Retirement Plans for the Small Business Owner

By Daniel Kravitz

As a small buiness owner, what would you do if the government offered to pay retirement benefits to your employees? And give you the credit? And pay you for letting them do it?

This is exactly what the government is doing for many small business owners who set up tax-qualified retirement plans.

Joe Smith is the owner of Smallco, a Los Angeles-based manufacturing company that makes widgets.  Joe has four employees.  Last year, Smallco contributed $100,000 to a tax-qualified retirement plan (Cash Balance Pension Plan) - $85,000 going into Joe's own account and $15,000 into the accounts of his employees.

Smallco recieved a tax deduction for the $100,000 contribution.  The money went into a trust fund where it will accumulate tax-free until it is paid out as retirement benefits to Joe and his employees.

Joe is 45 years old.  In 20 years, when he is age 65, his own account will be worth $2.8 million, assuming Smallco continues to make contributions and that Joe's account earns a 5% rate of return.  In addition, the employees' accounts will be worth $500,000 at the end of the 20 year period.

If Smallco did not have a Cash Balance Retirement Plan, it would not have made the $100,000 contribution.  It would most likely pay this amount to Joe as additional salary.  Joe would have to pay taxes on this additional salary and would probably invest the remainder and have to pay taxes each year on his investment income.  At a marginal tax rate of 45%, Joe would have about $1.4 million at the end of 20 years - only about half of what he will have in his retirement plan account.

Of course, if Joe takes all of his money out of the plan at age 65, he will have to pay taxes.  At a 45% tax rate, this will leave him with $1.5 million, still more than the $1.4 million he would have if Smallco did not have a retirement plan.

So, at the end of 20 years, Joe has more money.  His employees have more money.  And his employees think the money came from Joe!

Unlike Joe, many small business owners are unaware of the magnitude of the tax advantages of qualified retirement plans.

Our tax system is often used to encourage individuals and businesses to do that which they would not otherwise be inclined to do.  In this case, tax breaks are given to encourage retirement savings.  To prevent abuse, the tax code places limitations and restrictions on retirement plans receiving favorable tax treatment.  These limitations and restrictions are generally intended to prevent a plan from discriminating in favor of owners and other highly paid employees.  For example, a plan cannot cover a business owner and exclude all of the other employees.  Thus, Smallco had to contribute $15,000 to the accounts of employees other than Joe.

Most large businesses need to have retirement plans in order to attract and retain qualified employees.  But, for a small business, the tax advantage is the primary attraction of a qualified retirement plan.  Thus, the trick is to design the plan so as to maximize the portion of the total contribution that goes into the accounts of the owners and other key employees.  There are many techniques for doing this.

Until recently, most retirement plans were designed to provide a contribution on behalf of each participant equal to some percentage of his pay with each participant receiving the same percentage.  For example, a business owner earning $250,000 might receive a $12,500 contribution, which is 5% of his pay.  A $30,000 per year employee in the same plan would also receive 5% of his pay, or $1,500.

Recently, many firms have implemented a special type of retirement plan which is much more favorable to the small business owner provided they are older than some of their employees.  This type of retirement plan (called a "Cash Balance Pension Plan") might allow our business owner to dramatically increase the contribution made on his behalf without having to increase the amount contributed for the employees.

There are many kinds of retirement plans.  Some of them, like 401(k)s, IRAs, SIMPLE Plans, and Simplified Employee Plans (SEPs) are easy to set up and operate for employers with modest contribution objectives.  For those willing and able to take maximum advantage of the tax laws, a Cash Balance Pension Plan might make sense.

Cash Balance Pension Plans permit contributions as high as $225,000 for older participants.  Each participant has his own account, but the employer is required to guarantee a specified rate of return.  The ability to change contribution levels from year-to-year is restricted.

With the wide variety of plans available, a good retirement plan advisor is imperative, particularly for small businesses wishing to maximize their tax advantage.  Joe Smith was fortunate to have a good advisor.  Out of Smallco's total contribution of $100,000, $85,000 went directly into Joe's own account.  Not only will Joe be in a better financial position when he retires, but Smallco's other employees will have retirement benefits that would not otherwise be available.  These additional benefits will be financed by the tax savings granted to qualified retirement plans.  For a small business owner, this is an offer that is difficult to refuse.

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