QUALIFIED RETIREMENT PLANS

FOR SMALL BUSINESSES

The purpose of this manual is to provide employers and employeeswith the knowledge and understanding of the various retirement plan options available to them, with emphasis on options specific to smaller businesses. Not only will this manual provide course participants the opportunity to learn about the many tax advantages of retirement plans for small employers, but also describes the features of qualified plans that can reduce both the cost and complexity of implementing and maintaining them.

LEARNING OBJECTIVES

After reading this manual, you will be able to:

  • Compare the advantages and disadvantages of qualified and non-qualified retirement plans.
  • Analyze the tax and non-tax benefits of a qualified retirement plan.
  • List the basic steps in establishing a qualified retirement plan.
  • Contrast features of the various types of 401(k) plans.
  • Describe the basic requirements of maintaining a qualified retirement plan.

INTRODUCTION

Today, the American dream is to have the ability to set aside funds to plan for retirement and unforeseen financial emergencies. However, in today’s ever changing market, finding the extra money to save for the future may seem impossible for many workers. Typically, this is especially difficult for those employed in small businesses.

Today, more than ever, Americans realize the importance of saving for the future. Most experts estimate that the average American will need between $1.2 million to $1.5 million in a retirement plan to provide for a reasonable lifestyle after retirement. They also estimate that 8 months of expenses should be put aside for unexpected financial emergencies, or about $30,000 to $50,000 for the average worker.

In order to provide American workers the opportunity to save and plan for retirement a reality, the U.S. Internal Revenue Code provides a variety of tax-advantage retirement plans through which employees may save funds for retirement. In addition, employers can offer retirement plans for employees that, if they meet certain qualifications under the Tax Code, create tax advantages for both parties.

However, with any qualified retirement savings plan for which the government affords tax breaks, there are requirements, under the tax code and the Employee Retirement Income Security Act of 1997 (ERISA), for maintaining the plans. For example, plans must be updated to reflect changes in the law and information about the plan must be reported annually to employees as well as to the IRS. If a plan falls out of compliance or is inappropriately used for the advantage of the wrong parties, it must be corrected to avoid penalties or the loss of its qualification for special tax treatment.

RETIREMENT PLAN OPTIONS

Planning for retirement can be difficult with so many options available. One important distinction between types of retirement plans is whether they are qualified or non-qualified. A qualified plan is approved by the government and allows a contributor to avoid paying taxes until the funds are withdrawn. Non-qualified plans fail to meet the IRS guidelines for qualified retirement accounts, and the money is taxed before it goes into the account rather than when it is withdrawn.

QUALIFIED PLANS

Qualified retirement plans provide retirement benefits that meet the requirements under federal law which are not available to other types of plans. Qualified plans allow employees to defer reporting income from benefits until retirement, while at the same time allowing employers to claim a current deduction for contributions to the plans. Income earned by the plan is not taxed to the employees until it is distributed to them as part of their benefits. Almost every type of business entity may establish a retirement plan (sole proprietor, corporation, LLCs, and partnerships), and may be structured so that the plan is part of an employer’s retirement benefits package, or they may be independent of an employer plan. Regardless, all qualified retirement plans allow for tax-free accumulation inside the plan.

Qualified retirement plans provide businesses with a broad range of tax and non-tax benefits. In comparison to non-qualified plans, the qualified retirement plan has more benefits and you can significantly contribute more money. One main requirement of qualified plan is that plan assets must be held in a qualified trust that you can control as the plan administrator. Employers are obligated to offer benefits on a nondiscriminatory basis with respect to salary level to all rank-and-file employees. This requirement ensures that all employees (if any), not just highly paid executives and other key employees will benefit from the plan.

Additionally, qualified retirement plans are required to contain “anti-alienation” provisions that prohibit plan benefits from being assigned or alienated to creditors. This protects your plan assets from creditors and lawsuits. Fortunately, several plan options can make the requirements less burdensome and less costly for small businesses. The combination of tax advantages, variety, and flexibility of plan types makes qualified retirement plans preferable for a majority of small businesses.

NON-QUALIFIED PLANS

Non-qualified retirement plans fail to meet IRS guidelines and rules Congress has passed into law; and therefore cannot take advantage of most of the benefits of a qualified plan. These plans accept only non-deductible contributions. Money is taxable to the employee when it is received instead of when the funds are withdrawn from the plan. An example of this type of plan is an annuity. Annuity contributions are always made on an after-tax basis, and only gains are taxed when funds are withdrawn from the plan.

The disadvantage to non-qualified plans is in the fact that they do not receive all of the tax benefits that qualified plans receive. You may end up with less net income and total retirement savings when compared to a qualified plan as a result.

WHY HAVE A QUALIFIED RETIREMENT PLAN?

