Is Your Client Doing a 401(k)? – Part 1

Owners of small businesses are a special type of person – ambitious, goal-oriented, enthusiastic, and likable. They also are experts at stretching a buck – except, perhaps, when it comes to saving for retirement. The pressure of running a successful business often means that retirement planning is neglected. But then, where are they when they want to retire? Will they have enough in savings or from selling their business to retire comfortably?

The benefits of establishing a tax-qualified retirement plan are well known: tax-deductible contributions, tax-deferred growth, and protection of plan assets from creditors. A good retirement plan can also help a business retain and recruit key employees.

Yet, despite all of their benefits, business owners frequently shy away from retirement plans.  Why?  Perhaps it’s because they don’t know enough about them, or they don’t know which plan would be best for them (and their employees). They may also think that retirement plans are too expensive and complex to administer.  So, they default to a SIMPLE IRA or SEP IRA, which are easy to administer, have lower contribution limits, and generally are not able to provide business owners with the retirement income that they need.

Let’s see if we can address some of these concerns.

Types of Qualified Plans

First, what kinds of retirement plans are there?

There are two basic types of qualified retirement plans:

1. Defined Contribution. Benefits are based on contributions made by the employer, the employee or both, and the retirement benefit is the accumulated account balance, including investment results.  In a defined contribution plan, employees bear the investment risk. The two most common types of defined contribution plans are profit-sharing plans and 401(k)s.
2. Defined Benefit. Benefits are based on a formula set forth in the plan document that provides a guaranteed monthly retirement benefit for life.  In a defined benefit plan, the employer bears the investment risk. One type of defined benefit plan is a cash balance plan, which is a hybrid defined benefit plan.  A cash balance plan looks and feels like a defined contribution plan, but it pays a guaranteed annuity for life or the “hypothetical account balance” as a lump sum payout.

Retirement Plan Strategies

Small business owners have a lot to consider when choosing a retirement plan.  And the myriad of plan design options can be overwhelming. That’s where a financial advisor who is experienced and knowledgeable about retirement plans can be invaluable. So, let’s look a little deeper at some of these plans.

Profit-Sharing Plan

A profit-sharing plan is a qualified retirement plan that gives the small business owner flexibility in designing the plan’s key features, as well as allowing discretionary contributions. The employer can decide each year how much to contribute to the plan. The employer can also elect to make no contributions in years in which earnings are low.

A business owner also has the flexibility to choose how they want contributions allocated among employees:

• Pro-Rata. All employees receive the same percentage of compensation as an employer contribution. The employer contribution amount is capped at 25% of total employee compensation.
• New Comparability. The employer can divide its workforce into different groups and provide that each group receives a different percentage of compensation as an employer contribution. This is a popular option for small business owners who want to allocate a certain percentage to them and their key employees and another percentage to other groups of employees.

401(k) Plan

A 401(k) plan is a good option where the employer wants to rely on employee contributions.  Employees, including owner-employees, defer a percentage of their salary on a tax-deductible. A 401(k) plan also allows the employer to make matching contributions.

• Traditional 401(k). A traditional 401(k) plan is for a business with employees. But a traditional 401(k) plan to make sense, the business owner needs to be paid a salary just like the other employees, so they can make deferrals as well. If the business elects to make matching contributions, the owner would be eligible for those contributions as well, which would increase the owner’s retirement savings.
• Solo 401(k). A Solo 401(k) plan is for solopreneurs who don’t have any employees, except perhaps a spouse. In this case, the owner is both employer and employer. As an employee, the owner can contribute the maximum deferral amount, including catch-up if they are age 50 or older. In addition, as employer, the owner can make a matching contribution up to 25% of salary to the maximum allowed.

There’s a limit, however, to the amount of matching contributions a self-employed individual can make which involves using a special formula to calculate contributions based on net earnings minus one-half self-employment tax and employer contributions (more on this in Part II of this discussion).

A popular design feature is to pair a profit-sharing plan with a 401(k) plan, thus taking advantage of the tax savings and maximum contribution limits of each type of plan.

Defined Benefit Plan

Unlike a defined contribution plan, where the benefit depends upon the investment earnings of contributions, a defined benefit plan provides a guaranteed monthly annuity for life at retirement.  There are a number of different defined benefit plans.

• Traditional Defined Benefit Plan. A traditional defined benefit plan provides lifetime benefits to the plan participants. Small business owners like them because they permit larger tax-deductible contributions than defined contribution plans. Defined benefit plans are funded by the employer only; no employee contributions are generally allowed. Also, unlike a defined contribution plan, in a defined benefit plan the employer bears the investment risk.  If the plan’s investments go down, the employer will need to put more money into the plan in order to fully fund the benefit.
• Cash Balance Plan. A cash balance plan is a hybrid defined benefit plan. It looks like a defined contribution plan with the participant’s benefit expressed as a “hypothetical account” with “pay credits” based on the employee’s compensation and “interest credits” based on a fixed interest rate set forth in the plan document. The final benefit is either a single sum distribution of the amount in the “hypothetical account” or a guaranteed monthly benefit for life based on the account balance.
• 412(e)(3) Plan. A 412(3(3) plan is a fully-insured plan funded by fixed annuities or a combination of annuities and life insurance. Employer contributions to the plan are calculated by the insurance company and are paid in annual, level premiums. Most importantly, benefits are guaranteed by the insurance company. This is the most secure type of defined benefit plan, and generally required the largest contributions.

Small business owners often find themselves needing to play catch-up for retirement because they’ve spent a lot of time and money growing their business instead of saving for retirement. As a result, they look for a retirement program that will let them save a lot in a short period of time.

This means a well-designed retirement plan is a must. 401(k) plans by themselves cannot provide sufficient savings. But pairing a cash balance plan with a 401(k) plan gives the business owners additional options to take advantage of the tax savings and maximum contribution limits of each plans.

Which retirement program a business owner selects is very personal, taking into consideration the cost versus the ultimate benefit for the owner and the employees.

Conclusion

Retirement planning options can overwhelm the small business owner. So, it’s important for them to enlist the assistance of a good financial advisor – you – and explore the details of what they want for themselves and their employees before making a final decision.

Some advisors prefer to work with large companies and large plans, but the small business market can prove very rewarding.

We, in the Pension Division of RMC Group, specialize in working with advisors who serve the small plan market. We can help you market, set up, and administer your clients’ profit-sharing or other qualified plans.

Click here for an easy to read chart that explains each retirement plan’s key attributes and their benefits.

Call 239-298-8210 or visit our website at rmcgp.com to discover how we can partner with you to help small businesses successfully set up and administer a profit-sharing plan.

Read part 2 here.