In today’s recessionary economy, there’s only one thing harder than running a business: accumulating enough assets as a small-business owner to retire comfortably.
Owners of successful businesses tend to be older and more highly compensated than the non-managerial or non-executive employees who work for them. The relative benefits of age and wealth, often a virtue in the business world, are decidedly a vice when planning for their retirement.
The impact of age
The older the business owner, the fewer years he or she has to accumulate sufficient assets to continue his or her lifestyle in retirement. Any contributions made to defined contribution retirement plans are capped. And deferrals to 401(k)s may be returned if their retirement plan fails non-discrimination tests.
But with help from you–their knowledgeable financial advisor–business owners can maximize their contributions to available retirement plans and accumulate significant assets. The key is to understand the rules of the road and to know what roads provide the straightest route to your client’s retirement destination.
First, everyone should know their limits, as in the limits on plan contributions and compensation. The IRS allows periodic cost-of-living adjustments to these limits, which can push the limits higher, as often as annually.
In 2009, the limit on contributions by individuals to 401(k) plans is rising to $16,500 from $15,500 in 2008. Maximum contributions, including matches and discretionary profit-sharing from an employer, are rising to $49,000 in 2009 from $46,000 last year. And the maximum eligible compensation will be $245,000 in 2009, compared with $230,000 in 2008.
Of course, these ceilings can drop to the floor if your clients’ employees contribute little or nothing to their 401(k). In such instances, the plan will be deemed to favor highly compensated employees, such as the business owner, and will therefore fail non-discrimination tests. Highly compensated is defined as anyone earning $105,000 in 2008 and $110,000 in 2009, or a business owner with a 5% interest.
If your clients fear their 401(k) may ultimately fail the test, they can encourage more employees to contribute by promoting a little-known federal tax credit for deferrals of up to $1,000 by lower-paid employees. They can also consider alternatives such as Safe Harbor 401(k)s or automatic enrollment.
Your clients who own businesses might also consider incorporating a profit-sharing plan that allows wide latitude as to when and how retirement contributions are paid. Two examples of profit-sharing plans that enable business owners to maximize their contributions are age-weighted and new comparability allocation plans. Both allow business owners to skew or tilt contributions in their own favor.
Age-weighted plans are designed to benefit older (although not necessarily heavier) and more highly compensated employees. This is because contributions are converted to equivalent benefits at retirement. Since older employees have shorter time horizons to save for retirement and are generally compensated more highly than younger (although not necessarily thinner) employees, age-weighted plans allow larger contributions by the plan sponsor on their behalf.
Like age-weighted plans, new comparability plans tend to favor older, more highly compensated employees (in most cases, the business owner). Contributions are still converted to a benefit at retirement. But in new comparability plans, employees are divided into groups based on plan-sponsor funding objectives. Because cross-testing is done, plan sponsors can provide different benefits to different groups.
Typically, one group will contain owner employees who receive a larger benefit and non-owner employees who receive a smaller benefit. Although employees accrue benefits at different rates, these plans are designed to pass IRS general nondiscrimination tests.
From vice to virtue
Cross-tested plans are subject to demographic changes, so whether or not one of these profit-sharing scenarios makes sense for an individual client requires some analysis. Your plan provider should be able to assist. Profit-sharing plans can be the answer to helping many business owners prepare for retirement–and turn their age and wealth into a virtue instead of a vice.
E. Thomas Foster Jr., Esq., is the national spokesperson for qualified retirement plans at The Hartford, Harford, Conn. You can e-mail him at firstname.lastname@example.org