Qualified retirement plans can provide many tax and non-tax benefits to employers, as well as to employees, such as:

  • Help employers attract and retain better employees, thereby reducing turnover and new employee training costs.
  • Employers can immediately deduct their contributions (within certain limits) into a qualified plan and may even be entitled to receive a tax credit for a part of the costs of implementing the plan. The balance of the cost can be deducted on your tax return.
  • Employees pay no income tax on employer contributions (within certain limitations) until the funds are distributed.
  • Employees benefit from the tax-free accumulation of earnings.
  • Employees generally may make pre-tax contributions from their compensation to a qualified plan, called elective deferrals, thereby lowering participants’ taxable income.
  • One of the greatest advantages of qualified plans is that retirement savings from defined contribution plans are portable. Eligible funds can be rolled over to another defined contribution plan (or IRA), in accordance with certain requirements, thereby helping employees continue to build their retirement funds and cut down on the excess paperwork caused by maintaining several retirement accounts.
  • The U.S. government will even pay you back a portion of your contribution to a retirement plan up to $1,000 each year per participant for taxpayers in low tax brackets. Form 8880 is used to claim the credit.

GENERAL FEATURES OF ALL QUALIFIED RETIREMENT PLANS

This section describes examples of benefits that a qualified retirement plan can offer to the small business owner, including tax savings, asset protection, and credit for small business plan start-up costs.

TAX SAVINGS FOR ALL

Retirement plans that meet the requirements of Code Sec 401 provide employers and employees with many tax advantages.

The following are specific tax benefits:

  • Employer contributions to qualified plans are fully and immediately deductible by the employer.
  • Employees can make pre-tax contributions to a qualified retirement plan.
  • Employees are not taxed on employer contributions or on plan earnings. Employees only pay income tax upon distribution of funds.
  • Employers and employee contributions grow in a trust that is exempt from tax controlled by you, the plan administrator.
  • At the time plan distributions commence, an employee can further defer federal income tax by rolling over his or her eligible funds in a defined contribution plan (funds must be vested) to an eligible retirement plan (includes defined contribution plans, IRAs, etc.)

ASSET PROTECTION

As mentioned previously, assets held in a qualified retirement plan are required to contain “anti- alienation” provisions under ERISA. Therefore, pursuant to bankruptcy laws, employer and employee assets in qualified retirement plans are generally protected from creditors including the IRS. I recommend you discuss this with your tax advisor as every situation is different.

CREDIT FOR SMALL BUSINESS PLAN START-UP COSTS

If you set up a plan, you may be eligible for a special tax credit designed to encourage small business owners to start retirement plans. A small business employer eligible for the credit is one with no more than 100 employees who received at least $5,000 of compensation from the company in the preceding year. However, the plan must cover at least one employee who is not a highly compensated employee. Thus, a self-employed individual with no employees who sets up a profit-sharing plan cannot claim a tax credit for any of their start-up costs.

The credit is 50% of eligible start-up and administrative costs, for a maximum credit of $500 per year, or $1,500 for three years. The credit can be claimed for three years, starting with the year in which the plan is effective. However, you can opt to first claim the credit in the year immediately preceding the start-up year based on costs incurred in the preceding year. Use Form 8881 to claim the credit

Small Business Tax Credit for Qualified Retirement Plan Start Up Costs

Cost of Retirement Plan Set-up$ 2,495

IRS Tax Credit for Retirement Plan

Set-up and Administration< 500>

Net Cost after Credit$ 1,995

Deduction Tax Savings 798

(40% tax bracket)

Net after Tax Cost to Set Up QRP$ 1,197

Dramatic law changes in recent years, including those introduced by the Pension Protection Act of 2006, permit greater retirement savings opportunities than ever before.

SPECIAL RULES FOR 401(K) PROFIT SHARING

Various types of businesses may adopt a 401(k) and profit sharing plan. However, there are special rules for some types of businesses, as follows:

  • As defined in IRC §401©, a self-employed person is considered an employee.
  • A self-employed person, including sole proprietors and partners, earns his compensation on the last day of the business’ fiscal year, and cannot make a deferral election after the end of the year.
  • Subchapter S shareholder participants must use his or her salary as the base for everything. However, under the laws governing pension plans, S Corporation “K-1” income cannot be considered compensation for any purpose.

TYPES OF QUALIFIED RETIREMENT PLANS

This section describes the various types of plans which may be appropriate, taking into account the employer’s particular resources and objectives. Some qualified plans, called Defined Benefit Pension Plans (or Defined Benefit Plan), are structured so that the employee is guaranteed to receive a specific amount of benefits upon retirement, and require employers to make contributions. Defined Benefit Pension Plan Contributionsare more flexible and give employers the choice, rather than the requirement, of contributing to the employee’s retirement assets. Employers can also offer Profit Sharing Plans and 401(k) cash-deferred arrangements, which permit employees to make elective deferrals of their wages for payment into retirement plans, but with the significant tax advantage of a qualified defined contribution plan.

DEFINED BENEFIT PENSION PLANS

A Defined Benefit Plan is a qualified retirement plan that predicts what an employee will receive in benefits upon retirement. The predicted benefit amount is based on a variety of factors, such as the employee’s compensation, age, anticipated age of retirement, and the estimated amount of what the plan can earn over the years. Defined Benefit Plans are similar to savings accounts. The employer contributes to an account for each employee that may not actually be a separate account. While eligibility and distribution options are the same as other qualified plans, an actuary calculates how much a company must contribute to meet the ‘benefit defined’ in the plan documents The employer takes a deduction for the actuarially determined contribution, which can be significantly greater than defined contribution plans. The benefits that are ultimately paid to an employee are based on what the contributions actually earn and how much the employer and/or employees contributed over the years.

