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@1044 CHAP 8
┌──────────────────────────────────────────────┐
│ 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 important
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
income 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. (However, Congress repealed this favorable
lump sum averaging treatment, as part of 1996 tax
legislation enacted in August, 1996. After that date,
only certain older individuals born before 1936 will
be eligible for an older form of 10-year averaging
that was generally allowed up till 1986, which was
"grandfathered" at that time for those older taxpayers,
who must still use the 1986 tax rate tables to compute
the 10-year lump sum averaging, if it is elected.)
. While one of the main drawbacks of putting money into a
retirement plan is the fact that you will not ordinarily
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
retirement plan account in certain instances, at least
in the case of a plan maintained by a corporation other
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 either
a dead letter or are 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
investments, including stocks, bonds, money market funds,
CD's, and other passive types of investments. Some limited
investments 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
retirement 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 several decades can be almost as good as
paying no tax at all.
NOTE REGARDING STATE TAXATION OF RETIREMENT INCOME: On
January 10, 1996, President Clinton signed legislation that
forbids states from taxing the pensions of former residents.
This has been a major problem for taxpayers who earned
pensions in high-tax states such as California or New York,
but retired to low- or no-tax jurisdictions such as Florida,
Nevada, or Texas, only to find that the state of their
former residence was still seeking to find them and subject
their pension income to California or New York income taxes.
The new legislation prohibits those states, as well as a
number of other states that had done so, from taxing the
retirement income of non-residents, including income from
both qualified retirement plans and certain nonqualified
deferred compensation plans. This is a major win for
taxpayers, and makes retirement plans even more advantageous
as tax deferral vehicles. The new law is effective for
amounts received after December 31, 1995.
The key characteristics of all the major types of retirement
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 financial
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
employees, 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
contributions.
The drawbacks to the IRA are:
. You are limited to an annual contribution to an IRA
of $2000 (or $4000, if you have a non-working spouse,
and you contribute at least $2000 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. The
deduction 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 the "phase-out" starting at $25,000 of AGI).
. You may be able to withdraw funds from an IRA before
age 59 1/2 without incurring the 10% penalty, if it is
used to pay medical expenses that are in excess of 7.5%
of your adjusted gross income, or if used to pay health
insurance premiums after you are separated from
employment, provided that you collect unemployment
compensation for at least 12 consecutive weeks. Certain
self-employed individuals who would have collected
unemployment benefits except for the fact that they
were ineligible by virtue of having been self-employed,
may also qualify. This new exemption from the 10%
penalty is available January 1, 1997 and subsequently.
Thus, while an IRA is a nice place to put a couple of
thousand 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
incorporated, 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
percentage 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
earnings. The maximum deductible amount that can be
contributed 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
especially 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 1996 and 1997) 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).
NOTE: A special kind of SEP-IRA, similar to a 401k plan,
is the Salary Reduction Simplied Employee Pension plan,
or SARSEP. SARSEPs have been phased out by the new 1996
tax law. While existing SARSEPs established by December
31, 1996 will continue to qualify, no new new SARSEPs may
be created after that date.
"SIMPLE" RETIREMENT PLANS
-------------------------
The Small Business Job Protection Act of 1996 has created
a new type of plan, sort of a cross between an IRA and a
401K plan, called SIMPLE (Savings Incentive Match Plan for
Employees). These can be set up as either SIMPLE IRAs or
SIMPLE 401K plans, and are available for small employers
who had 100 or fewer employees who earned at least $5,000
in compensation for the preceding year. Under SIMPLE
plans, an eligible employee can elect to contribute a
percentage of his or her compensation to the plan, up to a
dollar limit of $6,000 a year.
The IRS has released a model SIMPLE plan that an employer
may use in combination with SIMPLE IRAs to create a SIMPLE
retirement plan. It can be adopted by using new IRS Form
5305-SIMPLE, which also contains a model notification to
eligible employees, which an employer may also use, to
meet SIMPLE plan notice requirements, plus a model salary
reduction agreement.
The form is not to be files with the IRS, but is to be
kept on file by the sponsoring employer. A plan will be
considered to be established when the form is completed and
signed by the employer and the designated bank or other
financial institution that will hold the IRA assets. If
your plan is to allow employees to choose the financial
institutions for their SIMPLE IRAs, you will not be able
to use the IRS standard form, but will need to draw up
your own plan, which is also permitted. To use the IRS
standard form, all assets under the plan must be held by
a single financial institution.
