Monster Media 1996 #14/Monster Media No. 14 (April 1996) (Monster Media, Inc.).ISO/business/sba961.zip/F401.SBE

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       ┌──────────────────────────────────────────────┐
       │  PENSION AND PROFIT SHARING PLANS AND IRA'S  │
       └──────────────────────────────────────────────┘


Qualified retirement plans (pension and profit sharing
plans) are the last great tax shelter.  If you run a small
business that is generating profits that you don't need to
reinvest in the business or to live on, socking away as
many dollars as possible into a "qualified" pension or
profit sharing plan or into an IRA (Individual Retirement
Account) can be a winning proposition, for several import-
ant reasons:

  . The money that you (or your corporation) put into
    the plan or IRA is currently tax-deductible for
    federal and state income tax purposes.

  . Once the money is contributed to a retirement plan
    trust or IRA, it can be invested and can compound
    tax-free, until you begin withdrawing it (voluntarily,
    after age 59 1/2, or required withdrawals after age
    70 1/2).  That is, dividends or interest earned on
    the retirement fund, or capital gains on stocks or
    other investments, are not taxable to the retirement
    plan trust or IRA account, as a rule.

  . When you do begin withdrawing funds from your plan or
    your IRA at retirement age, you may be earning less in-
    come overall, and thus may be in a lower tax bracket
    when you finally start to collect your pension.  (Of
    course, no one knows the future, so there is always the
    risk that income tax rates in general could be much
    HIGHER when you retire than now.  Even so, you will
    still probably come out far ahead if your retirement
    assets have had the opportunity to compound and grow
    tax-free for 20 or 30 years until you finally retire
    and have to pay tax on amounts distributed out to you).

  . Also, with qualified plans other than IRA's, there are
    presently some fairly significant tax benefits, in the
    form of lower tax rates, if you take all your pension
    or profit sharing plan assets as a single "lump sum,"
    since the tax law permits you to compute the tax on
    such a lump sum under a very favorable 5-year averaging
    method.  (Naturally, there can be no certainty that
    Congress will still allow this tax break several de-
    cades from now, or whenever you retire or die.)

  . While one of the main drawbacks of putting money into a
    retirement plan is the fact that you will not ordinari-
    ly have access to that money until you are age 59 1/2
    (unless you die, become permanently disabled, etc.),
    you may be able to borrow up to $50,000 from your re-
    tirement plan account in certain instances, at least
    in the case of a plan maintained by a corporation oth-
    er than an S corporation.  Thus you may still retain
    some access to the funds, within strict limits:  No
    loans to your business, must pay fair interest rate
    on the loan, provide adequate security, and must repay
    the loan over a 5-year period, except for a loan used
    to acquire a principal residence).

At a time when real estate and most other kinds of tax
shelters of the type that flourished in the past are eith-
er a dead letter or extremely limited, pension and profit
sharing plans are an extremely attractive, low-risk option
for small business owners, since the money placed in such
plans can be invested in a fairly wide variety of invest-
ments, including stocks, bonds, money market funds, CD's,
and other passive types of investments.  Some limited in-
vestments in UNLEVERAGED real estate are also possible.

DON'T be misled into thinking that money you put into a
retirement account is tax-free.  While you may get a
deduction or be able to exclude the amount put into a
plan from your current taxable income, what you are really
getting is a DEFERRAL of taxes until you retire, die, or
otherwise withdraw funds from your IRA or other retirement
account.  This deferral is still quite beneficial, of
course, since you not only defer tax on the money you put
into the plan, but also on all the investment income and
gains on such money, until you finally receive your retire-
ment benefits.  Put it this way:  If you have a choice of
receiving a $10,000 bonus and paying tax on it today, and
then paying tax on any interest you earn on that money
from now on as well, versus having it put in trust for you
and invested at interest, and paying tax on the $10,000
(plus whatever it has grown to from investing it) 30 or 40
years from now, which do YOU think is a better deal, tax-
wise?  Time is money, and deferring income taxes for sever-
al decades can be almost as good as paying no tax at all.

The key characteristics of all the major types of retire-
ment plans, of which there are many, are discussed below.


INDIVIDUAL RETIREMENT ACCOUNTS (IRA'S)

The simplest form of retirement account you can set up is
an IRA.  You can quickly and easily open an account with
almost any bank, saving and loan, mutual fund company, or
stock brokerage firm.

The main advantages of the IRA are:

  . Simplicity.  It usually costs nothing to open up
    an IRA or to maintain it, although most stockbrokers
    and mutual funds will usually charge a small setup
    fee of $25 or so, as well as an annual maintenance
    fee of $10 or $15.  Banks, S & L's, and other finan-
    cial institutions rarely charge any such fees.

  . You don't have to cover any employees.  For all other
    types of retirement plans, if your business has em-
    ployees, you must also contribute money to the plan
    on their behalf, as well as for yourself.  There is
    no such requirement for a regular IRA.

  . You don't even have to be in business, or making a
    profit, to set up an IRA and make tax-deductible
    contributions to it.  As long as you have earned
    income from some source, whether it be your business
    or a job with an employer, you can make IRA contri-
    butions.

The drawbacks to the IRA are:

  . You are limited to an annual contribution to an IRA
    of $2000 (or $2250, if you have a non-working spouse,
    and you contribute at least $250 to a separate IRA
    for your spouse).

  . Even this limited contribution amount will not be
    deductible, if you are covered by any other kind of
    qualified pension or profit sharing plan and your
    adjusted gross income ("AGI") exceeds $50,000 (deduc-
    tion begins to "phase-out" when income exceeds
    $40,000), or, if you are not filing a joint return,
    you lose the IRA deduction if your AGI exceeds $35,000
    (with "phase-out" starting at $25,000 of AGI).

