- Reason One: Tax Savings
- Reason Two: Effective Business Operation
- Reason Three: Nonqualified Plan Problems
- Reason Four: Advantages for the Business Owner
- Reason Five: Making Retirement Affordable
- Small Employer Tax Incentives for New Plans
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
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
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
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
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
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
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
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
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
- 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
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.
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