If a SIMPLE plan is set up as an IRA, it will not be
considered discriminatory if the employer either:
. Matches 100% of employee elective contributions up
to 3% of pay (but in 2 years out of 5, the employer
may match as little as 1% if employees are properly
notified of the reduced matching percentage); or
. Contributes 2% of each eligible employee's compensation
whether or not the employee makes any elective
contributions to the plan.
If set up as part of a 401K plan, the SIMPLE plan will not
be considered to be discriminatory if the employer either:
. Matches 100% of employees' elective deferrals up to 3%
of their pay; or
. Contributes 2% of each eligible employee's compensation
whether or not the employee makes any elective
contributions to the plan.
SIMPLE plans are expected to be very popular, and can be set
up after December 31, 1996.
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 benefits,
of various kinds. Note that "qualified" retirement plans
include Keogh plans set up by and for sole proprietors or
partners in a partnership; S corporation retirement 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: The
"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 "determination
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
comfortable 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 dollars
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
percentages of rank and file employees be covered or
eligible to participate in the plan. Not all employees
are necessarily "eligible" employees, however. You may
exclude 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
partnership, must generally cover ALL eligible employees
by the later of the date on which they reach age 21 or
complete one year of service (which means, generally
speaking, 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 after 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, officers,
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
employer, 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 contributed
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
participants have quit or been fired and have had part
or all of their accounts forfeited in favor of the
remaining 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 expense
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 investment
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 safer, like money market funds,
while you roll the dice on something a bit
racier, like Ethiopian government 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
compensation, 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 benefits
(say $30,000 or $40,000), the employer can contribute a
lower percentage of compensation than on higher levels
of compensation. This will tend to skew contributions
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 compensation,
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
perspective as an 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 employees,
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 key word item "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 provide 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
requirements.
As noted above, there are two kinds of DCP's, profit sharing
plans and a type of pension plan called a "money purchase"
pension plan, each of which has several variations.
PROFIT SHARING AND STOCK BONUS PLANS:
Profit sharing plans are a type of qualified plan where
annual 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
flexibility, 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 participants), of $30,000. Since
forfeitures are allocated to participants' accounts in
ADDITION to employer contributions, the total amount added
to a remaining participant's account can be more than the
15% contributed by the employer -- 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, this means that an │
│individual participant in a profit sharing plan│
│is now not really allowed to receive a $30,000 │
│contribution in one year, even though 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 participant's │
│allocation for the year to as much as a total │
│of $30,000.) The $150,000 amount, which is │
│indexed for inflation, has increased in 1997 │
│to $160,000. │
└───────────────────────────────────────────────┘
Note that, in addition to limiting eligible compensation
that can be counted to $160,000 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 $160,000 of your
total compensation of $250,000 would be counted (allocated
between you). This requirement makes the new rules even
more restrictive. (However, note that the Small Business
Job Protection Act of 1996 has eliminated this aggregation
requirement for plan years that begin after December 31,
1996.)
Contributions to profit sharing plans are usually allocated
to participants based strictly on compensation (and are
often "integrated with Social Security", so that higher
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 participant'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 participant'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 earning 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 allocation
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
considered 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
contribution plans.
===========================================================
401K PLANS are another kind of DCP (usually set up in
the form of a profit sharing or stock bonus plan), where
employees are allowed to "defer" part of their compensation,
and have it go into the profit sharing plan for their
account. These can be excellent incentives to attract
employees, since they enable thrifty employees to set aside
up to $9,500 a year (in 1997, with inflation indexing)
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.
Note, however, that the Small Business Job Protection Act
of 1996 has considerably alleviated some of the complex
problems associated with 401K plans:
. For years beginning after 1996, the once formidably
complex definition of who is a "highly-compensated
employee" has been greatly simplified, to include only
an employee who was a 5% owner during the current or
the previous year, and an employee who had compensation
of over $80,000 from the employer in the preceding
year (and, if the employer elects, was in the top 20%
of employees based on compensation level).
. For years beginning after 1998, the non-discrimination
"safe harbor" for 401K plans has been made much simpler
and easier to achieve. The employer needs only to do
one of the following: (1) Make a nonelective 3%
contribution to the plan for each eligible participant,
whether or not the employee makes an elective
contribution; or (2) Match 100% of the elective
contributions of non-highly compensated employees, up
to 3% of pay, and matches 50% of elective contributions
from 3% to 5% of pay, and the match rate for highly
compensated employees is not greater than that for the
non-highly compensated employees.
STOCK BONUS PLANS are just like profit sharing plans, for
the most part, except that an employer can make contributions
to a stock bonus plan even if it has no current year or prior
accumulated profits from which to make the contribution.