  . When you withdraw money at retirement age from an IRA,
    there is no special 5-year averaging tax treatment for
    receiving a "lump sum," unlike lump sums you might re-
    ceive from "qualified" pension or profit sharing plans.

Thus, while an IRA is a nice place to put a couple of thou-
sand dollars a year for an additional tax deduction, if
you don't have any other kind of pension plan coverage, or
if you make under $50,000 (or $35,000 if single) a year,
it's still not enough of a deduction to enable you to build
up a very large nest egg for your retirement.  To do that,
you will need to set up either a "SEP-IRA" or a qualified
pension or profit sharing plan.


SIMPLIFIED EMPLOYEE PENSION PLANS ("SEP-IRA'S"

SEP-IRA's, or SEP's, as they are also called, have many
of the benefits of qualified plans, while retaining much
of the simplicity and low administrative costs of IRA's.
To set up an SEP, any business, whether or not it is incor-
porated, merely fills out a simple IRS form (Form 5305-SEP),
which becomes the plan document.  It isn't even necessary
to file this form with the IRS.

The employer then sets up individual SEP-IRA accounts for
each employee who is required to be covered under the
plan, and makes contributions each year into their
accounts.  The contributions which must be a certain per-
centage of each employee's salary or wages (and of the
owner's net profit from the business, in the case of an
unincorporated business), up to a maximum of 15% of ear-
nings.  The maximum deductible amount that can be contri-
buted for any single participant for a taxable year is
limited to $30,000, which is the same as for "defined
contribution" pension and profit sharing plans (discussed
below).

Advantages of the SEP-IRA:

  . It provides a deduction comparable to that of many
    qualified "defined contribution plans," and far
    greater than that for a regular IRA.  It is especi-
    ally suitable for a sole proprietor or partnership
    that has no employees.

  . It is extremely simple to set up, and the compliance
    requirements for an SEP under ERISA (the Employee
    Retirement Income Security Act of 1974) are very
    minimal.  Thus you won't have to pay hundreds, or
    thousands of dollars a year to lawyers, accountants,
    benefit consultants and/or actuarial consultants to
    keep the plan "legal" under ever-changing IRS rules
    and onerous IRS and Department of Labor paperwork
    requirements, all of which can make it very expensive
    to maintain "qualified plans."

  . The amounts contributed to the plan are put in
    individual accounts for the employees who participate
    in it, so your "fiduciary" exposure for making bad
    investments with employee pension plan funds is
    virtually eliminated.

Drawbacks of SEP-IRA's include the following:

  . While they are simple, you must contribute a uniform
    percentage of earnings for yourself and all employees
    who are covered by the plan.  This is different from
    the various types of qualified plans, which can be
    tailored so that, within certain limits, you can put
    in a larger percentage of your current earnings than
    you must contribute on behalf of your lower-paid (or
    younger) employees.

  . The maximum amount deductible is limited to 15% of
    a participant's earnings, or $30,000, whichever is
    less, which is the same as for a qualified profit
    sharing plan, but less than for a qualified "defined
    contribution" pension plan, for which the limit is
    the lesser of 25% or $30,000.  (And far less than
    for a "defined benefit" plan, for which the amount
    of the deductible contribution for a participant
    is determined by actuarial calculations, and MAY BE
    WELL OVER $100,000 A YEAR if the participant is old
    enough and has a high enough income.)

  . You have much less leeway in excluding certain part-
    time employees from the plan.  A SEP requires you to
    cover any employee who is 21 years old or older and
    who has performed services for you during at least 3
    of the preceding 5 years and who receives at least
    $300 a year (indexed for inflation -- $400 in 1995
    and 1996) in compensation.  Thus, just about anyone
    who works for you during 3 different years must be
    covered.  (However, you may exclude union employees
    who are covered under a collective bargaining agreement,
    or NONresident aliens who don't receive any U.S.-source
    earned income from your firm.)  For qualified plans,
    by contrast, you can exclude any employee who has
    less than 1000 hours of service during the plan's
    fiscal year.

  . All contributions made to participants' accounts are
    fully vested, immediately.  This means that when an
    employee leaves your firm, he or she takes whatever
    is in his or her account with them (although they
    may leave it in their IRA account rather than pay
    tax on it by withdrawing it).  This is in contrast
    to qualified plans, where the plan can provide for
    vesting schedules, so that employees who leave after
    only a few years of working for you will "forfeit"
    all or part of the amount you have put into the plan
    for them, which either reduces the amount you have
    to contribute to the qualified plan for the year,
    or gets allocated to the accounts of the other
    participants (which would include you).

  . Distributions to participants from SEP's are treated
    like distributions from ordinary IRA's.  That is,
    there is no special 5-year averaging treatment for
    lump sum distributions.


QUALIFIED RETIREMENT PLANS
--------------------------

"Qualified" retirement plans tend to be a lot more complex
to set up and administer than IRA's or SEP-IRA plans, but
also tend to offer more flexibility and greater tax bene-
fits, of various kinds.  Note that "qualified" retirement
plans include Keogh plans set up by and for sole propri-
etors or partners in a partnership; S corporation retire-
ment plans that cover the employees (including "shareholder-
employees") of S corporations, and corporate plans set up
for the employees of a C corporation.  Keogh plans and
S corporation plans are virtually identical in every way
to corporate plans, except for one significant difference:
"Owner-employees" in a Keogh plan or "shareholder-employees"
in an S corporation retirement plan are prohibited from
borrowing money from the retirement plan, for any reason,
while employees (including the owners) of a C corporation
may sometimes borrow up to $50,000 from the pension or
profit sharing plan maintained by the C corporation.

