service. (2024). 401(k) limit increases to $23,500 for 2025, IRA limit remains $7,000 (IR-2024-285). https://www.irs.gov/newsroom/401k-limit-increases-to-23500-for-2025-ira-limit-remains-7000