Retirement Plans for the Small Business Owner

By Louis Kravitz, MAAA, MSPA, EA and John Horning, FSA

As a small business owner, what would you do if the government offered to pay retirement benefits to your employees? And give you all the credit? And pay you for letting them do it?

This is exactly what the government is doing for many small business owners who set up tax-qualified retirement plans.

Joe Smith is the owner of Smallco, a Los Angeles-based manufacturing company that makes widgets. Joe has four employees. Last year, Smallco contributed $45,000 to a tax-qualified retirement plan,$30,000 going into Joe's own account and $15,000 into the accounts of his employees.

Smallco received a tax deduction for the $45,000 contribution. The money went into a trust fund where it will accumulate tax-free until it is paid out as retirement benefits to Joe and his employees.

Joe is 45 years old. In 20 years, when he is age 65, his own account will be worth $1,718,000 assuming Smallco continues to make contributions and that the trust fund earns a 10% rate of return. In addition, the employees' accounts will be worth $859,000 at the end of the 20-year period.

If Smallco did not have a retirement plan, it would not have made the $45,000 contribution. It would most likely pay this amount to Joe as additional salary. Joe would have to pay taxes on this additional salary and would probably invest the remainder and have to pay taxes each year on his investment income. At a marginal tax rate of 45%, Joe would have $863,000 at the end of 20 years, only about half of what he will have in his retirement plan account.

Of course, if Joe takes all of his money out of the plan at age 65, he will have to pay taxes. At a 45% tax rate, this will leave him with $945,000, still more than the $863,000 he would have if Smallco did not have a retirement plan.

So, at the end of 20 years, Joe has more money. His employees have more money. And his employees think the money came from Joe!

But, there is more good news. Joe does not have to take his money out of the plan when he retires at age 65. He can leave his money in the plan or transfer it to an IRA. In either case, his money will continue to accumulate tax-free until he withdraws it. He is not required to make any withdrawals until he reaches age 70-1/2. These additional years of tax deferral make a good deal even better.

Unlike Joe, many small business owners are unaware of the magnitude of the tax advantages of qualified retirement plans.

Our tax system is often used to encourage individuals and businesses to do that which they would not otherwise be inclined to do. In this case, tax breaks are given to encourage retirement savings. To prevent abuse, the tax code places limitations and restrictions on retirement plans receiving favorable tax treatment. These limitations and restrictions are generally intended to prevent a plan from discriminating in favor of owners and other highly paid employees. For example, a plan cannot cover a business owner and exclude all of the other employees. Thus, Smallco had to contribute $15,000 to the accounts of employees other than Joe.

Most large businesses need to have retirement plans in order to attract and retain qualified employees. But, for a small business, the tax advantage is the primary attraction of a qualified retirement plan. Thus, the trick is to design the plan so as to maximize the portion of the total contribution that goes into the accounts of the owners and other key employees. There are many techniques for doing this.

Until recently most retirement plans were designed to provide a contribution on behalf of each participant equal to some percentage of his pay with each participant receiving the same percentage. For example, a business owner earning $100,000 might receive a $5,000 contribution, which is 5% of his pay. A $30,000 per year employee in the same plan would also receive 5% of his pay, or $1,500.

Several years ago, a new kind of plan was developed which is much more favorable to the small business owner provided they are older than some of their employees. This new plan design (called "New Comparability") might allow our $100,000 business owner to double the contribution made on his behalf without having to increase the amount contributed for the $30,000 employee.

There are many kinds of retirement plans. Some of them, like IRAs, SIMPLE Plans, and Simplified Employee Plans (SEPs) are easy to set up and operate for employers with modest contribution objectives. For those willing and able to take maximum advantage of the tax laws, the following kinds of plans are appropriate:

Profit sharing plans allow the employer to change the level of contribution from year-to-year. Contributions on behalf of any individual are limited to 25% of pay or $30,000, whichever is smaller. The maximum deductible contribution for all plan participants combined is limited to 15% of total pay.

Money purchase pension plans allow larger tax-deductible contributions (up to 25% of total pay) but the employer's ability to change the contribution level from year-to-year is restricted.

Defined benefit pension plans do not have accounts for each individual participant. Instead, the plan promises to pay a monthly benefit when the participant retires. The amount of the monthly benefit can be based on an employee's pay and the number of years he is employed by the company. Because the benefit promise must be kept, the employer must contribute more to the plan if the plan's investments perform poorly. On the other hand, employer contributions will be smaller if the investment return is good.

Cash balance pension plans permit contributions in excess of $30,000 for older participants. Each participant has his own account but the employer is required to guaranty a specified rate of return. The ability to change contribution levels from year-to-year is restricted.

Finally, there are the much publicized 401(k) plans that allow participants to contribute a portion of their pay to the plan on a pre-tax basis. These plans frequently provide for a matching contribution from the employer. Participants often have the opportunity to direct the investment of their accounts and to borrow against their account balances. From the business owner's point of view, these plans can be very beneficial because they allow the owner to make a contribution on his own behalf without having to make a corresponding contribution on behalf of his employees.

With the wide variety of plans available, a good retirement plan advisor is imperative, particularly for small businesses wishing to maximize their tax advantage. Joe Smith was fortunate to have a good advisor. Out of Smallco's total contribution of $45,000, $30,000 went directly into Joe's own account. Not only will Joe be in a better financial position when he retires but Smallco's other employees will have retirement benefits that would not otherwise be available. These additional benefits will be financed by the tax savings granted to qualified retirement plans. For a young business owner with four employees, this is an offer that is difficult to refuse.

Louis Kravitz is President of Louis Kravitz & Associates, Inc., the largest California-based firm of actuaries, consultants and recordkeepers specializing in the design and administration of retirement plans for the small to medium sized business.

John Horning is a Senior Consultant with Louis Kravitz & Associates, Inc.

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