Odds Against Choosing the Optimum Plan
December 13, 2005 (update of November 17, 2003 article to include Roth and 412(i) commentary)
The choices for owner-only plans (including the so-called Solo(k) and Individual(k) plans) are numerous and far more complicated than one might suspect. Selecting the right plan type, benefits and features portends the plan's ultimate success or failure. Unless you are familiar with all of the plans and each of their respective forms discussed below, the odds are you may not choose the optimum plan.
How many owner-only plans do you know? Let's count them...
The Odds of Choosing the Optimum Owner-only Plan are 29:1¹!
In reality these odds are considerably higher since each plan type and form has different:
• eligibility requirements for part-time employees
• compensation, individual contribution and employer deduction limits
• reporting and contribution requirements
• optional benefits and features (e.g., Roth, loans, investment options, ability to add a working spouse, etc.)
Factor in these choices and...
The Odds are Greater than 100:1!
¹The odds against choosing the optimum owner-only plan are higher if you consider a Money Purchase Pension Plan as a viable plan option. The increase in the employer deduction limit to 25% effective in 2002 for Profit Sharing and SEP plans rendered this plan type virtually useless for the owner-only plan sponsor. An employer who continues to sponsor a Money Purchase Pension Plan should consider the termination or merger of this plan.
Roth Option Starting January 1, 2006, owner-only plans can permit after-tax contributions to a Roth 401(k) option. Unlike a Roth IRA, eligibility for the Roth 401(k) is not prohibited based on your adjusted gross income. This means that anyone eligible for the plan is eligible to contribute to the Roth option.
As our previously published articles on the new Roth option discuss and illustrate, business owners interested in maximizing their benefits during retirement are likely to choose in favor of this new benefit. However...
Be mindful that existing plans must be amended to permit this feature. New plans established in 2006 must allow for the Roth feature as well (don't automatically assume a new plan contains this feature). All plans, existing or new, must state "in writing" within the plan document that this feature is available. Also be sure that your service provider is able to separately record keep and report the Roth account contributions and investment gains/losses from those of the pre-tax 401(k) and other employer contribution money types (e.g., match, profit sharing).
Learn more about Roth 401(k)
Access Articles on Roth 401(k) for small businesses
412(i) Plans In February of 2004, in answer to abusive schemes promoted to sell unsuspecting buyer's on the benefits of the so-called "412(i) Plan," the IRS issued a regulations and other guidance aimed at shutting down plans using these abusive schemes.
Post this guidance, the promoters modified their life insurance policies to conform to the new rules; however, that has not stopped them from continuing to sell these plans to the uninformed, a practice which in and of itself, might be considered abusive. We simply do not believe that these promoters have the expertise to determine if a defined benefit pension plan in any form or fashion is the appropriate plan type for their small business clients. We routinely receive calls from referring professionals inquiring relative to the applicability of a defined benefit plan for their small business clients. In the vast majority of instances, a defined benefit pension plan is simply not the proper solution.
The one thing for certain about the future is that it brings change. Therefore, the potential for change in the owner's desire for tax-sheltered benefits is a reality that must be considered during the planning process. In the context of a traditional defined benefit plan, a change of this nature could lead to a cutback in benefits to mitigate plan costs. It might even necessitate the termination of the plan resulting in a distribution of the owner's accrued benefit into an IRA. In the context of a fully insured defined benefit pension plan under §412(i), changes in the plan's benefit structure or plan termination could leave the small business owner with the continued expense to maintain a superfluous life insurance policy or an unanticipated taxable event.
Using a §412(i) plan in the context of an owner only business with a legitimate need for the death benefit protection provided by life insurance may be an appropriate place for this plan type. However, we believe that until such time that there is no estate tax due after death (as current law dictates for the year 2010 only), a traditional defined benefit plan along with a conventional life insurance policy held within an irrevocable life insurance trust (ILIT) is a more prudent choice for the small business owner. While this plan design may cost more than a 412(i), it provides the small business owner with a significantly higher probability for a positive outcome and the flexibility to address change in the future.
Bottom Line on 412(i) Plans for Small Businesses In theory the §412(i) plan provides a small business owner with a retirement plan that provides significant benefits on a tax deductible basis absent the complications typically associated with a traditional defined benefit pension plan. In reality, this plan type is rarely appropriate for owners of small businesses.
See March 28, 2003 article: 412(i) Plan: A “Dream” or "Nightmare" for the Small Business Owner?
Closing Commentary We routinely receive inquiries relative to the viability of a "401(k) plan" for an owner-only business. In many instances, a SEP or SIMPLE IRA plan is the appropriate plan. In other instances, the business owner or advisor believes that a so-called "Keogh," SEP or SIMPLE is the right plan when a 401(k) or a Defined Benefit Pension Plan is appropriate.
We received a call from an advisor asking if his 52 year old owner-only client has the right plan. The owner-only client earns in excess of $300,000 per year and currently sponsors standardized prototype money purchase pension and a profit sharing plans provided at no cost by the institution that employs the advisor.
We suggested that the advisor's client did not need the money purchase pension plan. We also offered that a profit sharing plan with a 401(k) feature would allow his 52 year old client to contribute $46,000 in 2005 and $49,000 in 2006, and that a defined benefit plan along with a 401(k) plan would permit the client to contribute as much as $187,000 per year in 2005 (higher in the following years based on preset increases in the 401(k) and "catch-up" limits, and cost-of-living adjustments to the maximum contribution/benefit limits).
We discussed that each of these plans required a fee to establish the plan and an ongoing fee for the annual compliance requirements. The advisor stated that he saw no reason for his client to pay a fee to establish a plan especially since his client was not interested in contributing more than $42,000.
We didn't want to insult the advisor by pointing out that his client already had a plan that permitted a $42,000 contribution but we did ask: "Why doesn't your client use a SEP plan to avoid the compliance and reporting requirements associated with a qualified plan?" A moment of silence was followed by: "I thought the SEP only allowed a 15% contribution . How is it possible for my client to contribute $42,000 to a SEP?"
If you are not aware, the SEP contribution limit was increased to 25% in 2002. We did not create this story to illustrate the point of this article, we wrote the article because of this story.
Selecting the wrong plan that limits the owner-only plan sponsor from making a higher deductible contribution can translate into the loss of hundreds of thousands of dollars at retirement.
Bottom Line Even the "Simplest" plans are not really all that simple to understand and operate in accordance with the rules. Before you choose a plan, consider all available options and weigh all costs (including the cost of losing future benefits at retirement).
As a business owner, be mindful that low cost plan providers typically do not help you consider all of the choices, and.... Be mindful that if you do obtain a plan from them, the odds are it's the wrong plan. So you save fees but typically lose the assurance of a compliant plan that affords higher tax deductible contributions and increased benefits at retirement.
As an advisor, learn that working with a knowledgeable pension professional is good for both you and your clients, and.... Be mindful that if your clients learn this elsewhere, they may be looking for something other than just the optimum plan.
Learn more about qualified retirement plans for owner-only businesses
Learn more about the "The Mini(k) Advantage"
Access case studies for owner-only businesses
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The information provided is intended as a general resource, not as investment or retirement planning, or legal plan compliance advice or counsel. If you consider any actions discussed in this update, we suggest that you consult a qualified planning, tax or ERISA professional. ERISA Expertise LLC and Barry R. Milberg do not warrant and are not responsible for any errors and omissions from this update. Any tax advice included in this written or electronic communication is not intended or written to be used, and it cannot be used, by the taxpayer for the purpose of avoiding any penalties that may be imposed on the taxpayer by any governmental taxing authority or agency.