Despite negative publicity stemming from stock market losses and the Enron fiasco, qualified plans remain an integral part of any business operation. Recent tax law changes have made qualified plans more attractive by increasing contribution and deduction limits and reducing red tape, making it easier than ever for employers to sponsor a retirement plan.
Let’s revisit the fundamental reasons that make a qualified plan essential for almost every business and every employee. In other words, let’s review why a qualified plan is essential for effective compensation planning and put the proper perspective into decision making.
Because they involve front-end, accumulation and back-end tax advantages, qualified plans are the most effective way to save for retirement (unless, of course, you have a system to win the lottery!). On the front end, employees have the ability to put away money before taxes (or have it put away on their behalf). This is analogous to receiving an interest-free loan from Uncle Sam because employee accounts earn interest on money that might otherwise be lost to the IRS. The amount of the “loan” for an individual in the 38% federal, state and local tax bracket is 38 cents for every dollar saved.
During the accumulation phase, qualified plans enjoy tax-deferred earnings. In other words, qualified plan investments earn interest and appreciate without being subject to taxation in the year any gain occurs. In effect, the ability to compound interest without paying taxes raises the rate of return earned on plan investments.
When distributions are required to be made at the back end, rollover options, which prolong qualified plan tax advantages, are available. In addition, annuity payouts over a person’s lifetime extend payback of the interest-free loan.
To encourage low- and moderate-income workers to save for retirement, the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”) introduced a tax credit available from 2002 through 2006 for employee contributions to 401(k) and other employer-sponsored retirement plans, including voluntary after-tax contributions. The maximum annual contribution that is eligible for the tax credit is $2,000. The credit ranges from 10% to 50% of the contribution, depending on the participant’s adjusted gross income, and is phased out for joint and single incomes of over $50,000 and $25,000 respectively.
Besides meeting the retirement needs of employees, qualified plans solve a number of operational problems for the business. Although these solutions don’t show up on the balance sheet, the following are key ingredients in a company’s fiscal success:
Managers contend that the compelling reason for the salary levels and other employee benefits they offer is local and industry standards. The same logic holds true for private pension programs. In other words, if the local pay scale calls for X amount in salary to attract and retain employees, it also calls for a certain level of retirement benefits. Employers who ignore what the competition is doing with their retirement programs soon become noncompetitive.
Perhaps the most important role of retirement plans is not to attract but to retain employees. If they are well designed and correctly implemented, retirement plans can be a primary reason for staying with a particular company. In this age of job-hopping and multiple careers, a soundly structured pension program may be the employer’s best recourse against the loss of experienced personnel.
Numerous studies have shown that profit sharing plans and stock ownership plans both increase employee identification with the corporation and provide an incentive to increase productivity. A highly visible qualified plan can do wonders for employee morale, can improve workers’ attitudes toward authority in the work environment, and may be the best management tool available for turning the corner on important projects or getting through crucial times.
Employers face a common problem dealing with the employees who outlast their usefulness. Such employees have been there “forever” and are highly compensated, but productivity does not warrant the high salary. Since it is not considered valid business practice to dismiss long-time employees who are not economically productive and since personal affection and respect may keep an employer from demoting these employees, an alternative solution is necessary.
With sound plan structure early retirement can be made attractive. If handled properly, a potentially uncomfortable situation can be turned into a mutually beneficial solution through the use of the qualified retirement program.
Some employers desire to provide economic security for retired workers despite the lower profit margin that may result. Traditionally the retired worker could rely on social security and private savings as well as a company pension. These employers, however, feel a need to beef up the company pension because they fear for the future existence of social security (at least in its current state), and they recognize that we have become a society of spenders and not savers.
