Selecting the right retirement plan from the many plans available is perhaps the most important thing for a business owner to consider. Before presenting any of these plans to your clients, it helps to view them as different tools. To choose the proper tool, it is necessary to first define the job that needs to be done.
The business owner might wish to offer a competitive, sound and affordable employee-benefit program that helps recruit and retain top labor and might want the plan to create the maximum income-tax-deductible contribution for himself (and possibly any working family members) with minimum cost. If the job is to take care of the employees, then typically, the ideal plan is a 401(k) plan. If it is to take care of the business owner, then the ideal type will not be a standard 401(k). This article will focus on plans designed to take care of the business owner.
To identify the proper plan, the owner should answer two important questions: What are the demographics of the employee group, and how much money does the owner want to put into the plan?
IRAs, SIMPLEs and defined-contribution
The first plan to consider is an IRA. Under current law, an individual may contribute up to $4,000 to an IRA or $8,000 if married and filing a joint tax return (2007). People age 50 or older in 2007 may contribute another $1,000 (2007) under the catch-up provision. For the business owner who can only afford to contribute amounts in this range, there is no reason to establish a retirement plan. Remember, in this case, the goal is not to offer an employee benefit but to maximize the contributions for the owner at a minimal cost.
If the business owner wants to contribute up to around $20,000 (per owner), and the company has fewer than 100 employees, the next choice is the savings incentive matching plan for employees (SIMPLE). Participants can contribute 100 percent of their earned income (2007). In addition, the company must make a mandatory contribution from a couple of options, the more common being a matching contribution on a dollar-for-dollar basis, up to the first 3 percent of the participant’s wages. Because the company contribution is mandatory, there are no antidiscrimination tests with a SIMPLE, and the amount the business owner may contribute is not tied to employee participation.
With a SIMPLE, the business owner receiving a yearly compensation of $225,000 in 2007 may put up to $17,250 into his SIMPLE account—the $10,500 personal deferral plus $6,750 (3 percent of $200,000) of matching dollars from his own company. Business owners and other employees participating in the SIMPLE who are 50 years old or older during that year may also contribute an additional $2,500 under the catch-up provision. One downside from the business owner’s perspective is that company contributions to the SIMPLE are immediately vested for the employee.
If $20,000 per person is not enough or if the closely held company has more than 100 eligible employees, the next rung on the contribution ladder features retirement plans known as defined-contribution plans, for which the law limits the maximum contribution, $45,000 in 2007, in most situations.
SEPs and Solo-Ks
Selecting the best defined-contribution plan will be determined largely by the company’s demographics. For companies with one to several employees, the likely option for many years was a simplified employee pension. Like a SIMPLE IRA, SEPs use IRAs to hold the plan assets. Under a SEP, the sponsoring company may contribute on a discretionary basis up to 25 percent of the eligible payroll for all eligible employees. If the closely held business owner is the only employee, this does not present a problem. However, if the business has employees other than the owner or his family, then SEPs can get expensive. For example, a business owner has a $200,000 annual salary and eight other eligible employees who each earn $50,000. If he wants to put $40,000 into the SEP (20 percent of his wages), he must contribute 20 percent for everybody else—another $80,000 for the employees. Few business owners want to make such a large retirement-plan contribution if they keep only a small portion of the dollars for themselves.
Recent tax-law changes created another option for successful closely held business owners with few to no employees other than themselves (or close family members), the Solo-K plan. This combines 401(k) employee-deferral contributions with a profit-sharing contribution to maximize the business owner’s contribution. For example, if an owner has annual wages of $100,000, his maximum Solo-K contribution would be $40,000 ($15,000 from his deferral and $25,000, or 25 percent of the total eligible payroll, contributed as profit sharing). With a SEP, this same business owner’s maximum contribution is only $25,000 because only a company contribution up to 25 percent of payroll is permitted. When the business owner has employees in addition to himself, then, depending on the demographics, the Solo-K may be more favorable than a SEP in those situations as well.
When there are more than several rank-and-file employees, the key question becomes if the retirement plan can be designed to permit the target contribution for the business owner without requiring excessive contributions for his employees. For example, a business owner makes a tax-deductible contribution of $50,000 to a retirement plan. Of the total contribution, $40,000 is for the owner. This means $10,000 had to be contributed for other employees—which is a cost to the business owner. However, assuming that at a 30 percent income-tax rate, the $50,000 contribution creates a tax savings of $15,000. In this case, the retirement plan creates a $5,000 net positive leverage.
With companies from several to several hundred employees, standard, off-the-shelf 401(k) plans will likely fail to provide leverage for the owner because of the antidiscrimination tests. Other plan design tools exist, including cross-tested profit-sharing plans. In a traditional profit-sharing plan, a discretionary company contribution is allocated uniformly to all eligible employees according to their eligible wages. This contribution is clearly nondiscriminatory because it inherently treats all employees the same. Many business owners do not know that there are other ways to make profit-sharing allocations. A profit-sharing plan may create different classes of employees and provide each class with different benefits and still comply with the antidiscrimination rules. This is called a cross-tested or new comparability plan. Successful business owners can potentially use this strategy to create tremendous tax leverage.
A business owner can also use a safe harbor 401(k) plan to automatically achieve the required antidiscrimination balance. There are two common safe harbor options: nonelective contributions or a matching formula. Safe harbor contributions are immediately vested for the employees. The advantage is that the plan complies with the antidiscrimination testing, and the business owner and other highly compensated employees may make the maximum deferrals into the plan, no matter what the rank-and-file employees contribute.
If the business owner wants tax-deductible, retirement-plan contributions above the defined-contribution plan limits, defined-benefit plans are the next option. With these plans, the law sets a maximum retirement benefit they may provide to a participant. In 2007, the maximum benefit permitted is $180,000 per year, starting at retirement and continuing for the rest of the participant’s life. The current contribution is calculated by determining how much needs to be contributed to the plan each year and invested in order to provide the expected benefit for all plan participants.
The most common form of a defined-benefit retirement plan is a pension plan. Traditional pension plans have declined in use because of their costs. For the successful closely held business owner with a smaller number of eligible rank-and-file employees, the cost of providing the plan may be far less than the income-tax benefits—thus creating leverage.
Closely held business owners considering a defined-benefit plan must carefully weigh the potential advantages against the burden of providing the plan. Skipping or reducing an annual contribution may leave the plan underfunded, creating a potential for penalties assessed to the company. Situations in which the business owner faces uncertain cash flows may not be appropriate for a defined-benefit plan. Pension plans may be used on a stand-alone basis or in combination with a defined-contribution plan to create more flexibility.
There is no one-size-fits-all retirement plan for owners of successful, closely held businesses. As an advisor, you need to work with the business owner and his tax advisors before implementing any plan. Qualified retirement plans are complex, ever-changing and often misunderstood. Despite this, they are perhaps some of the most effective income-tax-saving, wealth-accumulation and wealth-diversification tools for the successful business owner.
Patrick Ungashick, ChFC, CLU, is a partner with White Horse Advisors, LLC, in Atlanta. You can reach him at 678-322-3030 or at firstname.lastname@example.org.