For a sole proprietor with no employees, a Keogh plan
can usually be set up for him- or herself with a bank,
mutual fund, stockbroker or other financial institution,
with virtually the same ease and only a little bit more
in the way of tax compliance obligations than opening an
IRA.  However, for a corporate plan, or a Keogh plan where
employees are involved, things tend to get much trickier
and much more expensive in a hurry.

If you hire a law firm or employee benefit consultant to
design and set up a qualified plan for your firm, you will
usually incur substantial legal or consulting fees, which
may include paying them to go to the IRS for a "determina-
tion letter," a piece of paper that blesses your company's
plan, saying that it meets all the requirements for tax
qualification.  And you can also usually count on some
extensive annual administrative expenses thereafter to
pay your CPA or benefit consultant to do all the tax, Labor
Department, and other filings that may be required to keep
your plan "qualified," all of which can run into serious
money, year after year.

However, you can usually keep your front-end costs down
quite a bit if you are willing to adopt a "canned" (or
"prototype") plan, for which some benefit firm, CPA firm
or law firm has already gotten basic IRS approval, as to
form.

Many financial institutions, such as mutual funds, banks
and brokerage houses and insurance companies, also offer
such "canned" plans at a nominal cost, if you let them
manage your pension plan money in their mutual fund, bank
trust fund, or insured pension account, and often do much
or all of the accounting and administration of the plan
for you as well, as part of the package.  If you are com-
fortable with their investment "product," this can be a
cheaper alternative than hiring CPAs or consultants to
handle the highly technical administrative and compliance
chores for your company, which can cost thousands of dol-
lars a year, even for a relatively small plan with only 10
or 20 participating employees.

"Qualified" retirement plans come in two basic flavors,
PENSION plans and PROFIT SHARING plans, with a lot of
variations on each.  All of them have a few things in
common.  The most important common features are the
minimum coverage, participation and vesting rules.

The minimum coverage rules require that certain per-
centages of rank and file employees be covered or eli-
gible to participate in the plan.  Not all employees are
necessarily "eligible" employees, however.  You may ex-
clude certain classifications of employees, so long as you
make eligible most (a minimum of 70%, plus certain other
complex calculations that must also be satisfied) of the
NON-highly compensated employees of the company -- or else
meet an alternative non-discriminatory "average benefits"
test.  (As with SEP's, unionized employees and nonresident
alien employees with no U.S.-source earned income don't
have to be taken into account at all.)

The minimum participation rules require that your plan,
whether is it maintained by your corporation, or as a
"Keogh" plan in the case of a sole proprietorship or part-
nership, must generally cover ALL eligible employees by
the later of the date on which they reach age 21 or com-
plete one year of service (which means, generally speak-
ing, a 12-month period in which they perform at least
1,000 hours of service for your company).  However, if
benefits are 100% vested immediately for all participants,
the plan may require a 2-year waiting period, rather than
one year, before a new employee can begin to participate
in the plan.

The minimum vesting rules require a plan that is "top-
heavy" must either fully vest a participant's account af-
ter he or she completes 3 years of service, or else must
be 20% vested after 2 years of service, with an additional
20% vesting after each subsequent year of service, which
means full vesting at the end of 6 years.  ("Top-heavy"
plans will include the plans set up by many small firms,
where over 60% of the assets or accrued benefits under
the plan are allocable to "key employees" --owners, offi-
cers, highly-paid employees, etc.)

Plans that are not considered "top-heavy" can be set up
to vest over somewhat longer periods of service (5-year
"cliff" vesting, or 20% a year "graded" vesting, starting
after 3 years of service).


All qualified plans come under two general categories:
"defined benefit plans" ("DBP's") (which are a special
kind of pension plan) and "defined contribution plans"
("DCP's"), which include all other kinds of pension plans
as well as all profit sharing plans.


DEFINED CONTRIBUTION PLANS
--------------------------

Defined contribution plans all have certain things in
common:

  . The plan document defines the amount that will be put
    into the plan each year (the contribution) by the em-
    ployer, based in most cases on the compensation earned
    that year by each of the participants.  The benefits
    the participants will receive many years down the
    road, when they retire, are not defined, but will
    depend on how well (or poorly) the assets put into
    the plan for their individual accounts are invested
    and managed.

  . You don't generally need to hire an actuarial firm
    to do an actuarial report for the plan, in the case
    of a DCP.  This is important, because actuaries charge
    a lot of money, usually a minimum of several thousand
    dollars a year to do the actuarial certification that
    is required for most defined benefit plans (DBP's).

  . Each employee in a DCP has an individual account under
    the plan, and must receive a report each year, showing
    how much his or her invested account balance has grown
    (or shrunk) from investing, plus new amounts contribut-
    ed to the account by the employer for the year, plus,
    in the case of a profit sharing plan, the amount of any
    forfeitures allocated to the account, where other par-
    ticipants have quit or been fired and have had part or
    all of their accounts forfeited in favor of the remain-
    ing plan participants.

  . Because of the individual accounts, DCP's can and often
    are set up so that each participant can "direct" the
    way the money in his or her account is invested.  This
    can be a major administrative headache and added ex-
    pense for the employer, but is often worth it, since:

       (a) by letting the employees manage their own
           accounts, you, as the employer, are off the
           hook (usually) in terms of legal exposure for
           making any bad investments; and

       (b) you, and your key or highly-compensated
           employees, may want to make your own invest-
           ment decisions, and may want to put money
           into higher-risk investments than you would
           be comfortable investing the funds of lower
           paid participants in; so you can let the
           rank and file employees invest their smaller
           accounts in something safe, like money  mar-
           ket funds, while you roll the dice on some-
           thing a bit riskier, like junk bonds or penny
           mining stocks.