One of the biggest advantages of a Defined Benefit Plan is the potential for larger contributions and deductions. The plan works extremely well with participants that are 50 or older, and have a substantial business income in excess of $140,000. It is important to note that contributions to a Defined Benefit Plan are mandatory. You may be required to contribute to the plan in years you did not make a profit.

DEFINED BENEFIT PENSION PLAN CONTRIBUTIONS

The Defined Benefit Plan must accumulate the funds to provide the benefits by the time the participant has less time until retirement and therefore less time for the plan to accumulate the funds required to provide his/her retirement benefits. Accordingly, the contribution on behalf of the older participant must be relatively high compared to those required for a younger participant.

Example:

ParticipantAgeCompensationAnnualBenefit at

ContributionRetirement

Owner55$ 220,000$ 196,285$ 2,610,078

Employee24$ 24,000$ 3,876$ 357,962

The example above shows what appears to be unfair contributions between the owner and the employee. The owner’s contribution is much larger than the employee contribution. The reason for this is because the plan is providing benefits as a percentage of income to both participants. As you can see from the example, a Defined Benefit Plan can be an extremely powerful tool that allows an owner to contribute large sums of money to ensure the benefit at retirement is met.

PENSION PROTECTION ACT

Under the Pension Protection Act of 2006, a person can make additional 6% profit sharing contributions (maximum compensation considered is $245,000) and may contribute $17,000 pre-tax into a separate 401(k) plan. This Act will allow you to increase your defined benefit contribution by $36,700. Below is an example that illustrates the additional contributions:

Owner-Only Employee / Age / Compensation / DB Contribution / 401(k) / 6% Profit Sharing / Total
Participant / 49 / $75,000 W-2 / $120,000 / $16,500 / $4,500 / $141,000
Participant / 61 / $160,000 W-2 / $205,000 / $22,000 / $9,600 / $236,600

DEFINED BENEFIT PLAN FLEXIBILITY

Defined Benefit Plans are much more flexible than they have been in past years. Typically, the plans should exist for at least three years, with a minimal contribution of $5,000 per year, unless terminated earlier for qualified business reasons. The owner can contribute their desired amount annually with proper plan design and effective funding strategies. It isn’t uncommon for an owner’s contribution objective to change considerably. When this occurs, the plan can be amended to provide additional flexibility.When the plan investments outperform expectations, contributions will decrease. Likewise, when plan investments underperform, contributions should increase. This strategy helps to keep the owner’s desired benefit on track.

PROFIT SHARING PLANS

A Profit Sharing Plan is a defined contribution plan to which the company agrees to make substantial and recurring, through generally discretionary, contributions. Amounts contributed to the plan are invested and accumulate tax-deferred for eventual distribution to participants either at retirement, after a fixed number of years, or upon the occurrence of some specified event (that is, disability, death, or termination of employment). Contributions to a profit sharing plan are flexible and usually keyed to the existence of profits. Neither current nor accumulated profits are required for a company to contribute to a Profit Sharing Plan. Even if the company has profits, it can generally limit its contribution for a particular year if the plan contains a discretionary formula. However, a contribution formula tied to profits can encourage productivity.

Thus, the attractive feature of a Profit Sharing Plan is the employer’s ability to decide from year-to-year the percentage of employee compensation that will be contributed to the plan. Because profit sharing contributions are flexible, these plans are especially suitable for start-up companies, companies in cyclical industries, or companies simply wanting discretion in determining plan contribution amounts.

Another advantage of a Profit Sharing Plan is that it may allow for in-service distributions; that is, distributions occurring other than upon retirement, disability, death, or termination of service. Some of the distributable events allowed are the passage of a fixed number of years, reaching a certain age, or financial hardship. A Profit Sharing Plan must hold contributions in a trust for at least two years before making a distribution based on a fixed number of years.

401(K) PLAN

A 401(k) Plan is a qualified retirement plan that is funded primarily through employee contributions via salary reductions. It was legislatively created in 1978, and by 1981, half of all large corporations had adopted them. Today, use of 401(k)’s is not exclusive to large corporations; even a sole proprietor with no employees can use a 401(k). Through a 401(k) Plan, companies have the option to make matching contributions, which vest for participants in the same manner as contributions to other defined contribution plans explained earlier.

Perhaps the most popular type of defined contribution plan today is the 401(k) Plan. The 401(k) Plan allows employeecontributions to be made through salary reduction arrangements that let them fund their retirement plan with pre-tax dollars. These employee contributions are called elective deferrals. Employers often match a percentage of employee elective deferralsas a way to encourage participation, something desirable so that owners, executives, and other highly paid employees can benefit. In addition to pre-tax contributions, a 401(k) Plan may offer a Roth contribution option.