When it comes to saving for retirement, small business owners often have unique needs that require some extra research on your part to identify the best option for their situation. Not only do they need to consider their own successful retirement, but they also need to offer solutions to facilitate their employees’ savings. Here, from the perspective of a brief case study, we’ll look at some of the retirement plan options you might consider for your small business owner clients.
Case Study: The Thompsons
Janice and Ed Thompson, a wealthy (and fictional) couple, were referred to you by a mutual acquaintance. The Thompsons, both age 65, are nearing retirement, and their $15 million net worth means they have a number of immediate business, estate, and investment planning issues they need your help with. The couple resides in the Fort Point Channel District of South Boston, which is undergoing a commercial and housing boom. They have three children—Katherine (age 29, married); Chase (age 26, single), and Ryan (age 24, single)—as well as two grandchildren, one of whom has special needs.
Janice is an executive at a local pharmaceutical company, through which she has been receiving stock option grants, on top of her salary, for a number of years. Ed is an owner along with his brother, Bill, of the family electrician business, Thompson Electric, Inc. The brothers have plans to pass the business on to Chase and Ryan once they retire and also want to ensure that their key employee, Tony Balducci, is positioned for success.
In terms of the Thompsons’ retirement plan needs, here’s what else you need to know:
- Ed and Bill have a 401(k) plan for their business, Thompson Electric.
- Ed and Bill are working on their exit from the business, so they’ve decided to undertake a comprehensive review of their plan to see if there are any options for potentially increasing their retirement savings. Part of this review is about what is best for Ed and Bill. But it should also address options that will benefit Ed’s sons, Chase and Ryan, as they move into ownership positions, along with other members of the extended family.
Let’s look at what retirement plan options you could present to these small business owners, starting with a review of their existing plan.
How Does the Existing Profit-Sharing Plan Measure Up?
You learn that Thompson Electric has been making consistent contributions to its profit-sharing plan over the years. As such, it makes sense to take a closer look at the methods used to calculate the profit-sharing amount. Keep in mind that many owners think they’re required to give their employees the same amount as they receive. But there are a number of testing methods, including age-weighted and new comparability testing, that would allow the allocations to skew toward the owners and more senior personnel at Thompson Electric.
A good third-party administrator can help the Thompsons with different testing results and ongoing support. If they have not done so already, you could also suggest that they add a vesting schedule to the profit-sharing plan to reward longtime employees and reduce obligations to employees with short work tenures.
Can You Add an After-Tax Contribution Option to the 401(k)?
One strategy the Thompsons may want to consider is the addition of an after-tax source to their 401(k) plan. This would allow employees to contribute more than the IRS 402(g) limits ($18,000, or $24,000 with a catch-up, for 2017). For key and high-income employees who have exhausted their pretax and/or Roth 401(k) contributions, this is often an effective solution. With the ability to make after-tax contributions, these individuals can save up to the IRS 415 limits ($54,000, or $60,000 with a catch-up, for 2017).
As an added benefit, after-tax contributions (cost basis) can be rolled into a Roth IRA, making future withdrawals tax-free, instead of tax-deferred. In addition, the earnings associated with the after-tax contributions can be rolled into a traditional IRA. Keep in mind, however, that the after-tax source is subject to discrimination testing, even if the plan follows safe harbor rules.
Would a Cash Balance Plan Be Appropriate?
Cash balance plans are defined benefit pension plans that represent a significant benefit for business owners who want to defer compensation beyond the limits of a defined contribution plan. Most cash balance plans are designed to increase contributions for owners/key employees as they approach retirement. The average life span of a cash balance plan is seven to ten years.
Ed and Bill are both within a couple of years of retirement, so this may not be the optimum vehicle for them because of the associated cost and funding requirements. But a cash balance plan may be something to keep in reserve for Ed’s sons, Chase and Ryan. They will be taking over the business in a few years and will certainly be looking to increase their retirement savings later in their careers.
What Other Retirement Plan Options Should You Consider?
Backdoor Roth. For all parties involved, a backdoor Roth IRA may be an effective long-term tax savings strategy. With a backdoor Roth, individuals who earn too much to contribute to a Roth IRA can instead contribute to a traditional IRA and then convert that amount—in some cases, tax-free—to a Roth IRA. This strategy is complex, so it’s important that you understand the rules and evaluate each individual and situation separately.
For example, you learn that Ed’s wife Janice, has a sizable rollover IRA ($650,000) from a previous employer. Here, the backdoor Roth strategy may not be advantageous due to the tax implications and her income bracket. For Ed and Janice’s children (Chase, Ryan, and Katherine) and for Thompson Electric’s key long-term employee (Tony), however, the strategy may be sound. There would be a number of options to consider, including:
- Current access to a company retirement plan and if that plan has an employer match
- Current salary and tax bracket versus future earnings potential and tax bracket
- Other IRAs or IRA-based retirement plans that the individual may hold
- Vesting schedules associated with current workplace retirement plans
Rollover strategies. If Janice were to roll her existing IRA into her 401(k) with her current employer, she could delay required minimum distributions for this IRA at age 70½ if she were still working. Keep in mind that the rollover into the qualified retirement plan would need to happen the year prior to the year the client turned 70½.
Increasing contributions at bonus time. Ryan and Chase should also look to increase their 401(k) contributions at bonus time to help alleviate the higher tax rate that often affects employee bonuses. Most companies allow employees to modify their 401(k) deferral percentage if or when bonuses are paid.
Focus on the Goal
The above-referenced retirement strategies can be a great starting point to the retirement plan discussion with your small business owner clients. By first understanding their retirement goals, you can then help them find the appropriate solution and work toward the retirement vision they’ve worked so hard to achieve.
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This post originally appeared on Commonwealth Independent Advisor, a blog authored by subject-matter experts at Commonwealth Financial Network®, the nation’s largest privately held independent broker/dealer–RIA.