We met “Luis” during the meet-and-greet following a chamber of commerce sponsored event for member business owners. My team and I had been part of an expert panel talking about preparing a business for sale, but that wasn’t what was on Luis’ mind.
After introducing himself, Luis jumped right in, “My retirement isn’t going to come from the deep pockets of the buyers you and the other speakers talked about. Don’t get me wrong: it’s a great little construction business that’s given my family a good life and will put three kids through college. But I’ve got to sock away more cash than I’m saving right now. Any ideas?” We understood that Luis was really looking for an answer to a very common question: how do I choose a retirement plan for my small business?
A Succession Plan Isn’t Always the Answer
We have lots of ideas about retirement plans and told Luis, “Many of the owners we work with—especially those who own smaller businesses—create retirement security using retirement plans—not succession plans. Let’s set up a time to talk. Bring in an employee census (employee date of hire, salary and age), and we’ll see what your goals are.”
We met with Luis about two weeks later. During that time, we could tell that Luis had done some online research. “I’ve learned that there are some plans that allow me to put away pre-tax dollars, but force me to put away equal amounts for my employees,” Luis said. Maybe we need to look at something else. Maybe lottery tickets!”
“Let me stop you right there,” I said. “Yes, some retirement plans are better—from a tax standpoint—than others. But no, all plans do not require you to match the amount you put in for yourself with what you put in for your employees.” Luis visibly relaxed.
“Let’s look at your employee census.”
- Luis was 52.
- His wife (Sonja), also active on a part-time basis in the business, was 49.
- In addition to Luis and Sonja, there were 48 other employees.
- The three senior members of Luis’s management team—all project managers—were in their early 30s.
- The other 45 employees ranged in age from 19 to 40.
- Of the 45 non-management employees, very few had been with the company longer than three years.
Two Types of Retirement Plans: Choosing One for Your Small Business
We explained to Luis that there are two basic types of retirement plans: qualified and non-qualified. In terms of tax:
- Contributions to qualified plans are immediately tax-deductible. If an employer makes the contribution for an employee, the employer receives the tax deduction. In return for this tax treatment, plans have to meet guidelines (related to the employee age, income, etc.) in the US Tax Code. Common qualified plans are 401(k), defined benefit and cash balance plans.
- The taxes on contributions to non-qualified plans are deferred. Non-qualified plans are not governed by ERISA (Employee Retirement Income Security Act) and include deferred compensation and executive bonus plans.
Each type of plan has its own advantages and restrictions so rather than bore Luis with long descriptions of each, we started with his goals: How much money did he need to have in the bank when he left his company? To calculate that, we needed to know the:
- Current value of Luis’ business and non-business assets.
- Date that Luis hoped to retire.
- Likely value of the couple’s assets on Luis’ retirement date.
- Life expectancy of both Luis and Sonja.
- Rate at which Luis and Sonja could safely withdraw money from their nest egg.
“Wait a minute,” Luis said. “I thought we were going to talk about choosing a retirement plan!”
“We are. Well, we will,” I responded. “We’re happy to give you a long or short tutorial on the ins and outs of all the possible retirement plans, but until we know what you and Sonja need when you retire, and more importantly, how the two of you want to live, we can’t tell you which plan is best for you.”
“I get it,” said Luis, “but I’ll need to bring in Sonja for that meeting. Today, can you just give me quick idea on how one of these plans might work in my company?”
Taking a Peek into Profit Sharing Plans as a Retirement Plan Option
“Sure. Let’s look at a profit sharing plan that’s just one type of a defined contribution plan. These plans are cheaper to set up and maintain than defined benefit plans—although defined benefit plans are great for older employers who need to make massive contributions before they retire,” we explained.
Luis laughed, “I’m beginning to see why there’s more to this than just spinning a wheel and picking a plan! So, tell me about a profit sharing plan.”
“Let’s say that you are age 50 and make $200,000,” we began. “Your three project managers are 30 and make $100,000 each. You want to contribute 20% of your salary (or $40,000) to your plan account. Well, a 20% contribution to your project managers’ accounts would be $15,000 or $5,000 each.”
Luis jumped in. “I thought you said that there were plans that didn’t force me to match my contribution to my employees’!”
I continued, “I did. Matching is what you’d have to do in a traditional profit sharing plan, but not in an age-weighted profit sharing plan.”
Luis threw his hands in the air. “That’s it! I give! This is impossible without knowing how much Sonja and I need when we retire.“
Luis was exactly right: choosing a retirement plan without knowing exactly what you need that plan to accomplish makes no sense.
Starting with Your Goals When Choosing a Retirement Plan for Your Small Business
What’s the best retirement plan for Luis? How does he know which retirement plan to choose for his small business?
The better question: what’s the best retirement plan for you? The answer depends entirely upon your goals, preferences and unique situation. Talk with a business planning expert today to get started on your future!