New Pension Options for Small Business Owners
Folks age 50 and over, especially small business owners, generally are playing catch-up with their retirement savings. Many self-employed and small business owners don’t know all the retirement plan options available to them to enhance their savings. That’s understandable. There are many pension plan options available, and several were created quietly by Congress over the last few years. You could be overlooking some good financial opportunities, especially if you need to catch up on funding retirement plans because you didn’t have the cash in earlier years.
One option is the old-fashioned defined benefit pension plan. Large companies have been phasing out these plans over the last few decades, but for some small business owners they are ideal.
A DB plan promises you a fixed annual income at retirement. An actuary calculates how much money is needed to fund that promise, and the business deposits it into the plan each year. You don’t have to make equal annual contributions. When you have substantial cash flow this year, you can put in more than the required annual minimum, essentially making future contributions early. Once the actuary determines the plan is fully funded, contributions stop. The contributions are tax deductible.
The DB plan can be attractive to a small business owner who has no employees or a small number of young employees, is 50 years old or older, and has good, reliable cash flow from the business. The older you are, the higher the annual contributions will be. Deductible contributions can be $100,000 a year or more, depending on your age and the annual income you want to fund.
All employees must be allowed to participate in the plan, which is why the plan is best for someone with no employees or a few younger employees. Yet, some business owners find a defined benefit plan is a good way to attract and retain employees, reduce turnover and increase the business’s value to a potential buyer.
The DB plan usually costs a few thousand dollars in annual fees plus start-up costs. Annual reports must be completed and filed, and an actuary must compute the contributions. The other potential downside is once the DB plan is established, contributions must be made each year until it’s fully funded. That’s why the business should have reliable free cash flow.
A simpler, lower cost variation created in the 2006 Pension Protection Act is called the DB(k). This is a combination of a DB plan and a 401(k) plan. The DB(k) is a standardized plan, so it should be easier and lower cost than a DB plan. It’s available to companies with at least two and no more than 500 employees.
The employer must make contributions to the DB portion of the plan that will pay a pension of up to 20% of the employee’s estimated average annual pay during the last few years of employment with the firm. The benefits vest after an employee is with the firm for three years. In addition, 4% of an employee’s pay is automatically withheld and deposited in the 401(k) plan, unless the employee opts out or sets a different withdrawal percentage. The employer makes a matching contribution of 50% of the deferral that doesn’t exceed 4% of salary. These 401(K) amounts are vested immediately. A vested benefit is one the employee is entitled to keep if he leaves the firm any time after vesting.
The total cost to the employer of these payments is estimated to be 6% to 8% of the total payroll, but the amount will vary by the age of the workers. The older the work force, the higher the DB plan payments will be. Because the plans are standardized and rolled into one hybrid plan instead of two separate plans, it should cost less to set up and maintain than two separate plans.
The IRS was slow to issue regulations and other information on the plans, so financial services firms are slow to offer and promote the plans to business owners. Ask tax or financial advisors for your business if they know of any firms that help set up and maintain the plans.
Two other plans that could be helpful to self-employed people in their 50s or older are the solo 401(k) and solo Roth 401(k). They were created by the law a few years ago but only began to get some publicity and traction recently. The solo plans allow you to set aside for retirement more than you can under a SIMPLE IRA or regular IRA and perhaps more than under a Simplified Employee Pension (SEP).
These plans are just what their names imply. A one-person business (or one where the owner and spouse are the only workers) can set up these standardized plans. Most financial services firms (mutual funds, brokers, insurers) offer standardized plans. They generally charge modest set up and annual maintenance fees, though the fees might be higher than for SEPs and SIMPLE IRAs, and once the account reaches a $250,000 balance, annual reports must be filed with the IRS.
The solo 401(k)s have standardized plan documents. The contribution limits vary by the way your business is organized. For an unincorporated business, for example, you can defer up to 100% of income from the business until you’ve deferred $16,500 ($22,000 if you’re 50 or older) plus up to 20% of net adjusted business profit can be made as a matching contribution. You generally can put a total of $49,000 into the account annually if you’re younger than 50 and $54,500 when you’re 50 or older. You should consult a tax or retirement plan advisor to calculate your maximum contributions. The calculations are a bit different for corporations and other forms of business.
A good general rule is that you should consider a solo 401(k) when you plan to contribute more than $15,000 annually, but use a SEP or SIMPLE IRA when you plan to contribute less. When you have more to contribute look at a DB plan or DB(k).
RW April 2011