  . Contributions (which include allocations of forfeitures
    in the case of a profit sharing plan) to the account of
    any participant in a DCP may not ever exceed 25% of com-
    pensation, or $30,000, whichever is less, in any plan
    fiscal year.

  . Contributions can be "integrated" with Social Security.
    This means, as a practical matter, that a DCP can be
    set up so that on a certain "base compensation level"
    on which the employee is earning Social Security bene-
    fits (say $30,000 or $40,000), the employer can contri-
    bute a lower percentage of compensation than on higher
    levels of compensation.  This will tend to skew contri-
    butions in favor of higher-compensated participants
    (such as yourself, ordinarily, if you are the owner or
    president of the company).  For example, a plan might
    call for putting in 10% of the first $20,000 of compen-
    sation, and 15% on the excess.  If you make $150,000
    a year, and each of your 4 employees makes only $20,000
    a year, this would mean that your contribution for each
    of them would be 10% of $20,000, or $2,000 each, while
    the contribution for you would be $2,000 plus 15% of
    the $130,000 of "excess" compensation over $20,000, or
    $19,500, for a total of $21,500 for you.  From your
    standpoint as employer, this is a lot cheaper than
    contributing a flat 15% of all participants' income,
    which would cost you $3,000 for each of the 4 employ-
    ees, rather than $2,000 apiece.  (Contributions to
    DBP's can also be "integrated," but the methodology
    is quite different, although the overall effect is
    similar, to shift a higher percentage of contributions
    to high income participants, which is usually the goal
    in most small firms.)

  . As full-fledged qualified retirement plans, DCP's are
    subject to the numerous IRS and Department of Labor
    reporting and disclosure rules, which result in huge
    amounts of paperwork for all but the smallest and
    simplest of plans.  See the menu item for "ERISA"
    compliance requirements in this program, to get an
    idea of the large number of information returns,
    plan summaries, and other documents you must prepare
    and either file with the government or give to your
    employees, if you maintain any kind of qualified
    retirement plan.  This administrative burden is a
    significant and ongoing cost of maintaining such a
    qualified plan, and is one reason that SEP-IRA's have
    become quite popular among small companies, since they
    have virtually zero reporting and disclosure require-
    ments.

As noted above, there are two kinds of DCP's, profit shar-
ing plans and a type of pension plan called a "money pur-
chase" pension plan, each of which has several variations.

    PROFIT SHARING AND STOCK BONUS PLANS:

Profit sharing plans are a type of qualified plan where an-
nual contributions to the plan are entirely optional, and
if the employer sets it up that way, can be based partly or
entirely on company profits.  This provides a lot of flexi-
bility, so that in years when business is bad, a company
can reduce its contribution to the plan, or even omit it
entirely, as desired.  In a good year, you can contribute
up to 15% of each employee's compensation, limited to a
total annual addition to an individual's account under the
plan (including forfeitures from departing non-vested par-
ticipants), of $30,000.  Since forfeitures are allocated
to participants' accounts in ADDITION to employer contribu-
tions, the total amount added to a remaining participant's
account can be more than the 15% contributed by the employ-
er -- but NOT over 25% of earnings or over $30,000 for the
year.

          ┌───────────────────────────────────────────────┐
          │CAUTION: The Revenue Reconciliation Act of 1993│
          │has limited the amount of compensation that can│
          │be taken into account in computing pension or  │
          │profit sharing plan contributions, to only the │
          │first $150,000 of compensation.  Since 15% of  │
          │$150,000 is only $22,500, an individual partic-│
          │ipant in a profit sharing plan is no longer al-│
          │lowed to receive a $30,000 contribution in one │
          │year, even he or she earns well over $150,000, │
          │in a profit sharing plan with a flat 15%-of-pay│
          │contribution formula.  (However, forfeitures   │
          │could still conceivably increase such a partic-│
          │ipant's allocation for the year to as much as a│
          │total of $30,000.)                             │
          └───────────────────────────────────────────────┘

Note that, in addition to limiting eligible compensation
that can be counted to $150,000 a year, the new rules also
require you to AGGREGATE the compensation of certain family
members (spouse or children under age 19) who work for the
company, so that if you and your spouse both earn $125,000
a year from the company, for instance, only $150,000 of your
total compensation of $250,000 would be counted (allocated
between you).  This requirement makes the new rules even
more restrictive.

Contributions to profit sharing plans are usually alloca-
ted to participants based strictly on compensation (and
are often "integrated with Social Security", so that high-
er income participants receive a higher percentage of their
income as contributions).  However, it is also possible to
do "age-weighted" plans, where each dollar of a partici-
pant's compensation is multiplied by a "present value"
factor, which is based on his or her age, and which goes
up exponentially as a person's age approaches the expected
retirement age (usually 65).  The resulting "benefit factor"
for all participants is added up, and the company's plan
contribution for the year is allocated based on each parti-
cipant's percentage share of the total number, as a way of
divvying up the amount employer's contribution to the plan.

It is not uncommon, under such a plan, for a 45-year-old
owner making $150,000 a year to get an allocation equal to
15% of his or her earnings, while a 25-year-old making
only $20,000 a year would only get 3% of earnings under
the age-weighted allocation method.  Obviously, an age-
weighted plan will be very attractive if you are both
older than, and earn significantly more than, most or all
of your covered employees.  Note, also, that unlike Social
Security "integration," which can only be done with one
plan if your company has 2 plans, age-weighting can be
done with both a pension plan (defined contribution plan)
and a profit sharing plan, if you have both kinds of plans.
(You'll probably need to see a benefit consultant about
this allocation method, since many lawyers and CPA's are
not yet familiar with age-weighted pension and profit
sharing plans, and may give you a blank stare and try to
change the subject if you ask them about such plans.)

