Traditional pension plans may be underfunded, but while employees of large corporations may eventually face a crisis if their pension payments dry up, many financial advisors are quietly helping small business owners build substantial nest eggs through defined benefit plans designed just for them.
In fact, several types of pension plans are available to owners of small, closely held corporations. These qualified plans -- which are commonly known by their Internal Revenue Code designations -- have unique benefits in both tax savings and wealth accumulation. The client can maximize the power of tax deferral and leverage investments for even greater returns.
Advantages of these plans include:o Maximum deductions for the businesso Fully guaranteed retirement benefitso An easy-to-understand retirement plano Significant retirement asset build-up in a short period of timeo Ability to contribute up to $10,000 on behalf of non-compensated family memberso Complete control over the moneyo Account holders can borrow from the assetso Safe from creditors and judgments
Some plans offer incentives to encourage key employees to remain loyal, reducing turnover. "While the rules and set up can seem daunting, private business owners who fall into certain age groups and retirement scenarios may still benefit from creating a defined benefit pension plan," explains Alex Donnell, president of Colorado Comprehensive Wealth Management in Colorado Springs, Colo. According to Donnell, who specializes in working with small business owners such as physicians, dentists and construction business owners, defined benefit plans are the most advantageous plans for individuals who want to retire within seven to 15 years and have significant monies to contribute.
"If the plan is established when the owners are 40 or older, the benefits can be much larger than other types of plans. All contributions are tax-deferred and are a corporate expense," he adds.
Defined benefit plans are set up to provide monthly benefits at retirement age, depending on the amount of contribution, anticipated rate of growth and years of service with the company. An actuary determines the contributions required to meet the goals of the plan.
Defined benefit plans are more difficult to set up than defined contribution plans such as SEPs, SIMPLEs and 401(k)s, and require a professional administrator. "Ideally, the client will select and work with a competent financial advisor who understands the in's and out's of defined benefit plans," Donnell says. "The advisor will also need to select and work with a competent team that includes an attorney, a CPA and a plan administrator."
Substantial BenefitsDonnell explains how a 412(i) plan might work for a theoretical individual. "Let's say the company owner is in his mid-fifties, wants to retire at age 62, has 10 or fewer employees and has very good cash flow in his business. He is concerned with the amount of tax he is paying out and realizes that a traditional profit-sharing plan combined with retirement plans such as a 401(k), SEP or SIMPLE will not allow him to sock away the money he needs to accumulate for retirement. Based on an actuarial study of the company owner and employees, a 412(i) plan may potentially hit the owner's target retirement dollar numbers. He could possibly put $356,000 into his own account for the next seven years: a grand total of $2,492,000. This is certainly a greater amount of money then the approximate $315,000 he could put into the profit-sharing / 401(k) combination. Through the use of a fixed life insurance policy such as whole life (the only type of insurance allowed in a 412(i) plan) and a variable premium fixed annuity, the benefits could be substantial."
However, in 2002 the Department of Revenue took a special interest in 412(i) plans, eventually concluding that there were too many abuses; plan owners were not reporting their plans correctly and plan funding was not necessarily supported by an actuarial study. Three years later, the IRS instituted new guidelines for 412(i)s. Because of the current restrictions on 412(i) plans, the pension industry and employers have sought out other means to the same end.
Split-Dollar PlansTwo large U.S. insurance companies are the front runners in creating the next generation of qualified plans, thanks to advantages created through I.R.C. 79. Section 79 of the Internal Revenue Code permits a corporation to provide up to $50,000 of group term-life insurance for full-time employees at no cost to the employee. The total cost of providing this coverage is fully deductible to the corporation.
The code also allows for coverage to be offered using permanent life insurance such as universal life, variable universal life and variable appreciable life, thus giving business owners and professionals a way to use excess pre-tax profits to provide tax-advantaged benefits in a cost-effective manner. This is especially true in professional and service-oriented businesses that, because of affiliated service group rules, often have difficulty making pension plans economically feasible. Because permanent life insurance and traditional investments are used, this is known as the "split-funded" or "split-dollar" plan.
The primary benefits of Section 79 are the availability of permanent life insurance and supplemental tax-free retirement income. Contributions are 100 percent deductible for the corporation. The employee reports as taxable income the cost of permanent benefits as calculated by the plan actuary each year. The cost of permanent benefits is typically only 60 percent to 65 percent of the life insurance premium.
"Using the same scenario as before, the business owner would for the next seven years be able to deposit a maximum of approximately $305,000 per year into his split-dollar defined benefit plan, for a total of $2,135,000," Donnell says. "While $2.1 million is less than the $2.5 million he might be able to accumulate in a 412(i) plan, the rules are more flexible with a split-dollar plan and the tax-deferred dollar amount still trumps the profit-sharing/401(k) plan by a wide margin."
Employees who are full-time (1,000 hours or more), age 21 or older and have at least two years of service are eligible to participate in the split-dollar plan described above. Plan administrators may select more liberal eligibility requirements, if desired. A class or classes of employees can be excluded as long as the plan satisfies the requirements set forth in Sections 410(b) and 401(a)(2)(6).
An Overlooked OptionWhy do we not hear of these plans more often? Donnell thinks it's because there are a large number of product pushers in the industry who are not willing to look at advanced programs outside their area of sales. In addition, finding a third-party administrator to do the reporting on hybrid plans can be a daunting task, not to mention being in compliance with all of the rules associated with these plans.
"Defined benefit plans provide a great opportunity for contributions and deductions," Donnell concludes. "For the private business owner who is willing to do his homework and find knowledgeable professionals to help him, the opportunity for retirement savings can be substantial. The nuances must be adhered to and the details can be daunting, but the potential is staggering."
Marie Swift is president of Impact Communications, a marketing and communications firm for independent advisors; see www.impactcommunications.org.