Successful businesses often still have things to learn about managing taxes and income.
Many business owners and managers are aware of “qualified plans” or programs like 401(k) and Defined Benefit plans, which allow the sponsoring employer:
- current income tax deduction for plan contributions;
- tax deferred growth on plan assets;
- asset protection under ERISA (the Employee Retirement Income Security Act of 1974); and
- the ability to roll your account, income tax free, to your IRA.
There are, however, many misconceptions about “qualified plans.” Known as “qualified” because contributions qualify for a current income tax deduction, these plans can be a valuable tax planning tool.
Qualified plans come in two general styles: Defined Contribution (DC) and Defined Benefit (DB). Examples of DC plans are 401ks and SEPs. You “define” the contribution that is made to the plan. In 2014 the maximum contribution is 25 percent of payroll, not to exceed $52,000 for any one participant. What’s unknown is what you will receive in the future: It depends on how much is put in each year, how many years monies are contributed and what it earns on investments.
The traditional plan is the DB plan. Think back to your parents’ or grandparents’ generation: They went to work for a company for 30 years and retired on perhaps 75 percent of their salary. That company’s plan defined the benefit that was paid at retirement.
Defining the benefit
At one time DB plans were the cornerstone of most retirement plans. Lately they have fallen out of favor after taking on negative connotations due to the financial crisis. Newspaper stories publicized the underfunded or unfunded liabilities in DB plans. These articles, however, have been generally about large companies, organizations or government agencies. Most larger companies have stopped their DB plan and replaced it with a DC plan. It’s not news.
Nevertheless, the DB plan remains a valuable program for the closely-held business and professional practice—because the small business is often run by focused and driven individuals. The DB plans set up for this sector are not about employee benefits or retirement as much as they are about the income tax deduction, the tax deferred growth, the asset protection under ERISA and the fact they are approved, in writing, by Internal Revenue (Favorable Determination Letter).
For these entrepreneurs, DB plans can be an ideal vehicle, allowing businesses to keep a larger share of their hard-earned dollars. Still, many businesses and professional organizations have not implemented any type of qualified plan. Why not? In one word: misconceptions.
“A plan will cost too much to administer.” “My employee costs will kill me.” “I’m already paying salary, sick pay, vacation pay, matching Social Security and Medicare, paying into Workman’s Comp, unemployment … I don’t want to add more overhead.” “My employees don’t or won’t appreciate it.”
In another word: nonsense. A custom-designed DB plan can provide substantial tax benefits to a business or practice owner without incurring any of the above situations.
For those generating more than $200,000 a year in taxable income, consider setting up a pension plan, even if you already have existing retirement investments, such as a 401k or IRA. Many clients that come to us already have an existing plan. “The plan is okay; it’s just that the deductible contribution is not enough. I need a larger annual tax deduction.” This is when the DB plan makes sense. And you can add on a DB plan in addition to any existing 401k plan.
DB plan advantages
A few key benefits that DB plans offer:
Higher annual contribution limits. Like a 401k plan or an IRA, DB plan contributions are income tax-deductible. A key difference is the higher tax-deductible contribution limits allowed in DB plans.
A DB plan can create substantial annual tax-deductible contributions over and above existing 401k plans. The maximum deductible contribution is around $200,000. The point? I’ve never had a client ask for a DB plan to be designed to provide a specific benefit. We’d all probably like to retire on $1,000,000 per month; do we have the resources to set aside to get there? The answer is that we all have a budget, and it’s that budget that drives the DB plan’s contribution. In other words, a client will say, “I’d like an additional deduction over and above my 401k plan of $XX dollars.” We design a plan that absorbs that annual contribution.
Asset protection. Under ERISA, pension benefits are “inalienable and non-assignable,” meaning that you cannot be alienated from your pension monies. This has been argued all the way to the Supreme Court in Patterson v. Schumate. It’s not even up for discussion. Here’s one example: How did O.J. Simpson run around leading a decent lifestyle when Ron Goldman’s father had a judgment against him? His NFL pension was a protected asset!
For anyone with “Doctor” in front of his or her name, or for anyone with a successful and profitable business, it’s often not if you will be sued but when. In today’s litigious society, frivolous lawsuits are commonplace. Pension monies are one asset these judgment creditors cannot take away.
Vesting. Just because money goes into a plan for employees does not immediately make it their money. This is not a severance plan or a bonus. Employees vest, or earn, their benefits over time. The typical vesting schedule is a “2-20” schedule, meaning if the participating employee leaves your company, she is entitled to 0 percent of the benefit if she’s worked for you fewer than two years. After two years, she is 20 percent vested. Vesting increases by 20 percent annually until she is 100 percent vested after 6 years.
Say an employee leaves after three years. He is 40 percent vested. He forfeits, or leaves behind, 60 percent of that benefit’s value. Those forfeited assets stay in the plan. There is one caveat: vesting accelerates to 100 percent on death, retirement or plan termination.
Tax-deferred growth. All assets in a qualified plan are tax-exempt. Under ERISA, pension monies must be held “in trust” for the participating employees. The trust is a tax-exempt trust, so no taxes are due on plan earnings. Of course, taxes are due on these monies when you take them out of the plan. However, in many circumstances the taxable receipt of funds, and therefore taxes, can be delayed up to age 70½, at which point you must begin taking Required Minimum Distributions.
With all the above benefits, is there a downside? There is no “silver bullet.” A DB plan, like a 401k, has annual reporting requirements, actuarial certification, etc. The cost for a DB plan is typically about twice what a 401k plan costs. Unlike a 401k or any other DC plan, DB plans have required contributions; they’re not set up for a one-time contribution. When establishing the plan, consider this an item that will be added to overhead. The fact that the business owner gets the bulk of the contribution is a distinct advantage, so it’s not really a “cost” in that sense. However, it is something that has to be done annually.
For the high-net-worth, high-taxable-income business owner wanting to take steps to minimize income taxes, protect assets and personal wealth from judgment creditors, all with up-front approval from the Internal Revenue Service in the form of a Favorable Determination Letter, a DB plan could help address all these objectives.
First: keep yourself informed. Don’t make any assumptions, and don’t go into a plan blind. Find a DB plan custom-designed for your particular situation and get your accountant involved in the decision-making process. When making a business decision, go in with all the facts and look over the numbers in black and white. In this case, you could be pleasantly surprised.
William H. Black Jr., president of PensionSite.org, has been in the pension administration business for more than 35 years, and is a well-known author and speaker on financial and retirement topics. Contact him at Bill@PensionSite.org.