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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 (However, Congress repealed this favorable lump sum averaging treatment, as part of 1996 tax legislation enacted in August, 1996.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 $60,000. The deduction begins to "phase-out" when income exceeds $50,000, or, if you are not filing a joint return, you lose the IRA deduction if your AGI exceeds $40,000 (with the "phase-out" starting at $30,000 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. The Taxpayer Relief Act of 1997 also added a new kind of "backloaded IRA," called a Roth IRA, which is also attractive. These IRA's will provide no tax deduction for annual contributions, but the withdrawals you make at retirement will generally be tax-free. 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 $60,000 (or $40,000 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 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 401(k) plan, is the Salary Reduction Simplied Employee Pension plan, or SARSEP. SARSEPs were phased out by the 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 401(k) plan, called SIMPLE (Savings Incentive Match Plan for Employees). These can be set up as either SIMPLE IRAs or SIMPLE 401(k) 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 filed 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 401(k) 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. @CODE: CA CAUTION: As of mid-1997, California has not conformed its tax laws to permit establishment of SIMPLE plans, so that any contributions to a SIMPLE plan will be taxable wages for state purposes. @CODE:OF 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). QUALIFIED PLANS --------------- 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│ │limited the amount of compensation that could │ │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, increased in 1997 to │ │$160,000, thus permitting $24,000 deduction.) │ └───────────────────────────────────────────────┘ 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). 401(k) 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 401(k) 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 401(k) 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 401(k) 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 did everything else right, Congress has in recent years enacted excise taxes on retirement plan benefits, which came into play if you were 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 built up such a nice pension fund for yourself that you either receive an annual benefit of over $150,000, or a lump sum of 5 times that amount, you would be subject to a 15% excise tax on the excess amount (in addition to income tax) when you receive it. Or, if you died before you withdrew all your benefits from the retirement plan, your estate would have to pay a 15% excise tax on the accumulated amount in all your retirement plans, to the extent it exceeded $750,000 (approximately). Fortunately, the Taxpayer Relief Act of 1997 has repealed these excise taxes. However, 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. 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 want to play, you've got to 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 401(k) 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 401(k) 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 401(k) plan, and instead set up a nonqualified plan on the side for such highly compensated employees, which makes it much simpler to keep the 401(k) 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.