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
informed decisions.
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
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
[email protected].