Calculating a 401(k) Plan’s Tax Efficiency Quotient©

Business owners want to get the maximum tax savings from their company retirement plan. We candetermine how tax efficient their plan is by calculating the plan’s Tax Efficiency Quotient (T.E.Q.)©

The Section 415(c) limit is the total amount someone can stash into their 401(k) plan from all three plan sources, which are salary deferral, match, and profit sharing. These are also referred to as annual additions.

Example: In 2022 the 415(c) limit was $61,000. If the owner is 50 years of age or older, they could contribute an additional $6,500 as a catch-up contribution for a total of $67,500. Using these limits and making an assumption of the average participant salary, we can calculate the plan’s maximum tax efficient contribution, which is represented by the variable k . Let’s use this with a hypothetical six-person medical practice.

The formula for the plan’s T.E.Q. is:

T.E.Q. = 8(a)(1) + 8(a)(2)/k

k = b ($61,000) + c (d) (.05) + e ($6,500)

b = number of owners

c = average annual salary of staff

d = number of eligible staff

e = number of owners aged 50 or older

8(a)(1) and 8(a)(2) are simply the employer and employee contribution line items from their form 5500

Our plan assumptions are: one owner, age 52, with an average staff salary of $55,000. A custom profit sharing allocation requires about a 5% contribution to the staff to maximize the owner’s 415(c) limit.

In our example:

k = 1($61,000) + $55,000(5)(.05) + 1 ($6,500), or $81,250.

The form 5500 employer contribution is $17,500, employee deferrals are $31,500, totaling $49,000.

Tax Efficiency Quotient = $49,000 / $81,250, or 60% tax efficient.

Our example medical practice leaves plenty of room for additional tax savings, creating a great conversation starter with the owner. This formula can be applied to any company’s plan by using their plan’s latest form 5500 filing information.