While many small businesses have, over the past couple of years, been adopting 401(k) plans, some say they would actually be better served by considering the retirement plan options that the defined benefit (DB) space has to offer, not least because of the impending increases to income taxes that are set to happen in most states at the end of this year.
Income taxes for both individuals and corporations will be increasing by nearly 40% once the tax cuts introduced by former president George Bush expire, predicts James Podleski, president of Washington-based National Pension Partners. For many small businesses that are already suffering from the economic downturn, things are going to get quite tough, so it's in their best interest to look toward strategies that can help them save taxes, he says.
"There's been a lot of misinformation about defined benefit pension plans in general," Podleski says. "People think that once they choose one, they are stuck with it forever, but that's not true. There is a lot of flexibility in pension plans, and a pension plan is the only qualified retirement plan that will allow a business owner to contribute and deduct more than $49,000 for 2010."
While small businesses have been exploring the DB space and there has been a noticeable uptick in the number of pension plans they're implementing, many people are still not aware of the advantages that these plans offer, Podleski says. Advisors working with small business owners need to be better informed about these DB plans so that they can help figure out whether a DB or a DC plan is a better fit for a particular business, he says, because there can be no one-size-fits all kind of approach, especially in fiscally tight times.
Podleski believes that most small businesses decide to offer 401(k) plans to their employees simply because they are so ubiquitous now and have been mass marketed. In reality, though, a 401(k) isn't always the best option for many small businesses, because they can prove to be very costly. Lack of employee enrollment is an issue, and "what many people don't know is that in a 401(k) plan, Social Security and Medicare taxes are withdrawn from deferred amounts, which makes them more expensive," Podleski says. "But individuals can save up to 15.3% in additional Social Security and Medicare taxes by electing to use a pension or profit sharing plan as opposed to a 401(k)."
According to Thomas Foster, spokesperson for insurance giant The Hartford's corporate retirement plan business, DC plans have completely overshadowed DB plans, even if some of the latter might be a better bet from a tax point of view for a smaller business.
Cash Balance Plans Revisited
The cash balance plan, for instance, which is much like a DC plan in that employees' accounts earn a fixed rate of return that can change over a period of time from year to year, is a good DB option for a highly profitable small business, and is fast becoming a very popular option for many, he says.
"If you're a business owner who is highly profitable and you're looking for something to offset more taxes, then the cash balance plan is the way to go," Foster says. "Because of the dip in the market, we're seeing more small business owners starting to use cash balance plans, particularly Baby Boomers, who are prime candidates for it."
But the cash balance plan is, again, not for every small business, Podleski says, and should only be implemented by businesses that are highly profitable and that can foresee funding one for five years.
"The government would want the plan to be in place for at least five years and could take away the deductions if that's not feasible," he says.
However, the cash balance plan, like other DB plans, does allow for some flexibility, and it's important that advisors and business owners be properly aware of every plan's details before they select one or the other, Podleski says. They should explore all viable plans for the most suitable design and make sure to use a third party administered platform for combination plan testing and maintenance.
Foster agrees that information and education are the most important factors at play here. The momentum in the small business space to have a retirement plan in place is only going to get stronger, bolstered by the pace of regulation. The good news, though, is that providers of retirement plans, both on the DC and the DB side, are able to offer a broad range of options now as well as a high degree of customization, he says. This has helped small business owners previously afraid of setting up retirement plans because of their cost and the logistical burden they involve and will continue to do so as plan providers further hone their offerings.
"We call ours the No-Gap Solution, because no matter how big or how small the company, we have the ability to help," Foster says.