Also, a stock bonus plan is allowed to invest a large part
of its assets in stock of the employer corporation, 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 employee 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 favorably 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
corporation. 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. (Repealed by Section
1602 of the Small Business Job Protection Act of
1996, for loans made after August 20, 1996.)
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
employees' compensation, your company MUST make the
contribution 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 terminate 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 contribute
to the money purchase pension plan for the year, unlike
a profit sharing plan, where such forfeitures are
re-allocated to the continuing participants 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 larger 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
flexibility in case of a downturn in business, the
best solution is often a combination of a 15% profit
sharing 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 contribution, which is not nearly as
heavy an obligation as if a single 25% money purchase
pension plan had been set up.
Many professional corporation and Keogh plans are set
up as a combination of a 15% profit sharing plan and a
10% money purchase pension plan. Often if there are
employees other than the owners, 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 $65,400 of wages, in 1997,
per participant), and 10% only on the excess, taking
full advantage of the 5.7% differential allowed when
a plan is "integrated" with Social Security. This
shifts a higher contribution percentage to the 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 contributed
to the plan each year, or to do the "actuarial
certification" that must be filed with the plan's
annual report to the IRS each year. This is a major
cost savings vs. a defined benefit plan (DBP). However,
as expensive and complex as they are to administer,
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 contributions 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 behalf 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 participant.
The effect is very similar to a DBP, except that
individual accounts are maintained for each participant,
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
to a target benefit plan does not have to be actuarially
adjusted to take into account changing investment
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
below), 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 complex,
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
expected 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
employee, so that there will be enough money when Y retires
at age 65 to pay Y an annuity (pension) for his or her
remaining 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 (1997) $125,000, an amount that
is indexed and increases each year with inflation.
As you may have already guessed, these kinds of calculations
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 some 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
insurance 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
insure 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, only 50 cents per employee initially,
is already up several THOUSAND percent 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
contributions 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
payments 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
complex factors. (It may even be zero in some years,
if the plan becomes significantly OVERfunded.)
. The employer is, in effect, guaranteeing that the
pension 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
significantly reduce the amount the employer must
contribute 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
accounts for the individual participants, so that it
is usually not feasible for the participants to manage
their own accounts. This brings into play the
"fiduciary" 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
performance 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
special 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 computing
and making quarterly contributions to the plan.
. While regular DBP's can easily become overfunded,
resulting in a hefty (20% to 50%) excise tax on the
excess 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 necessary
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
excellent 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.
COMBINATIONS OF PLANS -- LIMIT ON CONTRIBUTIONS
-----------------------------------------------
Nothing prevents you from setting both a defined benefit
plan and a defined contribution plan. You might think this
would allow you to contribute up to the maximum $30,000 a
year for the defined contribution plan and contribute the
full actuarially allowable amount for a pension of up to
$125,000 a year for the defined benefit plan. However,
that is not the case, under present law.
If you have one of each kind of plan, a complex formula
(the "Rule of 1.4") must be used to compute a reduced
limitation under each plan. However, note that the Small
Business Job Protection Act of 1996 will eliminate this
overall limit for plan years beginning after 1999. This
means you would be able to get a full contribution, up to
the annual limit, for both a defined contribution and a
defined benefit plan in the year 2000 or later. After
that date, if you are bumping up against the annual
contribution limitation for a single plan, you may want
to consider setting up another plan of the other type.
┌─────────────────────────────────────────────────────┐
│ 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 ($160,000
in 1997, as indexed for inflation) 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 retirement plan, your estate will have to pay a 15%
excise tax on the lump sum amount to the extent it exceeds
$750,000 (approximately). This tax has NOT been suspended
for the 1997-9 period. 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. Some states also impose a similar, but
lesser penalty, such as California, which imposes a 2 1/2%
penalty, for example. After age 59 1/2, if you take out TOO
MUCH a year (over $155,000 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.
NOTE: Congress has temporarily, for the three years 1997,
1998, and 1999, suspended the 15% excise tax on distributions
of over $160,000 (1997 amount) a year. Thus, this may be
a good time to raid your pension piggy bank, if you have
qualified plans or IRAs with "too much" money in them, even
though you will still have to pay regular income tax on the
distributions (and perhaps the 10% penalty tax if you are
under the age of 59 1/2).
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
incentive to motivate its employees, a bonus to some or
all employees 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
qualified 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
benefits 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
creating 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 1997, 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 the
dividends, 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, depending
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
appreciated 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.