Three options can help owners retire one day

Retirement is a hot topic for many baby boomer business owners right now. But despite all the attention, the possibilities aren't widely understood.

Many entrepreneurs have spent years growing their business and are realizing that they aren’t financially prepared to retire. Younger owners may just want to get a head start on saving toward retirement.

A question we often hear from business owners is: How can I meet my retirement goals? This article explores possibilities for retirement savings, ranging from “big” to “bigger” to “biggest”.

Big: 401(k) deferrals

Most people are familiar with 401(k) plans (or variations like SIMPLE or solo-k). In a 401(k) plan, employees can contribute to a tax-deferred retirement account. If this is the only company retirement plan, it’s also common for the employer to make matching or other contributions.

If your business doesn’t have a 401(k) plan yet, then this is the place to start. In 2011, individual deductible contributions can be as large as $16,500. Owners and employees over age 50 by year-end can contribute an extra $5,500 “catch-up” contribution. Taken together, an eligible individual can elect to defer up to $22,000 into a 401(k) plan each year.

A 401(k) plan is relatively simple for employees to understand and employers to administer. In addition, it offers quite a bit of flexibility if there are “lean” years when owners are not able to make the full deferral.

Bigger: Profit sharing

Once you’ve taken full advantage of deferral opportunities in a 401(k) plan, it’s time to start thinking bigger. The key here is to be aware of the IRS’s annual contribution limits.

For 2011, the limit for an individual is $49,000 (excluding defined benefit plans, which we’ll talk about later). This amount excludes catch-up contributions, which would raise the effective limit to $54,500 for those over age 50.

Even if you’ve already deferred $16,500 to your 401(k) account, you can still put away another $32,500 for retirement through a profit-sharing plan. If designed properly, this type of plan is also quite flexible and can be adjusted annually depending on business conditions.

Profit-sharing allocations are often made as a percent of pay. Staff won’t have to receive the same rate as owners or other highly paid employees, but in most small businesses they will need to receive at least 3 percent of pay from the profit-sharing or the 401(k) plan.

Profit-sharing plans are relatively simple to set up, but do require a bit more administration if owners and other highly paid employees receive higher contributions than others.

Biggest: Defined plans

Annual retirement deferrals of $49,000 through a 401(k) and profit- sharing plan may be sufficient for some business owners. Others will need more. And they can potentially get a lot more with a defined benefit pension plan. With these plans, owners’ deductible contributions can be as high as $100,000 or even $200,000 per year. This can often be on top of the $49,000 in the profit-sharing and 401(k) plan.

A quick tutorial on defined benefit plans: The employer pays for all benefits in the plan and takes the investment risk or reward. (The “benefits” are defined and must be paid regardless of the plan’s assets). In exchange for the employer assuming the risks, the IRS allows defined benefit plans to have much larger deductions than a 401(k) or profit-sharing plan.

Most new defined benefit plans today are “cash balance” plans. These plans have the look and feel of a 401(k) plan, but provide the security of a defined benefit.

Each year, all plan members receive a pay credit (usually a percent of pay) to their account. They also get interest credits on the account balance. Both the pay credit and interest credit rates are specified in the plan. That’s what makes this a defined benefit plan, with its big tax deduction opportunities.

Cash balance plans are an excellent solution for companies that:

• Want to set aside (and deduct) more than $49,000 for owners or partners;

• Want to retain a link between owners’ contributions and benefits;

• Have a reliable earnings stream;

• Can afford a generous contribution to employees (usually 7 percent of pay).

One example

Here is a brief example of a defined plan:

An owner, age 55, with 20 years of service and a $245,000 salary, would have a projected cash balance of $1.2 million after 10 years; the first year credit would be $100,000.

Employee One, 40 years old with 10 years of service and a $50,000 salary, would have a projected cash balance of $68,000 after 10 years; first year credit would be $5,000.

Employee Two, 30 years old with five years of service and a $30,000 salary, would have a projected cash balance of $41,000 after 10 years and a first year credit of $3,000.

Those figures assume an expected retirement age of 65, annual investment returns of 4 percent, annual cash balance interest credits of 4 percent, and annual pay increases of 3 percent. Cash balance contributions for staff would be lower if they also received benefits from a profit-sharing or 401(k) plan.

Of course, business owners need to be aware of the complexities of cash balance plans before jumping in to the biggest option of the three. Since these plans allow large deductible contributions, the IRS has strict rules about how they must be set up and administered. The plan and its investments should be designed to maximize benefits and minimize risk.

What’s sufficient?

There are many options for business owners to consider when adopting a retirement plan. A 401(k) or profit-sharing plan with annual deductions of around $49,000 may be perfectly adequate. Others will want to maximize their savings opportunities with a cash balance plan. Whatever your choice, you’ll want to consider all the possibilities.

Mark Schulte,
Van Iwaarden Associates:

Mark Schulte