When it comes to small business owner retirement plans, a one-size-fits-all plan is often not the most effective option, as personal circumstances and goals can vary widely. Fortunately, the tax code allows for more flexibility in plan designs than most people are aware. However, the variety of retirement plans currently available may prove overwhelming to you, making it difficult to select a plan ideal for your situation.
This article provides you with a brief overview of a few different types of retirement plans that may be designed to effectively meet your retirement objectives.
An article titled “Ten Common Errors,” published in the September 2008 issue of Trusts and Estates, demonstrates the impact of maximizing a 401(k) deferral for an extended period of time. In this hypothetical illustration, an average return of 8 percent over 40 years on annual contributions of $15,500 (the 2008 limit) produces a retirement nest egg of over $4 million. These impressive results would seem to indicate that contributing the maximum amount to a 401(k) solves the retirement puzzle.
But what happens if you are only 15 to 20 years away from retirement or have been incapable of maxing out your 401(k) until recently? Or, what if you are a small business owner who must also make contributions on behalf of your employees? What about market setbacks over the last year that made 8 percent returns highly improbable for the vast majority of investors? In these scenarios, a cookie-cutter 401(k) plan becomes impractical for many business owners, especially for those who cannot count on a 40-year contribution timeline.
For many, the search for an answer begins with identifying the amount of pre-tax surplus available for retirement savings. If you want to save $50,000 or less annually, a 401(k) profit-sharing plan can be a great solution, as it has maximum flexibility and low administration costs. However, if you would like to contribute in excess of the $50,000 annually, there are many solutions that may be more appropriate for you.
Defined Benefit Plans
Although large pension plans are slowly losing favor to 401(k)s, defined benefit plans are still expanding in the small business owner marketplace. Depending on your age and income, these plans can allow you to annually contribute between $60,000 and $200,000, making a positive impact on both retirement accumulation and tax liability. However, defined benefit plans are not for every business.
You may be a good candidate for a defined benefit plan if:
• You are able to contribute more than $70,000 a year, including current retirement savings
• Your business has a consistent profit pattern and available surplus, as defined benefit plan funding is not discretionary
• You own a business and have employees—ideally no more than 10 employees per owner, and the workforce should generally be younger than the ownership
• You are in the 45-to-60-year-old age range (if your business has no employees, age becomes less of a deciding factor)
• You are willing to contribute 5 to 7 percent of your pay to the staff
If you meet the above criteria, it may be worth your while to speak to an advisor who understands the nuances of defined benefit plans.
Cash Balance Plans
Cash balance plans are often referred to as “hybrid” plans because while they are technically defined benefit plans, on the surface they look like defined contribution plans, which include 401(k)s and profit-sharing plans. Cash balance plans establish a hypothetical account for every participant, and each account is credited annually with a contribution credit and an earnings credit based on a formula specified in the plan.
For example, a cash balance plan will describe a retirement benefit as a lump sum payment based on a $1,000 contribution credit and a 5 percent interest credit earned in the plan. In contrast, a traditional defined benefit plan may define a participant’s benefit as a $100 per month annuity, payable at normal retirement age. At retirement, a cash balance plan typically allows lump sum distributions, which can be annuitized or rolled over to an IRA to retain tax-favored status.
If you need to catch up on retirement savings or would like to increase your tax-favored nest egg, cash balance plans may be a desirable option. However, there is another option that can prove even more advantageous. Combining your existing profit-sharing 401(k) with a cash balance plan may allow you to significantly increase the contribution allocation while only marginally increasing the employee costs, and in some instances, lowering employee costs.
To understand how a custom plan can benefit a small business owner, it is often easiest to provide a real-life example. Our captive pension design company, Advanced Equities Pension Services (AEPS), recently reviewed a plan sponsored by one of our advisor’s prospective clients. In this particular case, the business employed an owner and the owner’s spouse (aged 50 and 49, respectively) and six non-owner employees. The clients sponsored a profit-sharing plan, which allowed $98,000 in contributions to the owners and required a contribution of $21,800 to staff.
The owners planned to work at least six to eight more years but had a substantial retirement savings gap. Since the business had a stable income and a history of recurring surplus, our objective was to maximize the owners’ contributions. After an in-depth study, we proposed a safe harbor 401(k) profit-sharing plan, combined with a general-tested cash balance plan. This advanced plan design increased contributions to the owners three-fold, from $98,000 to $313,500, while reducing plan contributions required for the employees by 50 percent to $9,700.
Existing Plan Contributions Safe Harbor Plan Contributions
Owner and Spouse $98,000 Owner and Spouse $313,500
Six Employees $21,800 Six Employees $9,668
Percent to Owners 82% Percent to Owners 97%
As you can see, this design produced a truly winning combination for these particular business owners. Advanced plan design allowed these business owners to optimize their plan and align it with their objective of closing the retirement savings gap. Your results may vary.
Are You In a Similar Situation?
In the coming year, the Internal Revenue Service (IRS) is requiring that all defined contribution plans be fully restated onto a new document that complies with the changes in pension law contained in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The most recent requirement of this kind was associated with GUST, when all plan sponsors were required to bring their retirement plans in compliance with the series of laws passed from 1994 to 1997. While the changes brought about by EGTRRA have already been adopted by most plans through good faith amendments, the IRS is now requiring a full restatement of all defined contribution plans so that the plan document itself contains the required EGTRRA language.
Because the entire document must be restated to include the new provisions required by EGTRRA, this is an ideal time to consider whether you might benefit from including some optional provisions that could help you reach your business and retirement objectives more efficiently.
If you are investigating your retirement plan possibilities or currently sponsor an IRA-based plan, such as a SEP or SIMPLE, it may be worth your while to investigate your options.
If you are interested in investigating your retirement plan options, contact an advisor who understands small business owners and their particular needs. And do yourself a favor: don’t settle for advice that only considers cookie-cutter 401(k) or profit-sharing plans. While good for many, they may not be the most effective solution for you.
About the Author:
Alex Petrenko serves as Manager of for the Advanced Case Design Group of Advanced Equities Wealth Management, an affiliate of First Allied Securities, assisting independent financial advisors in their efforts to design custom retirement plans for small business owners. In addition to performing retirement plan consulting, Mr. Petrenko researches retirement plan solutions and helps advisors locate possible candidates for retirement plans, and present proposals to clients. Mr. Petrenko has been working in the financial services industry for almost 10 years. Prior to Advanced Equities Wealth Management, he worked with small business owners in creating retirement plan strategies. For more information, please visit www.aewm.advancedequities.com, call (866) 350-4237, or e-mail email@example.com.