Retirement plans were confusing even before the market’s downturn depleted many Americans’ 401(k) plans. Choosing the right qualified plan may be one of the most important decisions you make in your working life.
“Like everybody else, business owners come to a point where they are either unwilling or unable to work as hard as they did at their peak,” says Bill Coffey, senior pension consultant with Peachtree Planning Corp. “Making provisions for that eventuality during a business’s profitable years is part of the life cycle that begins with acquiring the skills to create that business.”
Smart Business learned more from Coffey about how a properly structured qualified plan can become a strong foundation for you and your employees’ retirement.
Why should business owners consider qualified plans?
Starting in the 1980s, defined benefit plans, which provide a monthly benefit at retirement, were decreasing in use due to a combination of poor tax law and corporate cost-cutting as the work force aged and funding became prohibitive. Defined benefit plans were replaced by salary deferral plans with investment decisions made directly by plan participants, often with little input from knowledgeable advisers.
While almost everyone has been affected at the end of a decade during which the markets made negligible returns, those with successful businesses face the most dramatic drop in income upon retirement. To provide a lifetime income of $1,000 per month at age 65 currently costs $138,000.
A positive is that allowable contributions to qualified plans, including defined benefit plans, have increased dramatically throughout the decade. The available increased benefits and contributions make these plans very desirable from a tax viewpoint.
What are some advantages of qualified plans?
The tax incentives that allow current deductibility of contributions and tax deferral on any earnings of retirement funds result in greater accumulations than could be achieved otherwise. Another important aspect is the fact that retirement plans in general cannot be attached by creditors. High-quality prospective employees will also want to see a qualified plan among the benefits offered by an employer.
What do business owners need to do to ensure that their plans are in compliance with the IRS code and ERISA?
They need to realize that a qualified plan is not an investment vehicle. It is a trust to hold assets allocated for the retirement of employees of the business, including the owner. If you start there and get the structure right by establishing a plan with individuals with expertise in the field, then you will be on the right track. The accountants should work in unison with the plan providers to make sure the plan is set up properly and that all filings are made in a timely manner.
Do qualified plans make sense for everyone?
In general, yes, but it is possible to have too much money allocated to qualified plans. We have to remember that the tax advantages outlined above are offset by the fact that all income taken from the plans is subject to ordinary income tax. Ideally, we want to deduct at a higher tax rate and receive at a lower rate. Decisions on the funding of a qualified plan should be made in the context of a participant’s total financial plan with current and future taxation, including potential estate taxes, warranting particular scrutiny. Some businesses may also find their needs better met with a nonqualified plan, particularly where the objectives are to reward or retain a few key individuals.
What incentives are there to choose traditional qualified plans over SIMPLE IRA plans?
I am not a fan of SIMPLE plans, because the contribution limits are too low and it is likely that anyone who found the deduction sufficient would be better off funding a Roth IRA. In addition, the adoption of a SIMPLE plan prohibits the establishment of any other plan for a business.
Safe harbor 401(k) plans are a much wiser choice for a profitable small business, but even making the maximum deposits to a profit sharing/401(k) plan ($49,000 to $54,000 in 2010) won’t replace income for an owner of a profitable business or a well-paid executive. However, for 2010 the benefit limitation for defined benefit plans is $195,000 for ages 62 through 65. This is the maximum annual benefit you can fund with the required deposits depending on current age in addition to interest rate and annuity purchase rate assumptions. Defined benefit plans are valued each year and participants have a clear picture of how their projected income at retirement is growing.
What are some common mistakes business owners can make regarding their retirement plans, and how can they be avoided?
The most common mistakes are made at plan inception. Businesses often adopt a plan without understanding the fundamentals of the particular plan with respect to funding obligations and other issues, including vesting requirements. Poor investment strategies are also common. Striving to make high returns can lead to market losses, which can negate the value of the tax deduction and deferral when funds are subsequently taxed on retirement distribution.
Again, it is very important to have the right person or firm advise you on plan structure. Too often a preoccupation with investment choices takes precedent over plan design.
It is best to make sure the plan will provide the desired benefits and be well-received and communicated to the employees. A clear understanding of administrative expenses and funding requirements is essential.
Bill Coffey is a senior pension consultant with Peachtree Planning Corp. Reach him at firstname.lastname@example.org or (404) 260-1641.