Thus, if you are 55, and make $150,000 a year, and most
of your employees are in their twenties or thirties, and
make about $20,000 a year, you can readily see how this
kind of profit sharing formula could result in an alloca-
tion of a disproportionately large percentage of the
plan contribution to you.  This type of formula will only
be permitted, however, if its overall effect is not con-
sidered discriminatory against lower-paid employees (such
as where there are also a significant number of older
employees who are in the lower-paid group).


===========================================================
CAUTION REGARDING AGE-WEIGHTED PLANS:  The IRS is currently
very strongly urging Congress to enact legislation that
would, if passed, eliminate such age-weighted defined con-
tribution plans.
===========================================================


401K PLANS are another kind of DCP (usually set up in the
form of a profit sharing or stock bonus plan), where em-
ployees are allowed to "defer" part of their compensation,
and have it go into the profit sharing plan for their ac-
count.  These can be excellent incentives to attract em-
ployees, since they enable thrifty employees to set aside
up to $7,000 a year ($9,500 in 1996, with inflation index-
ing) of their wages in a tax-deferred qualified plan. Many
employers will also make "matching" contributions, putting
up, say, 50 cents for every dollar that an employee elects
to "defer" into the 401K plan.  Unfortunately, they can
be grotesquely complex and administer (you may have to have
as many as 6 separate types of accounts for each participant,
typically with sub-accounts for 3 to 5 investment choices
for each) and they must be very carefully monitored and
administered to avoid disqualification or penalties, in
case lower paid employees choose not to defer as high a
percentage of their pay as the highly paid employees.

STOCK BONUS PLANS are just like profit sharing plans, for
the most part, except that an employer can make contribu-
tions to a stock bonus plan even if it has no current year
or prior accumulated profits from which to make the con-
tribution.  Also, a stock bonus plan is allowed to invest
a large part of its assets in stock of the employer cor-
poration, and typically, when a participant retires or
dies, he or she (or his or her estate, if deceased) will
usually receive a distribution of the company's stock
from the plan, instead of just receiving cash.  This can
be advantageous to the recipient if the stock has gone up
in value since it was bought by the plan, since the em-
ployee will only be taxed on the COST (to the plan) of
such stock, rather than on its current value, if it is
distributed to him or her in a lump sum.  Any unrecognized
gain on the stock will be deferred until the recipient
later sells the stock, at which time the gain will be fa-
vorably treated as long-term capital gain.

One form of stock bonus plans is the "ESOP," or Employee
Stock Ownership Plan, where a stock bonus plan invests
primarily or exclusively in stock of the employer corpor-
ation.  A plan that qualifies as an ESOP is entitled to
a wide range of special tax benefits.  These are highly
technical beasts, however, and you will need some high-
powered accounting and legal help to set up and maintain
one, which will usually make an ESOP feasible only for a
relatively large firm or a very profitable smaller firm.
However, certain "leveraged" ESOP's, where the plan borrows
money from a bank or other lender to purchase stock from a
major shareholder, can provide unmatched tax benefits,
including:

  . The ability of the selling shareholders to "roll
    over" their gain tax-free by investing the proceeds
    in certain "qualifying securities"; and

  . An exclusion from income of 50% of the interest
    earned on such a loan to an ESOP by the lender,
    enabling it to offer such a loan to the plan at a
    reduced a interest rate.


    MONEY PURCHASE PENSION PLANS:

The other type of DCP, the money purchase pension plan, is
quite similar to profit sharing plans in a number of ways.
However, there are some key differences:

  . The formula for contributing to the plan, which is
    usually based on employee compensation, is a FIXED
    obligation of the employer, and can range from
    nearly nothing to 25% of compensation.  Unlike a
    profit sharing plan, if your money purchase pension
    plan calls for a contribution of X% of covered employ-
    ees' compensation, your company MUST make the contri-
    bution each year, or else you will run afoul of the
    IRS's "minimum funding requirements" and tax penalties
    for as long as the plan remains "underfunded."  Thus,
    through good times or bad (unless you decide to termin-
    ate the plan altogether or amend it to reduce the
    level of contributions), your firm must continue to
    put in the formula amount specified in the plan
    document, or face severe penalties.  As such, money
    purchase pension plans are much less flexible, and
    thus somewhat less popular, than profit sharing plans.

  . Any forfeitures of the accounts of employees who exit
    the plan before their accounts have fully vested are
    applied to reduce the amount the employer must con-
    tribute to the money purchase pension plan for the
    year, unlike a profit sharing plan, where such for-
    feitures are re-allocated to the continuing partici-
    pants in the plan.  This can be a good thing in a
    year in which the employer company is strapped for
    cash and having a hard time coming up with the money
    to make the pension plan contribution; or it can be
    a bad thing if the company has the money and you want
    to put more money into the plan in order to get a lar-
    ger tax deduction, but can't, because of significant
    forfeitures during the year, as unvested employees
    quit or are terminated.

  . One of the potential advantages of a money purchase
    pension plan over a profit sharing plan is that an
    employer can generally contribute up to 25%, rather
    than only 15%, of compensation to the money purchase
    plan.  However, few employers are confident enough
    about their future that they would lock themselves
    into paying 25% of wages of their eligible employees
    into a pension plan for an indefinite period of time.
    Thus, where an employer (in the ideal situation, a
    self-employed person with few or no employees who must
    be covered by the plans) wants to try to put in the
    maximum of 25% in some years, but maintain some flexi-
    bility in case of a downturn in business, the best
    solution is often a combination of a 15% profit shar-
    ing plan and a 10% money purchase pension plan.  With
    that setup, in a good year, an employer can make tax-
    deductible contributions up to the full 25% or $30,000
    limit for each participant, but in a bad business year
    can cut back or skip the profit sharing contribution,
    and is only obligated to make the 10% pension plan con-
    tribution, which is not nearly as heavy an obligation
    as if a single 25% money purchase pension plan had
    been set up.

