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One of the benefits of owning a business is that you have tax-favored options to save for retirement that non-business owners don’t have. Your business can sponsor a qualified plan which may be designed to drive the majority of the benefits to you. This is a classic way to shift business dollars to you for retirement.
|Qualified Plan Decision Tree
Benefits of a qualified plan include:
- Contributions to the plan are tax deductible to the business.
- Contributions are not currently taxable to the participants.
- Contributions made on behalf of employees can be paid with dollars that would have otherwise been spent on taxes.
- Earnings on contributions grow tax deferred.
- Qualified plans are protected from creditors.
- Provides a valuable benefit to employees and helps to attract and retain employees.
- Taxation of benefits are deferred until taken in the future.
With defined contribution plans, you define how much money you want to contribute to the plan. What is available for retirement will depend on the contributions actually made and the earnings on those contributions.
With defined benefit plans, your retirement benefit is defined under the plan. (For example 75% of the highest five consecutive years' salary over the last 10 years.) The contribution amount will be based on a number of factors, including the benefit being promised, the number of years until retirement and an interest rate assumption.
Visit our Frequently Asked Questions.
Types of Defined Contribution Plans
There are many defined contribution plan options, but they generally fall into three distinct categories - profit sharing plans being one of them. One well known profit sharing plan type is the 401(k).
The General Advantages of Profit Sharing Plans:
- Allows you to change the plan contribution each year or even decide not to make a contribution in certain years.
- You can establish eligibility requirements that employees must meet to receive a contribution.
- Can be designed to favor select employees, including you.
Within the Profit Sharing category there are a number of design options. Which profit sharing plan is best for your business?
- Traditional Profit Sharing - Everyone receives the same percentage of pay as a contribution. This plan is appropriate if only owners of the business are eligible to participate.
- Integrated Profit Sharing - Those employees earning over the Social Security wage base receive a higher percentage of the plan contribution than those earning under the Social Security wage base. This plan is appropriate if you are younger than most of your employees but earn a higher salary.
- Age-Weighted Profit Sharing - The majority of the contribution goes to those older employees who are closer to retirement. This plan is appropriate if you are older than your employees or if you want to favor older, long-time employees.
- Cross-Tested Profit Sharing - Allows you to place employees in different 'groupings' allowing you to allocate a higher amount of the contribution to yourself and a lower amount to employees. This plan is appropriate if you are five to ten years older than the average age of your employees.
No matter which plan type is right for you, your contributions to a profit sharing plan are always an opportunity, not an obligation. You have the flexibility to choose how much to contribute each year (within the limits placed on these plans by the tax code).
The advantages of 401(k) plans:
- Allow employees to save money for their retirement.
- Employee salary deferrals may be made pre-tax, post-tax, or a combination of both.
- Employees have flexibility in how much they contribute up to certain limits.
- Employers may choose to match some of the employees' contributions.
Within the category of 401(k) plans, there are a number of plan options. Which 401(k) plan is best for your business?
- Traditional 401(k) - does not require you to make a matching contribution, but it could limit how much you can defer.
- Safe Harbor 401(k) - does require you to make a matching or non-elective contribution, but it will enable you to defer the maximum allowed by law. With auto enrollment, employees are automatically enrolled and must elect not to participate if they do not want to defer. Auto enrollment can help increase the participation in the plan.
- Solo 401(k) - available for businesses that do not have eligible employees. This plan allows the business owner, and key/highly compensated employees, to make elective salary deferrals as well as employer profit sharing contributions. These plans can also be combined with a Defined Benefit plan to get the maximum tax-deductible contribution allowed by law.
The advantage of Defined Benefit plans:
- Allows for substantially larger, tax deductible contributions
- Retirement benefit is known in advance
Which Defined Benefit plan is best for your business?
- Traditionally Funded Defined Benefit Plans - this type of plan engages an actuary who, based on certain assumptions, determines how much money must be contributed to plan a fund the determined pension benefit. Plan formulas can be as simple as everyone received the same percentage of pay benefit of they can be designed to favor older employees or select groups of employees.
- 412(e)(3) Fully Insured Defined Benefit Plan - with this type of plan, instead of engaging an actuary to determine the cost to fund benefits, the cost is determined based on the guaranteed* values of an annuity and/or life insurance policy that must be used to fund the plan. This type of plan will generate a higher tax deductible contribution than a Traditional Defined Benefit plan. Because the plan formula for this type of plan is a percentage of pay benefit, the plan is not ideal for employers who have a number of employees who are the same age or same age or older than the owners.
Purchasing Life Insurance Through Your Qualified Plan
Planning for your retirement may also impact someone else in your life, such as a spouse or partner.
Life insurance can help “self-complete” your retirement plan, helping to make sure that your goals for their retirement can be met.
Buying life insurance inside your qualified plan may be an affordable, tax-efficient way of meeting both your business and personal insurance needs.
The advantages of purchasing life insurance inside your qualified plan include:
- Premiums are paid for with tax-deductible plan contribution dollars, freeing up personal dollars
- Should death occur before you've had time to accumulate your retirement account, the life insurance proceeds can help complete your retirement savings for your family
- At retirement, the policy can be transferred to you to personally own, providing continuous personal protection for you and your beneficiaries
How does life insurance in your plan free up money for you?
If you were to purchase the same amount of life insurance outside your qualified plan, you would need to gross up your income in order to net the same premium paid from qualified plan dollars.
For example, assuming you're in a 34% personal income tax bracket:
Out of Pocket:
Gross Amount to Pay Premium:
Net Amount to Pay Premium:
How it works:
- The policy is applied for and owned by your pension trust, however, you name who the beneficiary will be of the insurance proceeds
- A portion of your deductible plan contribution is used to pay the insurance premium
- The life insurance cash value is attributed to your retirement savings, and because it is accumulated using pre-tax dollars, is subject to income taxes when received either through distribution at retirement or upon death
- The death benefit in excess of the cash value is received by your beneficiary income-tax free
- Because your pension is providing a tax-free benefit to your beneficiary, you will need to pay a small annual tax on this "economic benefit" which may be recovered at retirement
- At retirement, the insurance policy can be transferred to you as part of your retirement distribution
- Once you personally own the life insurance policy, you may choose to access the policy cash value, through loans and withdrawals, to help supplement your retirement income**
If you have a need for life insurance, you may want to consider purchasing it through your qualified plan.
- * Guarantees are dependent on the claims paying ability of the issuing company.
- **Policy loans and withdrawals reduce the policy's cash value and death benefit and may result in a taxable event. surrender charges may reduce the policy's cash value in early years.
The companies of National Life Group® and their representatives do not offer tax or legal advice. For advice concerning your own situation, please consult with your appropriate professional advisor.