Small Biz Owners Can Take Advantage of Many Different Retirement Plans
A quiet revolution has occurred in small business retirement planning, brought about by some new tax laws that drastically alter the playing field of small business retirement plans.
Since the passing of the Economic Growth and Tax Relief Reconciliation Act of 2001, small business owners could begin to put away more pre-tax money than ever before for their retirements. Self-employed individuals now enjoy all of the benefits of a 401(k) or profit-sharing plan without any of the hassles. Those benefits include the ability to put away $40,000 for retirement, a possible tax reduction for the business, access to personal loans and simplified reporting.
In order to understand the magnitude of the changes, some review is in order.
One of the first retirement plans offered to small business owners was the Keogh Plan. Keogh Plans were typically a profit sharing plan combined with a money-purchase plan. The profit sharing aspect allowed the company to make a 15% contribution on the owner’s behalf and the money purchase plan allowed for another 10%. That meant that someone making $100,000 could put away 25% or $25,000.
The problem with Keogh Plans was that the only way to maximize a retirement contribution was to piggyback the money purchase plan on top of the profit sharing plan. Money purchase plans are extremely unflexible. If one were to choose a 10% contribution, that contribution had to be made regardless of cash flow or how good the year was business-wise.
With the new tax laws, the Keogh Plan is extinct, and there is no reason to piggyback the two old plans. The same maximum contribution can be accomplished through more modern types of accounts.
Simplified Employee Pension
One account that replaced the coupling of profit sharing and money purchase plans is the SEP or Simplified Employee Pension. SEPs are easy to set up and the contribution limits on SEPs have been raised to 25% of income up to a maximum of $40,000 per year.
A SEP can be used for a business with a sole owner and up to a maximum of 25 employees. Each employee has an IRA account established for them in which the company contributes a predetermined percentage of the employee’s respective salaries.
Although greatly improved by the new tax laws, SEPs unfortunately have drawbacks, as well. First, the same percentage that is contributed for the owner has to be contributed for each participating employee. That means if the owner contributes 25% to the plan, they would also have to contribute 25% for each employee.
Secondly, there is no vesting with a SEP. Employees don’t have to be with the company for any specific period of time before the money becomes theirs. The "Golden Handcuffs" feature of a retirement plan match is lost.
It’s SIMPLE
Another plan that has gained popularity is the SIMPLE Plan – Savings Incentive Match Plan. Like its cousin the SEP, with a SIMPLE plan each participating employee has an IRA account opened on their behalf, and can opt to contribute or defer a percentage of their salary into the account.
With current tax laws, each employee may defer up to $8,000 per year. This amount will climb to $10,000 by 2005. With a SIMPLE Plan, the business is required to the make a contribution on the employee’s behalf each year. The contributions are more flexible than those required with a SEP, but they are still mandatory.
The company contribution is a mandatory 2% of every employee’s compensation or a matching contribution of 3% of the employee's own contribution for that year. The employer may also opt to go as low as 1% of each participant's compensation for two out of every five years.
The SIMPLE Plan is much improved with the increased compensation limits. However, there are drawbacks. Similar to those of the SEP, participants are limited as to how much they can contribute, and there is no vesting period.
Individual 401(k)
Now the revolution – the individual 401(k) plan. An individual 401(k) plan is not a new type of plan. It is nothing more than a traditional 401(k) designed for sole business owners.
The new laws under EGTRAA have made it much more enticing for an individual to sponsor their own 401(k) plan. The new structure provides the ideal solution for those self-employed individuals who are looking for a way to substantially reduce their taxable income and save for retirement at the same time. When coupled with a profit sharing plan and/or a defined benefit plan, there is nothing as powerful in the world of retirement savings, some feel.
The dynamics of the plan are simple. The owner of the business can defer up to 100% of their salary to a limit of $12,000 under this year’s rules. If the owner is over age 50, that number grows to $14,000 thanks to a catch-up provision. Now the fun begins: The owner can then combine a profit sharing plan with the 401(k) and put even more money away.
Yes, a profit-sharing plan does require that you put away money for all employees. That is why if you are the only employee, or if the business is family run, this plan is optimal.
That profit sharing plan will allow you to defer another 25% of salary up to a maximum of $40,000.
For the business owner who is taking too much income, accelerating them into too high a tax bracket, this is a way to defer a huge chunk of income pre-tax. Some examples:
Example 1: John Jones had compensation of $116,000 in 2002.
®€′ SEP contribution – $29,000 (25% of compensation)
®€′ 401(k) profit sharing plan contribution – $40,000 (25% of compensation + 401(k) elective deferral)
Difference – $11,000 more in qualified plan program
If an individual earns $116,000 or less, the qualified retirement program will always have at least an $11,000 advantage.
Example 2: Bob Davis is 25 years old, and had $160,000 in compensation in 2002.
®€′ SEP contribution – $40,000
®€′ 401(k) profit sharing plan contribution – $40,000 ($29,000 profit sharing + 401(k) elective deferral)
®€′ Defined benefit plan contribution – $11,000
Difference – $11,000 more in qualified plan program
The individual 401(k) plan works for anyone who is self-employed, regardless of the legal form of their business – corporation, partnership or a sole proprietorship.
Ease of Use
Aside from tax and retirement savings, you may also choose to allow plan participants to take out personal loans from their accounts – including yourself. And, all of these benefits can be reaped without having to shell out any of the added expense of having a classic 401(k) plan.
Also, as far as filing and testing requirements, as long as the plan is a one-person plan and the assets are under $100,000, testing and 5500 filing are not required. That means no third-party administrator and the fees and hassles that go along with them.
If you add a person or the assets exceed $100,000, you will need to file a 5500 tax form. If the person you have added is someone other than your spouse, your plan will then have to be tested. In most cases, though, the benefits in tax and retirement savings far outweigh the cost of the administration of the plan.
Although this qualified plan strategy will benefit any type of individual business owner, regardless of income level, it is especially useful for individuals who want to shelter substantial amounts of taxable income while maximizing their retirement savings. Take advantage of the revolution and make today the first day of the rest of your financial life.
James Ernst is a partner and vice president with Mangan, Ernst, & Rankin Wealth Management Group in Marlton, N.J., and is both an Accredited Asset Management Specialist and a Chartered Mutual Fund Counselor. He can be contacted at jernst@wachoviasec.com.