    Many professional corporations and Keogh plans (includ-
    ing this author's) are set up as a combination of a
    15% profit sharing plan and a 10% money purchase pen-
    sion plan.  Often the money purchase pension plan is
    "integrated" with Social Security, so that instead of
    contributing a flat 10% of wages to it, the contribution
    can be based on 4.3% of wages up to a given level (as
    high as $62,700 of wages per participant), and 10% only
    on the excess. This shifts a higher contribution percen-
    tage to highly paid employees, and also reduces the
    amount of the annual fixed commitment to be contributed
    to the pension plan.

  . As previously noted, a money purchase pension plan is
    a DCP, and unlike a DBP, you do not need to hire an
    actuary to determine the amount that must be contribu-
    ted to the plan each year, or to do the "actuarial
    certification" that must be filed with the plan's an-
    nual report to the IRS each year.  This is a major
    cost savings vs. a defined benefit plan (DBP).  How-
    ever, as expensive and complex as they are to adminis-
    ter, DBP's have a couple of major benefits over money
    purchase pension plans, including (a) the ability of
    an owner to make much, much, larger deductible contri-
    butions to a DBP, and (b) the advantage of a DBP to an
    owner who is older than most of his or her employees,
    since, for example, there are only 10 years until age
    65 retirement in which to build up a retirement fund
    for the 55-year-old owner, rather than 40 years to do
    so for a 25-year-old employee.  Thus, even if the 25-
    year-old makes as much as you, the owner, do, the
    amount that can be contributed to the DBP on your be-
    half as a 55-year-old will be many times larger than
    the amount that can be contributed for the 25-year-old.

    Fortunately, there is a special kind of money purchase
    plan, not widely used, called a "TARGET BENEFIT PLAN,"
    where a contribution formula is set up, based on the
    number of years till retirement age for each partici-
    pant.  The effect is very similar to a DBP, except
    that individual accounts are maintained for each par-
    ticipant, and the amount that will be paid out at
    retirement age is only a "target" amount, based on
    some advance assumptions about whether the invested
    funds will earn 6% or 10% or whatever, over the
    period of participation in the plan.  Unlike a DBP,
    the annual contribution doesn't have to be actuari-
    ally adjusted to take into account changing invest-
    ment results, unexpected levels of forfeitures, or the
    like.  In a target benefit plan, the recipient simply
    gets what his or her account has grown (or shrunk) to
    by the time of retirement, rather than some guaranteed
    or "defined benefit" amount, under a DBP.  Thus, a
    target benefit plan can also make a lot of sense to
    you as an employer if you are a lot older than most
    of your employees, since your greater age will skew
    most of the contribution towards funding your pension,
    and much smaller amounts for your younger employees.

    However, the one major drawback of a target benefit
    plan, as compared to a DBP, is that it is a DCP and,
    therefore, is still subject to the 25% of compensation
    or $30,000 annual contribution limit, whereas a 55-
    year-old participant in a DBP, earning over $100,000
    a year, may well be able to generate a contribution
    of about $100,000 (or even more) per year to fund
    his or her pension under a DBP plan.  If you are over
    50 years old and are making serious money, and want
    to sock away as much as you can into a pension plan,
    you will probably want to set up a DBP (discussed be-
    low), not a target benefit plan.


DEFINED BENEFIT PLANS
---------------------

Defined benefit pension plans (DBP's), are usually the
most complex and expensive to administer of all retirement
plans, with the possible exceptions of ESOP's.  However,
if you want to maximize your tax deductions to a retirement
plan, and if you want the maximum skewing of benefits under
a plan to highly-compensated participants (like you) in a
plan that includes employees, a DBP is also the best tool
available in many cases, although, as discussed above, a
"target benefit plan" can be an excellent, and less com-
plex, alternative, if you don't need to contribute beyond
the 25% of compensation / $30,000 a year limits that apply
to DCP's, including target benefit plans.

As the name implies, in a defined benefit plan, it is the
retirement BENEFIT that is defined by the plan, and not
the annual contribution to the plan.  Thus, a DBP will
never say that the employer is to contribute "X% of each
employee's annual compensation."  Instead, it will say
that, at retirement age (typically 65), each participant
who has worked the requisite number of years will receive
a pension equal to some percentage of his pay.  Thus, if
employee Y makes $35,000 a year now, is 32 years old, and
is expected have wage increases of 3% a year, has a 60%
chance of quitting before his pension benefit is fully
vested, and the plan's investments until Y retires are ex-
pected to grow at 8% a year, an "actuary" takes all these
and a host of other factors into account, does a lot of
higher mathematics and number-crunching, and comes up with
an "actuarially determined" amount that can or must be
contributed to the plan in the current year for that em-
ployee, so that there will be enough money when Y retires
at age 65 to pay Y an annuity (pension) for his or her re-
maining life expectancy of 15 years or so, at an amount
equal to, say 100% of Y's average annual salary for the
3 best earning years of his or her working career with the
company.

The maximum annual benefit that can be paid under a defined
benefit plan is currently (1996) $120,000, an amount that
is indexed and increases each year with inflation.

As you may have already guessed, these kinds of calcula-
tions are unbelievably complex, and the people (called
"enrolled actuaries") who perform them and who certify to
the IRS each year that you have contributed the proper
amount to your DBP plan, command very hefty fees.  Thus,
even a relatively simple one-person DBP plan can expect to
pay several thousand dollars a year in actuarial and other
ERISA compliance fees to actuaries, accountants, and other
professionals.

