3 Options To Help Business Owners Catch Up On Retirement Savings
As small businesses struggled over the last several years, many owners put retirement savings on the back burner. Now that businesses are on a more even keel, many owners are realizing that they have fallen behind in their retirement savings and want to catch up. The tax law offers a number of different tax-advantaged retirement savings plans in which contributions by the business are tax deductible (contributions by participants are excludable from income), and earnings on contributions are tax deferred — they are not taxed until distributions are made. Some plans may be better for playing catch-up than others.
Defined Benefit Plans
Defined benefit plans are pension plans that promise to pay a set amount to the owner or other participant at retirement. In order to meet this promise, an actuary calculates the contributions needed after factoring in retirement age, expected rate of return on investments, and other factors. The closer to retirement age, the more that must be contributed by the business to meet the promised pension.
For 2011, the maximum promised pension amount is $195,000. In order to set aside sufficient funds to pay this pension for an owner who is now 50 years old, the contribution could be as high as about $172,000; for an owner 55 years old, the contribution could be as high as about $191,000. The allowable contribution is fully tax deductible.
Advantages: The chief benefit is the ability of a business owner to shelter significant dollars each year and ultimately have a nice pension at retirement. These plans work best for older owners with few employees, all of whom are younger workers. Defined benefit plans often are used by professionals, consultants, and other high earners who meet the appropriate demographics.
Disadvantages: Plans must be nondiscriminatory, so that if a business has employees, they too must be covered; this can be pricey for the business. There are also annual required filings and, in addition, extra costs unique to these plans that can add up to serious dollars. For details on annual actuary fees and premiums, visit the Pension Benefit Guaranty Corporation.
401(k) Plans Combined with Profit-Sharing Plans
Many companies today use 401(k) plans because they shift the primary burden for retirement savings to employees. Companies may make contributions to the plans, but often they are minimal. However, these plans can be combined with profit-sharing plans to maximize contributions for owners.
An owner, age 52, wants to set aside the maximum amount for 2011. She can make a salary reduction contribution of $22,000 ($16,500 allowed for anyone, plus $5,500 for those age 50 and older). The business can also make a profit-sharing contribution of $32,500; the total amount added for retirement savings can be up to $54,500. To achieve the maximum contribution, compensation to the owner must be at least $245,000.
These plans can be used for both a corporation and an unincorporated business. Even a self-employed person with no employees can have a solo 401(k) + profit-sharing plan and maximize contributions.
Advantages: The cost to the business for covering employees is limited; employees value the opportunity for retirement savings even though they may not all make contributions. These plans are suitable for any type of business.
Disadvantages: Again, plans must be nondiscriminatory, so if the company contributes to an owner’s account, the same contribution percentage must be used for other plan participants. Like defined benefit plans, there are annual filings and other administrative costs on top of any company contributions.
Use an online calculator to see how your savings can mount, depending on the contributions you make.
The Pension Protection Act of 2006 created a hybrid plan, called a DB(k), which combines a defined benefit plan funded by the company, with a 401(k)-like plan funded primarily by employees along with minimum company contributions. The plans can be used only by companies with two to 500 employees and are designed to entail less paperwork than some other types of plans.
DB(k)s were set to debut in 2010. However, to date, there has been no comprehensive guidance from the IRS, so financial institutions have yet to design and implement these plans. (The IRS has said it will issue determination letters for individually-designed plans.) Once they become mainstream, these plans could be a nice solution for some businesses. Stay tuned!
Tax Credit for Setting Up a Plan
If your company hasn’t had a retirement plan in the past three years and you set one up now, you may take a tax credit for plan startup costs of up to $500 per year for the first three years of the plan. The credit is 50% of startup costs, which include costs for establishing or administering an eligible employer plan or costs for retirement-related education of employees about the plan.
The credit applies only to small employers, which are companies with 100 or fewer employees who each received at least $5,000 of compensation during the year. However, no credit can be claimed if the only participants in the plan are the owner or owner and spouse.
For more details about this tax credit, see instructions to Form 8881, Credit for Small Employer Pension Plan Startup Costs.
If you are uncertain which type of retirement plan to select for your situation, discuss your goals and concerns with a knowledgeable benefits expert.
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