To some, “pension” is a scary word, but to more and more business people, it provides unbelievable benefits. Whether you have one employee or 1,000, pensions are an incredible tax-planning tool for business owners. If you work for a business, encourage the owners to read this: they can create a significant win-win for themselves and their employees.
Too many people think that 401(k) plans are the only type of pensions still available. But take a look at what some small businesses are doing to increase the effectiveness of their 401(k) plans and how some are using other types of plans to deliver powerful benefits to owners and employees alike.
Traditional 401(k) plans may not provide the desired benefits for an owner who wants to maximize his personal pension contributions. For that owner to contribute the maximum $14,000 into that plan in 2005 ($18,000 if over 50 years old), his employees would have to contribute a relatively large percentage of their incomes.
To alleviate this problem, many firms are switching to Safe Harbor 401(k) plans. In those types of plans, owners can personally contribute the maximum and receive a match from the business – no matter what their employees contribute. Administrative costs are reduced because less discrimination testing is required.
The tradeoff is that firms need to make a 100 percent matching contribution up to 4 percent of an employee’s pay or else make a flat 3 percent contribution for each eligible employee. No vesting is allowed on these contributions.
In an environment where employers need to compete for talented employees, a tax-deductible expense of 3 percent of payroll may make a lot of sense. For example, an owner making $200,000 could contribute $14,000 pre-tax, plus receive a tax deductible contribution of $8,000 from the company. With five other employees making $30,000 each, that owner would contribute $6,000 (4 percent of $150,000) if they each contributed 4 percent of their pay. Who would not find that valuable?
In other words, it would cost $6,000 for an owner to have the ability to contribute $22,000 for his own benefit. Add the tax savings and it’s a good deal for the owner, too.
Some companies take one additional step. They layer a cross-tested profit-sharing plan on top. As long as the owners are not getting a disproportionate share of the contribution (as determined by complicated IRS-approved formulae), plan sponsors can contribute different amounts to different groups of employees.
For example, one employer with eight employees (including himself and his wife) is able to put away $44,000 for himself and $44,000 for his spouse. The tradeoff is that he has a Safe Harbor plan and makes the 3 percent contribution for each employee in that plan. On top of that, he makes a 2 percent profit-sharing contribution to the other employees (which can be vested). The result: a tax-deductible $88,000 for the owners, and $15,300 for the employees that otherwise would not have gone toward their retirement.
Newer versions of the “gold watch” plans – defined benefit plans – can provide even larger tax deductions. One Las Vegas employer puts away more than $1 million a year, with 80 percent of the benefit eventually accruing to the owner and his family.
Defined-benefit plans are more complicated than profit-sharing plans. They require more administration and skilled advisors to help establish them properly. However, for the business that wants large tax deductions, money for retirement, and a plan to reward and retain key employees, these and other cutting-edge pension strategies can make a lot of sense.