Analyzing plans requires balancing client needs and tax implications.
Small businesses need much assistance in designing
their own retirement plans. But before financial advisors recommend and
help clients implement the most suitable plan or plans that cover a
range of objectives, it's important to make sure that the client is
comfortable with the whole concept. It is, after all, a huge dollar and
time commitment, so advisors should be certain to address the client's
most pressing issues in the forefront to help them make the most
The first step in the retirement design process is to identify your clients' objectives. In other words, find out whether your clients want to make annual mandatory contributions, whether they wish to include all or only some of the employees, whether their earnings fluctuate annually, if they want to provide their employees with ownership as an incentive or simply reward some or all employees as sort of a golden handcuffs approach to the firm. You must determine whether the owners want to maximize their own retirement benefits received at retirement or if the interest is in maximizing contributions made during the year in order to lower their overall tax bill. After sizing up your client's direction, then proceed to educate the client on the benefits and pitfalls of the various plans available.
Qualified plans are the most preferred, simply because they allow the employer to make tax-deductible contributions and do not require the employees to recognize any income until the amounts are distributed from their plans. They are also the most stringent type of retirement plan because they have the closest ties to ERISA, the 1974 law that represented an intensified commitment by the federal government to oversee the retirement market in order to ensure and establish equitable standards and curtail perceived abuses. These requirements include mandatory participation at a minimum age of 21 and one year of service (defined as 1,000 hours), or two years of service with immediate vesting. It also requires mandatory passing of the Actual Contribution Percentage (ACP) test, in which either one of the following two tests must be satisfied:
The ratio percentage test, which means that the plan must cover a percentage of nonhighly compensated employees that is at least 70% of the percentage of highly compensated employees covered, or
The average benefits test, in which the average benefit as a percentage of compensation, for all nonhighly compensated employees, must be at least 70% of that for highly compensated employees.
And for those plans that have an employee contribution element (such as a 401(k) or saving and thrift plan), then an additional test must be satisfied. This test is called the Actual Deferral Percentage (ADP) Test, a requirement for plans that allow employees to contribute their own earnings towards their retirement. These tests revolve around highly compensated employees (as stated above) which is defined: being a 5% owner at any time during the current or preceding year or receiving compensation for the preceding year in excess of $100,000 (in 2006) and being in the top 20% of compensation paid by the employer.
All qualified plans must adhere to one of two types of vesting schedules. These include the five-year cliff or three- to seven-year graded. Again, the emphasis of the government is to protect the little guy (the non-highly compensated employees), and therefore the government requires more stringent requirements for the implementation of these plans.
That's why the ERISA laws are so severe. Unlike highly compensated employees, who determine passing the discrimination tests described above, vesting schedules deal with the company's key employees. In fact, if too many of these "key employees"-those who either are 5% owners of the company, are an officer of the company with compensation in excess of $145,000 (in 2006) or are more than a 1% owner with annual compensation of more than $150,000-are receiving too much benefit, then the vesting scheduled has to be accelerated (again to compensate for the little guy) to a three-year cliff or a two- to six-year graded schedule.
Since the formulas to determine how much can be contributed are very complicated and certainly outside the realm and responsibilities of us acting as financial planners, actuaries are needed to ensure that the tests are in compliance with these rulings from ERISA. Within qualified plans, the choices are narrowed to select either a defined benefit or a defined contribution plan.
Deciding Between Plans
With a defined benefit plan, the benefit the owner receives is defined, meaning the benefits received are determined by an actuary dependent upon a specific formula. Benefits can be based on age and/or years of service with the firm. In fact, past service credit can be had for those clients first starting a defined benefit plan but having worked in the company for years prior to the plan's setup.
In 2006, the maximum defined benefit your client can receive is $175,000 annually. What makes it all the more intriguing is that there are no limits on annual contributions. Unlike defined contribution plans where the contribution is limited to 100% of compensation not to exceed $44,000 (in 2006 under certain plans), with a defined benefit plan your client can contribute to the plan as much as necessary to pre-fund the benefit coming out. Essentially, the client is working backwards; that is, determining what is wanted as a retirement benefit and then figuring out how much to contribute in order to achieve that amount. This enables the owner to surpass the $44,000 annual contribution limit set with defined contribution plans and thus maximizes contributions and tax deductions.
Defined benefit plans work best for those clients over age 50, since they have a shorter time span to contribute until retirement. Therefore a 50-year-old who wants to pull out $175,000 per year at retirement at age 65 can deposit whatever is necessary in order to back into that $175,000 number. Alternatively, clients under the age of 50 would be best suited with a defined contribution plan, since the plan takes advantages of a longer tax deferral and younger workers can ride the market longer and thus build bigger nest eggs. However, unlike defined benefit plans, which are guaranteed by the employer (or partially covered through the Pension Benefit Guaranty Corp. (PBGC), with a defined contribution plan employees bear the risk if the investments don't grow as much as planned.
