A surprising number of successful small to mid-size business owners have minimal retirement savings or do not offer a plan to their employees. When it comes to saving for retirement business owners face two main challenges, getting a late start and the responsibility of establishing a plan.
The Impact of Starting Later
Traditional advice suggests start saving for retirement early and let compounding magic happen. However, in the early stages of building a business most owners focus on growth and operations. Any extra capital is poured back into the business rather than saved in account with limited access until 59 1⁄2.
Those who are starting to save for retirement later in life will need to aggressively put away money to catch up. For example, a 55 year old couple has $300,000 invested in a taxable account, no debt but nothing saved in retirement accounts. They want $9,000 a month for living expenses during retirement. How much would they need to save over the next 12 years to have at least an 80% probability they will not outlive their financial assets?
Investment allocation 60% U.S. large cap equities and 40% intermediate bonds. Analysis includes claiming Social Security benefits at full retirement age. Probability results are based on Monte Carlo projections and calculations provided by NaviPlan.
For this couple, the difference between saving $60,000 versus $100,000 in a tax-deferred account over the next 12 years is significant. The second take away is the power of tax- deferred growth. The couple could contribute $60,000 into a retirement account, take a bonus of $40,000 from the business, pay tax on the bonus and invest the rest. However, the tax erosion and taxable growth has a negative impact to their long-term financial outlook.
Business Owners Have More Options
The second hurdle is the responsibility of saving for retirement lands solely on the business owner’s shoulders. This includes time spent on research, setup costs and ongoing maintenance.
Pew Charitable Trust conducted a survey of 1,600 small to medium sized business owners. The top three reasons cited for not offering a retirement plan was expense, not having the resources to administer a plan and employees are not interested. However, business owners have multiple options to save for retirement. Successful business owners/entrepreneurs interested in sheltering as much as possible for their own retirement will typically consider establishing either a SEP IRA, 401(k) or defined benefit (DB) plan. The type of plan established will depend on the personal retirement needs of the owner, business goals and employee demographic.
• Cost: Listed as the main reason most business owners do not offer retirement plans. SEP IRAs are easy to establish and relatively low maintenance. Generally 401(k) plans tend to be more expensive depending if the plan is a safe harbor or non-safe harbor. DB plans are the most expensive type of plan to establish. The expense is primarily attributed to hiring a qualified administrator. In many instances the benefits of establishing a 401(k) or DB plan outweigh the annual cost.
• Vesting: Attracting and retaining valuable employees is critical for a small to midsize business. Retirement plans can reduce turnover by giving employees an incentive to stay. If this is an important feature then the 401(k) or defined benefit plan would be preferable. A vesting schedule such as 3-year cliff or 6-year graded can be established for either plan. In contrast, all contributions to a SEP IRA are immediately 100% vested by the employee.
• Contribution: The maximum dollar contribution to either a 401(k) or SEP IRA is $54,000. In contrast, the DB contribution is an actuarial calculation based on several factors such as age and salary. As an example, Company X could potentially contribute $185,000 to a DB plan for a 55 year old (assumes compensation of $270,000). The company contribution is tax deductible to the business.
• Asset Protection: Business owners are exposed to additional risks such as lawsuits or the potential of bankruptcy. Retirement assets saved in a DB or 401(k) plan fall under ERISA so they offer the strongest creditor protection. With the exception of an ex- spouse or IRS the funds in these plans are almost as impenetrable as the Game of Thrones ice wall. It is important to note that ERISA protection does not apply to a solo 401(k). IRAs receive no general creditor protection under federal law and is protected under state law. Depending on the state the level of protection may be weaker than what is offered under ERISA.
More on Defined Benefit Plans
Many affluent business owners implement DB plans to accumulate assets on a tax-deferred basis, accelerate the amount they can save in a retirement account, maintain asset protection under federal law and reduce current taxable income. The retirement plan can also be designed as a “combo” plan which can include both a 401(k) profit sharing plan and cash balance defined plan to provide the most flexibility. The DB plan strategy works well for business owners who are at least age 45 or older, has a small pool of employees and the business has steady to increasing cash flow.
The primary benefits of DB plans are:
• Depending on several factors, the contribution amounts for the business owner’s retirement can be significantly higher than other type of plans.
• The strategy can be tax-efficient since the contributions are generally tax deductible by the business and the funds invested grow tax-deferred until distributed.
• The DB plan also serves as a retention tool and employees have a vested interest in the success of the company. Longer term employees are rewarded for their years of service.
Despite the many advantages of a DB plan, there are a few elements to be aware of:
• The set-up and maintenance is generally more expensive than other plans.
• Annual actuarial calculations are required to keep the plan on track. A third-party is typically hired to administer the plan.
• DB plans are intended to be a long-term commitment, more than 3 years, so there should be a reasonable expectation to make annual contributions. There is flexibility in the dollar amount contributed on an annual basis and if necessary the plan can be frozen or terminated.
Conclusion Defined benefit plans are often overlooked as an option for business owners or entrepreneurs in their retirement planning. It can be a powerful strategy for individuals who need to accelerate saving for retirement.
Submitted by Petra Chien, Wealth Strategist, First Bank Wealth Management. Petra may be contacted at (424) 343-5209 or via email at Petra.Chien@fbol.com.