Some business owners believe that the answer to the high cost of covering all employees in a qualified plan is a nonqualified plan for selected executives. While a supplemental nonqualified plan is often desirable, consider, however, the following:
- In contrast to a qualified plan, a nonqualified plan cannot simultaneously give the employer the benefit of an immediate tax deduction and give the employee the benefit of tax deferral. Most nonqualified deferred compensation plans postpone the employer’s deduction until the benefit is paid as retirement income for the executive. In addition, earnings on money put aside to fund the plan will be taxed in the year realized unless a tax shelter is used.
- Funded nonqualified plans have a hidden cost–the cost of deferring a deduction. There is no easy way to predict the employer’s cost for deferring the deduction because of the interest and time assumptions that must be used (not to mention potential shifts in tax rates). But suffice it to say that for many companies it costs well over $1.50 to provide $1.00 in benefits.
- Many business owners mistakenly believe that implementing a qualified plan will be a windfall for rank-and-file employees. This commonly held opinion is correct only if benefits are an increase to the overall compensation package. If benefits are a piece of what is already being paid to an employee, however, employer costs are not increased. In other words, the employer should focus on how employees are paid, not how much he or she pays them.
Business owners have special needs and concerns when it comes to planning for their retirement and running their business, including:
It’s important to remember that employers are also employees. These taxpayers are excited about the qualified plan tax shelter not only because it provides big-dollar savings, but also because in the current legislative environment of “tax-shelter takeaway,” qualified plans remain one tax shelter that’s likely to be here today and here tomorrow.
Qualified plans are also appealing because they solve liquidity problems that often occur at retirement or death. Small business owners typically have a difficult time building personal liquidity. They are self-achievers and feel psychologically compelled to reinvest money in their “baby.” Since his or her “money personality” tends to be more of a spender than a saver, the savings that occur through a qualified plan may represent the business owner’s only cash available at retirement or death. Thus the qualified plan may be essential to the continuation of the business after death or retirement.
Federal pension law generally forbids the assignment or alienation of pension benefits. Federal bankruptcy law, however, does not specifically exempt pension assets from the bankrupt estate. The United States Supreme Court, in the case of Patterson v. Shumate (112 S. Ct. 1662 (1992)), granted protection for benefits in qualified plans, declaring that such benefits would be excluded from the bankrupt estate.
This is great news for the small business owner who can protect himself from financial ruin (in case of business failure) by accumulating assets in a qualified plan.
In addition to the corporate deduction for plan contributions, a corporation might also be able to remove corporate assets from the accumulated earnings tax. By shifting corporate assets into the qualified plan, the corporation can overcome the suspicion of storing undistributed dividends to avoid current taxation, while at the same time accomplishing this very objective.
Qualified plans are an important piece in the puzzle of retirement security. Consider the following factors facing the retiree:
- Experts estimate that Americans will need 60% to 80% of their preretirement income to maintain their current standard of living when they stop working.
- Because life expectancy is increasing and retirement is starting at an earlier age (average age 62), more pressure is being placed on financial resources.
- Inflation shrinks an individual’s purchasing power and makes it difficult to maintain the preretirement standard of living. A person who needs $2,000 a month at retirement will need $6,487 a month 30 years later to maintain the same purchasing power (4% inflation).
- Social security started out by having 43 workers per retiree; by the year 2030 there will be only 2 workers per retiree.
- Health and long-term care costs are skyrocketing beyond the reach of the majority of retirees.
- Spendthrift lifestyles, emergency expenses, other long-term financial goals such as education funding, divorce and other distractions make it hard for retirees to maintain economic self sufficiency.
To encourage the establishment of new plans by small businesses, last year EGTRRA introduced tax incentives for new plans effective after December 31, 2001. Small employers will be eligible for a federal income tax credit of up to $500 for each of the first three years against the cost of setting up the plan and educating the employees. This credit is available to employers with 100 or fewer employees and who have not sponsored a plan for the same employee group for at least three years. The plan must cover at least one non-highly compensated employee.
Qualified plans make sense! In addition to helping business owners and employees, recent tax law changes have made it easier than ever to sponsor a retirement plan.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.