Defined Contribution Plans
Defined contribution plans come in many types, including money purchase, target benefit, tandem plans and profit sharing plans. Like defined benefit plans, contributions are made by the employer on behalf of the employees. One specific type of defined contribution plan, the profit sharing plan, enables employees to contribute some of their own money through a 401(k) plan (which is before tax) and a savings or thrift plan (which is after tax). Remember, you are recommending a plan in accordance with the employer's needs, not the employees'. As such, it would make sense to recommend a plan that doesn't tie the employer down with annual mandatory contributions.
The only type of defined contribution plan that doesn't require annual contributions and provides the employer with a substantial amount of flexibility is the profit sharing plan. Profit sharing plans only require contributions that are "substantial and recurring," which generally means two out of every five years. Also, if the employer's earnings are unstable and cash flow fluctuates from one year to the next, a mandatory annual commitment to fund the plan doesn't make sense. And if the employer does decide to fund the plan, the same 100% of compensation not to exceed $44,000 is the maximum annual addition to the employee's account under any type of defined contribution plan. So in this case, the client reaps the best of both worlds. If your clients have other types of defined contribution plans, now would be a good time to recommend a switch to a profit sharing plan.
Personal Retirement Plans
Personal retirement plans (PRP) are different than qualified plans (QP). First off, QP can be borrowed against, whereas PRPs cannot. Any withdrawals from personal retirement plans will result in immediate taxable income. Second, QPs can qualify for ten-year income averaging for those employees born on or before January 1, 1936 (age 50 when the 1986 Tax Act began), whereas PRPs tax all income immediately upon distribution. Third, QPs must file IRS reporting and disclosure Form 5500 annually while PRPs do not. And fourth, creditor protection is available with all QPs, but that may not be the case with PRPs. Even though a recent ruling provided a limited amount of creditor protection for IRAs to maintain standard of living, it is unclear whether those rules would apply to significant IRA balances.
IRC Section 408(k) governs the rules relating to Simplified Employee Pension (SEP) plans. In these retirement plans, business owners can contribute up to $44,000 (in 2006) per employee (which is the same as a profit sharing plan). SEPs can be appropriate choices because of reduced administrative expenses and their simplicity. SEPs reporting and disclosure requirements are not as cumbersome as their defined contribution counterparts, in that SEPs are completed on Form 5305 (only when contributions are made) and they do not possess any of the actuarial assumptions required in other types of qualified plans.
The flipside of SEPs or any type of personal retirement plans, when compared with qualified plans, is the loss of flexibility. Employees are immediately vested upon the employer's contribution and the employer cannot base contributions on age-weighted factors or any other criteria. Essentially, the percentage of compensation given to each employee is the same. If the employee leaves the day after the contribution is made, then the employee can take the entire balance with them. Monies withdrawn by employees are subject to the 10% early withdrawal tax unless one of the exceptions applies.
Employees who are age 21, who have earned $450 of compensation for the year and who have performed services for the employer for at least three of the past five years must be covered. SEPs work well when small businesses wish to put away as much money as possible without dealing with the strict requirements of qualified plans, and for employers who have many employees who have been with the firm for less than three years of service. They tend to be poorer choices in situations where the employer has many long-term, part-time employees, since they all would have to be covered.
Savings Incentive Match Plan for Employees, or (SIMPLE) plans as they are most often called, are retirement plans that enable eligible employees to contribute on a pre-tax basis up to $10,000 of salary ($12,500 if age 50 and over before year-end in 2006). Requirements include that the business cannot have more than 100 employees who earned more than $5,000 in compensation. Furthermore, the employer cannot have any other type of qualified plan, 403(b) plan or SEP plan when offering the SIMPLE plan.
Employers must match employee contributions in one of two ways: a 3% match for employee's elective contributions or a 2% match toward all employees' (non-elective) contributions. Employees who withdraw funds at any time are taxed at ordinary income rates. If employees pull out money for college, the 10% early withdrawal tax will not apply. However, if withdrawals occur during the first two years for any other reason, employees are subject to a 25% penalty tax.
SIMPLE plans work best where the employer wants a retirement plan with low administrative costs, in which employees can make pre-tax contributions and where the employer wishes to limit their match of employer contributions. Unlike a 401(k) plan, if the rank-and-file employees do not wish to contribute, the highly compensated employees still can contribute. And just like SEP plans, employees are immediately 100% vested in any contributions made on their behalf.
Depending on the needs of the business owner, many options are available. The way to proceed is to make sure that the appropriate selection of a plan(s) is dependent upon the client's objectives.
Jeffrey H. Rattiner, CPA, CFP,
M.B.A., is president and CEO of Financial Planning Fast Track Inc. of
Centennial, Colo., an accelerated boot camp for financial planners
aspiring to satisfy the CFP Board educational requirements. His most
recent book, Getting Started as a Financial Planner-2nd edition
(Bloomberg Press) has just been re-released. He can be reached at