YOUR MONEY
Key
Considerations Regarding Money Purchase
and Profit Sharing Plans
Today, more than 60 percent of small business owners don’t
offer any retirement plan for their employees and 47 percent
are unsure about how they plan to handle their own retirement,
according to a survey by Harris Interactive for ShareBuilder,
an online brokerage company. Planning on working until you
drop or relying solely on the sale of a business is a dangerous
tactic. If you don’t have a reliable retirement plan
in place or one that’s outdated, it’s time to
re-evaluate your retirement strategy.
In previous articles I addressed the more common types of
pension plans available to small business owners and examined
their individual merits. Most companies have moved to these
newer retirement plan options. However, I have found a few
small business owners that still have an older money purchase
plan in place. Some business owners aren’t familiar
with tax law changes related to pensions (a clear downside
to neglecting ongoing financial business planning). Other
business owners simply haven’t taken the time to re-evaluate
their pension plan options.
In what now seems like the distant past (before 2002), a money
purchase plan offered the highest contribution percentage
(limit) of any defined contribution plan type, including profit
sharing, 401(k)s, SEPs and others. With a money purchase plan
a fixed percentage contribution was required annually; otherwise,
“underfunding” penalties were incurred. For example,
let’s say that your money purchase plan was designed
for 10 percent of each eligible employee’s annual pay.
You, as the employer, would need to contribute 10 of each
eligible employee’s pay to his or her pension account.
Most small businesses looked at this as an annual liability.
In order to maximize the contribution and minimize the liability
of the small business, the “paired plan” concept
was invented.
The pros and cons of the paired plan
A paired plan combined a 15 percent discretionary
profit sharing plan contribution with a 10 percent required
money purchase plan contribution. The small business then
had some flexibility. In a profitable year, the maximum 25
percent (15 percent + 10 percent) could be contributed for
each employee. (For this example, I’m intentionally
assuming there was no vesting schedule and that all employees
were fully vested.) In a less profitable year, the company
could change its discretionary profit sharing contribution
to 0 percent, and was required to contribute only the 10 percent
money purchase amount. In this situation, the Keogh Plan allows
but does not require annual contributions of up to 25 percent
of earned income.
This paired plan method created flexibility with limited liability.
There were drawbacks, however. The two plans cost the business
owner more to operate because they require separate maintenance,
including necessary employee disclosure and additional government
reporting.
After 2002, when the government increased the maximum profit
sharing contribution to 25 percent, the paired plan strategy
lost much of its appeal. With the tax law changes eliminating
the need to maintain two plans, the money purchase plan became
much less popular. The flexibility enjoyed by companies with
paired plans is now available with the profit sharing plan
because the total contribution percentage (limit) is discretionary.
For 2008, the 25 percent contribution is capped at $46,000.
In fact, the increase in the profit sharing contribution may
now allow employers who still have money purchase plans to
terminate those plans and eliminate the associated liability.
Money purchase plans are
attractive to some employees
If you still have a money purchase plan you may want to
consider keeping it in place. Say you are a small business
owner who has reliable profits from year to year and you
want to attract new employees from large corporations. The
prospective employee may be used to receiving large benefits
from a big corporation. Having a money purchase plan could
be a strong selling point for attracting job candidates
who are used to having a company-contributed type of pension
plan and enjoy the retirement security it offers. They might
find it quite appealing if you guarantee a fixed employer
contribution. The plan costs are also tax deductible for
the employer up to 25 percent of total payroll compensation
(subject to individual limitations), and plan earnings are
tax deferred.
Plan conversion considerations
If you have a money purchase plan and want to convert to
a plan that offers you more flexibility, you must handle
the conversion properly to avoid unwanted tax consequences.
As with any pension plan change, you should discuss this
with your financial planner (who should be a CPA) and with
a pension plan administrator or attorney. Also, remember
that plan termination or merger requires distinct government
reporting.
The rules regarding employer-sponsored
retirement plans are complex and easy to misinterpret. Even
after you've selected a specific type of plan there’s
frequently a number of options in terms of how the plan
is designed and operated. These options can have a significant
impact on the number of employees that have to be covered,
the amount of contributions that have to be made, and the
way those contributions are allocated.
I can’t stress enough the importance of having a qualified
financial advisor to run the numbers and help determine
the best pension plan for your company, whether it be a
defined contribution plan, defined benefit plan or combination
of both. In fact, without running the numbers every two
or three years you could easily miss opportunities to save
more money. So, if you haven’t reviewed your pension
plan in the last few years I recommended you do so. I find
that there are many creative ways for you, the small business
owner, to create more wealth with proper pension planning,
and the rules governing them change frequently.
If you think that you may be paying more than need be in
taxes and feel that you aren’t putting enough money
away for retirement, having a strategic pension planning
session with your financial planner should be added to your
“To Do” list.
Guy McPhail, CPA, CFP®, is president of Zdenek
Financial Planning, LLC.
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