Clearly, incurring such large administrative expenses for
a pension plan are only worth the trouble if there are
very good reasons for setting up a DBP plan, such as a
powerful desire to maximize your deductible retirement
plan contributions.

Note also, that many defined benefit plans are not only
regulated by the IRS and Department of Labor, but are also
under the thumb of the Pension Benefit Guaranty Corporation
("PBGC"), which requires that employers who maintain DBP
plans (with certain exemptions for small plans and insured
plans) pay hefty annual insurance premiums to the PBGC,
based on the number of participants in the plan.  This in-
surance is supposedly to be used to pay off employees of
companies that go broke without first having adequately
funded their defined benefit pension plans, in order to in-
sure that the employees get something like the pensions
they had been been promised by their deadbeat and defunct
employers.  Unfortunately, like other government insurance
schemes, such as the FSLIC and the FDIC for S&L's and
banks, the PBGC is already virtually bankrupt and rapidly
raising the insurance fees it charges solvent employee
pension plans, to help bail some of the giant corporate
pension plans that have already gone belly up.  The annual
per-employee premium is already up several THOUSAND per-
cent since the PBGC was created by Congress in 1974, and
is probably going to ascend straight into the stratosphere
in coming years.


As noted above, a DBP has some major advantages over most
other kinds of retirement plans:

  . Maximize contribution deductions.  In many cases,
    for an older individual who establishes a corporate
    or "Keogh" DBP, the annual deduction can be as much
    as 100% of annual compensation or over $100,000 per
    year (as determined by an Enrolled Actuary).

  . The ability to heavily skew contributions in favor
    of older employees, simply because there are fewer
    years in which to build up a pension fund for an
    older employee (like the owner) until he or she hits
    retirement age, than for a younger employee.

The chief disadvantages of a DBP are:

  . Costs of administering can be several times the cost
    of administering other qualified plans, mainly because
    of the need to retain an enrolled actuary to do the
    required actuarial certifications.

  . Complex and difficult for a layman (or for a lawyer or
    a CPA or a benefit consultant who isn't an actuary, for
    that matter) to understand.  Part of the complexity
    is due to the need to compute and make quarterly con-
    tributions to the plan, or else face penalties if the
    contributions are late or are too small.

  . Some DBP's are required to make insurance premium pay-
    ments to the PBGC, which can be another significant
    expense.

  . Like a DCP pension plan (but not a profit sharing plan),
    the employer is required to continue to fund a DBP plan
    at a specified level, although the annual amount is hard
    to predict in advance, since it depends on so many com-
    plex factors.  (It may even be zero in some years, if
    the plan becomes significantly OVERfunded.)

  . The employer is, in effect, guaranteeing that the pen-
    sion fund will earn a certain rate of return on its
    investments over time.  If the trustee of the pension
    fund makes bad investments, or falls short of the
    expected rate of return, the company must pony up the
    difference, in order to keep the total pension fund
    growing at the required rate.  (On the other hand, if
    investment returns exceed expectations, that can sig-
    nificantly reduce the amount the employer must contrib-
    ute to the plan.)

  . Where there are a number of rank and file employees,
    the assets of a DBP plan are usually commingled in
    one large fund for investment, without separate ac-
    counts for the individual participants, so that it is
    usually not feasible for the participants to manage
    their own accounts.  This brings into play the "fidu-
    ciary" and "prudence" requirements of ERISA, which,
    put in simplest terms, means that you or whomever you
    hire to manage the pension fund is going to need to be
    very competent and careful about not making "imprudent"
    investments.  Since hindsight is always 20-20, the
    "fiduciaries" of the plan, which include the employer,
    can expect to be sued if any investments of the plan
    go bad -- even if the plan's overall investment per-
    formance is outstanding.  ERISA holds anyone who
    directly or indirectly controls the management of a
    pension plan's funds to a very strict standard, and
    makes it easy for disgruntled participants to sue.


    FULLY INSURED DEFINED BENEFIT PLANS:

A rather obscure section of the tax code allows some spe-
cial tax breaks to certain DBP's that invest all of their
assets in "level premium" insurance contracts, where an
insurance company agrees, that for a fixed annual premium
payment from the employer, it will provide a given level
of pension income to each participant in the plan at the
specified retirement age.

For a small firm that wants a defined benefit plan, and
is also willing to forego the right of participants to
borrow from the plan, such an insured plan can be the way
to go.

Advantages include the following, as compared to uninsured
DBP's:

  . The company is relieved of the requirement of comput-
    ing and making quarterly contributions to the plan.

  . While regular DBP's can easily become overfunded, re-
    sulting in a hefty (20% to 50%) excise tax on the ex-
    cess funding if the plan is terminated and the excess
    assets revert to the employer, the nature of insured
    plans is such that they are unlikely to ever become
    overfunded.

  . While the IRS can (and does, frequently) attack the
    actuarial assumptions used for regular DBP's (such as
    the mortality rate for participants, the amount that
    can be earned on investments, etc.), there is little
    to quibble about where the insurance contract spells
    out exactly what the costs are and what the retirement
    benefits to be paid by the insurance company will be.

  . A fully insured DBP isn't required to file an actuarial
    report (Schedule B of Form 5500), so it is not neces-
    sary to hire an actuary to certify that the plan is
    being properly funded each year.

  . Annual costs of funding an insured plan fluctuate much
    less than with other DBP's, so that cash flow planning
    by an employer is much easier to do.

