When asked why they haven’t set up a retirement plan or made much use of their existing plan for themselves, a common response I often get from business owners is that it’s not worth the hassle. A follow up question I typically ask is why they view retirement plans as a hassle. The answer is always the same: it’s too costly, too cumbersome, their employees don’t care about saving, or they don’t want the responsibility. Yes, a retirement plan is technically an employee benefit and some business owners are more focused on protecting their own interests than paternalistic values. But retirement plans can also be a lucrative vehicle for the plan sponsor and in many cases employee satisfaction and retention is a side effect or added bonus.
Financial advisors who share the “hassle” mindset are missing opportunities to offer their clients valuable financial planning strategies. Not only that, but financial advisors who have a narrow focus or service offering which does not include offering small business owners retirement plans are missing out on sticky revenue and a never-ending pipeline of leads via ancillary business. So why aren’t more financial advisors discussing retirement plans with their clients? Why are they defaulting to recommending SEP and SIMPLE IRAs? The feedback I typically get is because they lack the expertise, retail IRAs are quick and cheap to establish, they want the path of least resistance, retail business has a shorter sales cycle and offers more immediate revenue.
Before I had the opportunity to gain an understanding of retirement plan design and the many benefits, this was my perception as well. What I have learned is that setting up a retirement plan can be surprisingly painless and rewarding. Most of the time when I assist an advisor in setting up a plan they are surprised to see how easy the process was and they are eager to do it again. I’d like to share five reasons to get out of your comfort zone and consider designing a retirement plan for your company or discussing retirement plans with your small business owner clients:
- Tax savings. A business owner can defer up to $55,000 per year into a 401(k) plan between their own deferrals and company contributions. Individuals who are aged 50+ can defer an additional $6,000 in catch-up contributions. If we tack on a cash balance defined benefit plan, we are looking at up to a quarter of a million or more in tax-deductible deferrals. What’s the catch? The IRS and DOL don’t want employers setting up plans solely for their own benefit, so business owners maximizing tax potential for themselves typically involves giving their employees a little something. The good news is the IRS and DOL also understand the income replacement ratio is significantly higher for highly compensated individuals than it is for rank-and-file employees. Thus, they offer levers business owners can pull which allow them to maximize what they pay themselves and minimize what they’d need to offer employees. The beauty of it all is that everything the employer defers for themselves, gives to employees, and every plan associated cost is a tax-deductible expense. TPA firms like TRA know all of the levers available and as plan design experts it is our goal to help a plan sponsors create the most optimal plan for the business. My favorite scenario is when the tax-savings by far exceeds what the business owner pays their employees in matching and profit sharing. Everyone wins!
- Succession planning. The aforementioned levers tend to work most in the favor of those business owners who are closest to retirement. A 401(k)/cash balance combo plan can allow a business owner nearing retirement to defer a very substantial amount of cash from their business. Not only will a business owner be receiving tax deductions for “super-funding” their retirement each year as they grow closer to transitioning their business, by moving large sums of cash from their business to their personal savings they are essentially decreasing the sales price of their business. This means whoever intends to buy them out is borrowing less and they are paying less taxes on the sale than they would have otherwise. Those within 3-10 years of retirement are great candidates for such a strategy.
- Protection from creditors. I often hear business owners say they aren’t interested in using a retirement plan for their succession strategy because they plan to sign the company over to Jr. and live off of income from their company in retirement. The problem with this idea is that the business owner (and their spouse) are betting their financial survival in retirement on the furthered success of their company. ERISA protected retirement vehicles are one of very few vehicles available which are sheltered from creditors and bankruptcy. Business owners who are in a highly cyclical or risky profession (i.e. surgeons, construction, etc.) need to make sure they have a nest egg on the sidelines which is off limits to business risk and other liabilities. (Sorry, ERISA doesn’t protect you from ex-spouses).
- Line of credit. I recently worked with a small business owner who decided to develop a software company as a side business to ,his consulting firm. He was frustrated because lines of credits were high interest and cumbersome to obtain since he lacked a track record or tangible collateral. Angel investors wanted equity he wasn’t interested in sharing. He was pleased to learn that he and his wife could each borrow up to $50,000 from their 401(k) plans for a total line of credit of $100,000. They now use this line of credit to make ends meet between projects and pay themselves back with interest. If a business owner is apprehensive about funding up their retirement plan, perhaps knowing they can use it as a line of credit will help them sleep a little better. Over the long-term, market returns in a retirement plan and tax savings will serve them well vs. letting their funds sit in cash to be eaten away by inflation. It is worth noting this loan feature is not available on SEP or SIMPLE plans.
- Roth/estate planning. Another great perk of a 401(k) plan is that income limits do not apply to Roth contributions. If a highly compensated person wanted to, they could put $18,500 per year + $6,000 catch up into the Roth. This is a very nice feature for younger professionals with a long time for tax-free compound earnings, and a great feature for those who want to avoid RMD’s in retirement. A lot of individuals like to use Roth monies to pay their kid’s college tuition or to let it grow in perpetuity for their heirs. Roth IRAs might not otherwise be accessible to those whose earnings are too high. Similar to loans, the Roth feature is not available with SEP or SIMPLE plans.
The reality is, when a retirement plan makes sense, a well-designed plan should save a plan sponsor money and provide the business owner with more benefits than drawbacks. The industry has evolved and Third Party Administrators like TRA and record keeping platforms we partner with have many resources available to help educate plan sponsors and advisors, and reduce administrative and fiduciary burdens for them. Similar to a CPA or estate planning attorney, financial advisors should work in partnership with trusted retirement plan professionals who can help them navigate through the process of establishing and managing retirement plans. Doing so is in the best interests of their clients as well as the development of their practice.
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