Floor Offset Plan

Let’s set up the background first with the help of an example. Let’s assume you are the owner of a small business with five employees and have a decent amount of free cash flow. You just turned 50 this year and are appalled by the fact that in spite of a successful decade in business, you have managed to accumulate only $500,000 towards your retirement goals. You want higher contributions each year, while keeping the allocations to your employees low.

Someone just mentioned about a defined benefit plan to you. However, since you have employees, you will have to provide a retirement plan option for them as well. If you include your employees in the defined benefit plan, you end up contributing a large amount of money to them, so large that it does not make sense to sponsor a retirement plan.

This is where a floor offset comes to the rescue.

The IRS permits segmentation in a defined benefit plan, which basically means assigning different people to different classes based on job title, location etc. As the owner, you are a part of class 1, while all other non-owner employees are a part of class 2. The IRS also permits different allocation formulas for each class. The allocation formula is typically a certain percentage of compensation that will be earned in retirement. This formula determines how much money you can accumulate as the owner and how much money you have to contribute towards your employees.

As the owner, you can choose to receive 100% of your compensation, subject to a cap of $250,000 (this cap is adjusted each year) each year after retirement. You can also design the plan, such that employees receive 5% of their compensation as retirement benefits. This is the first step in reducing the costs. However, the floor offset goes one step further in this regard.

A profit-sharing plan is designed to work in accordance with the defined benefit plan. Everyone is allocated a minimum of 5% of pay in the profit-sharing plan. These allocations in the profit-sharing plan are then used to ‘offset’ the benefits the employees receive in the defined benefit plan. In most cases, the entire benefits of the employees of the defined benefit plan are offset and they receive only the 5% contribution in the profit-sharing plan. When we say ‘offset’, it does not mean we take the benefits in the defined benefit plan and subtract the allocation in the profit-sharing plan. Complex financial mathematics is involved in this as everyone’s benefits are projected to an assumed retirement age of 62/65 and offset at that point.

There is also the added complexity of cross-testing of benefits and contributions. As your third-party administrator, we will mask all this complexity and do the math for you. We use high-end software and the expertise of actuaries to achieve the optimal allocations for our clients.

If you have employees who are older than you, then their benefits may not offset completely. Such employees will receive the allocation in the profit-sharing plan and the residual benefits which were not offset from the defined benefit plan.

The floor offset plan is probably the only plan design that allows you to contribute a large amount of money for yourself while keeping employee contributions in the 5–7.5% range. Below is a real example of a floor offset plan in action. This was designed for one of our clients who is relatively young.