  . And, finally, while DBP's have generally fallen very
    much into disfavor for small firms, except where the
    owner is about 55 or older, an insured DBP is an ex-
    cellent and somewhat less complex alternative, and
    will often allow even larger contributions to be made
    than a regular, uninsured DBP that provides the same
    level of retirement benefits.

   ┌─────────────────────────────────────────────────────┐
   │ WARNING ABOUT QUALIFIED PLANS AND IRA'S, GENERALLY: │
   └─────────────────────────────────────────────────────┘

Even if you do everything else right, be aware that Congress
has in recent years enacted excise taxes on retirement plan
benefits, which come into play if you are TOO successful in
building up a nest egg.  While these excise tax rules get
too complex to detail here, suffice it to say that if you
build up such a nice pension fund for yourself that you
either receive an annual benefit of over $150,000 (approx-
imately) or a lump sum of 5 times that amount, you will
be subject to a 15% excise tax on the excess amount (in
addition to income tax) when you receive it.  Or, if you
die before you withdraw all your benefits from the retire-
ment plan, your estate will have to pay a 15% excise tax
on the lump sum amount to the extent it exceeds $750,000.
Nothing is certain but death and taxes.  Especially the
latter.

Also, during your lifetime, if you take money out of your
IRA or other retirement plan prior to reaching age 59 1/2,
you will usually be subject to a 10% federal penalty on the
amount you take out.  After age 59 1/2, if you take out TOO
MUCH a year (over $150,000 at present), you get hit by the
15% excise tax on the excess amount.  Or, if you withdraw
TOO LITTLE from your retirement plan each year after you
reach age 70 1/2, the IRS will hit you with a 50% penalty
tax on the amount you should have withdrawn, but didn't.

In short, unless you do everything exactly right, or even
if you do and you are too successful in building up your
pension assets, the IRS will be biting and nipping at you
from every direction, sort of like being nibbled to death
by a thousand ducks.

Even so, qualified retirement plans are still the last,
best game in town, when it comes to sheltering significant
portions of your earned income.  If you wanna play, you
gotta pay, as the saying goes....


NONQUALIFIED RETIREMENT PLANS
-----------------------------

There is another whole breed of pension and profit sharing
plans you may not have heard of -- the nonqualified plan.

These can be as simple as the employee cash bonus profit
sharing plan, where the employer merely pays, as an incen-
tive to motivate its employees, a bonus to some or all em-
ployees once or more a year, based on the level of company
profits for the year, quarter, etc.  With such a plan,
there is no "trust" to be set up to hold the money, no
fund to invest, or any of the other trappings of a quali-
fied profit sharing plan.  Instead, the employer merely
establishes a formula for sharing some of its profits with
employees, announces it to the workers, and writes checks
to them (assuming profits reach a specified level) at the
end of the year, or quarter, or whenever.

A nonqualified pension plan is also generally much simpler
to set up and administer than a qualified one, and, unlike
a qualified plan, you don't need to submit it to the IRS
for a ruling (a "determination letter") that blesses the tax
qualification of the plan.  (Obviously, since the plan is
not "qualified.")

Companies that want to set up 401K plans for their employees
often find that they are dangerous and tricky to administer,
because the rank-and-file employees must contribute enough
to the 401K each year, in comparison to the highly compensated
employees, that the plan is not considered "discriminatory"
by the IRS.  One popular way around this is to exclude the
"top hat" employees and officers from the 401K plan, and
instead set up a nonqualified plan on the side for such
highly compensated employees, which makes it much simpler
to keep the 401K plan on the right side of the law.

While nonqualified plans come in many shapes and flavors,
some with trustees and investment funds similar to those
of qualified pension plans, others being a simple written
promise of the employer to pay the employee a certain
amount of retirement income if he or she works until an
agreed-upon retirement age and keeps his or her nose
clean (and if the employer is still solvent).  Because they
are not subject to hardly any IRS or Department of Labor
scrutiny and oversight, nonqualified plans can be far more
selective and flexible in their design than qualified plans.

For example, a nonqualified plan can be set up to pay bene-
fits only to top management employees, something you could
never get away with in a qualified retirement plan.  Also,
the employer does not necessarily have to "fund" the plan
by setting aside money each year in a trust for the plan
participants (although it may).

Thus, while nonqualified plans can be very useful for cre-
ating an attractive benefits package for a limited and
selected group of employees or managers, keep in mind the
fact that they lack certain key benefits of "qualified"
plans, mainly the following:

  . The employer typically doesn't get a current pension
    plan deduction, unless it puts aside money that is
    currently taxable to the recipient employee.  (Whereas,
    in a qualified plan, an employer deducts money it puts
    in trust for an employee in 1995, but the employee may
    not have to pay tax on that money until he or she
    retires in the year 2035.  A pretty nice little tax
    deferral, you might say....)

  . Or, if the employer DOES get a deduction by putting
    money in a nonqualified pension trust for employees,
    the benefits will become taxable as soon as "vested"
    on the employee's behalf, even though the employee has
    no access to the pension money in his or her retirement
    account until retirement date.

  . Also, if a nonqualified trust is set up, the investment
    income it earns is NOT tax-exempt, unlike the trust
    fund of a qualified retirement plan.  Thus, all divi-
    dends, interest, etc., earned on the trust fund will
    be immediately taxable, either to the employer, to the
    employee, or to the trust itself, as an entity, depend-
    ing on how the trust and plan are structured.

  . Finally, there are no special tax benefits, such as
    5-year income averaging or deferral of gain on appreci-
    ated employer stock received by a pension recipient,
    under a nonqualified plan.

In short, nonqualified plans can be very useful and flexible
for compensating key employees, and are relatively free from
government regulation, but the cost you must be willing to
pay if setting up such a plan is the loss of a number of
very attractive tax benefits that are only available to tax-
qualified retirement plans.