Today’s post is the last of our case study series, where we’ve showcased the many creative solutions you can take when you’ve landed clients with complex planning issues. Here, we’ll explore retirement plan options for small business owners.
We introduced your new clients, the Thompsons, in a previous post. In terms of their retirement plan needs, here’s what else you need to know:
- Brothers Ed and Bill Thompson have a 401(k) plan for their business, Thompson Electric.
- Ed and Bill are working on their exit from the business, so they’ve decided to undertake a comprehensive review of their plan to see if there are any options for potentially increasing their retirement savings. Part of this review is about what is best for Ed and Bill. It should also address options that will benefit Ed’s sons, Chase and Ryan, as they move into ownership positions, as well as other members of the extended family.
Let’s look at what retirement plan options you could present to these small business owners, starting with a review of their existing plan.
Review the Existing Profit-Sharing Plan
You learn that Thompson Electric has been making consistent contributions to its profit-sharing plan over the years. As such, it makes sense to take a closer look at the methods used to calculate the profit-sharing amount. Keep in mind that many owners think they’re required to give their employees the same amount as they receive. But there are a number of testing methods, including age-weighted and new comparability testing, that would allow the allocations to skew toward the owners and more senior personnel at Thompson Electric.
A good third-party administrator can help the Thompsons with different testing results and ongoing support. If they have not done so already, you could also suggest that they add a vesting schedule to the profit-sharing plan to reward longtime employees and reduce obligations to employees with short work tenures.
Add an After-Tax Contribution Option to the 401(k)
One strategy the Thompsons may want to consider is the addition of an after-tax source to their 401(k) plan. This would allow employees to contribute more than the IRS 402(g) limits ($18,000, or $24,000 with a catch-up, for 2017). For key and high-income employees who have exhausted their pretax and/or Roth 401(k) contributions, this is often an effective solution. With the ability to make after-tax contributions, these individuals can save up to the IRS 415 limits ($54,000, or $60,000 with a catch-up, for 2017).
As an added benefit, after-tax contributions (cost basis) can be rolled into a Roth IRA, making future withdrawals tax-free, instead of tax-deferred. In addition, the earnings associated with the after-tax contributions can be rolled into a traditional IRA. Keep in mind, however, that the after-tax source is subject to discrimination testing, even if the plan follows safe harbor rules.
Discuss the Cash Balance Plan
Cash balance plans are defined benefit pension plans that represent a significant benefit for business owners who want to defer compensation beyond the limits of a defined contribution plan. Most cash balance plans are designed to increase contributions for owners/key employees as they approach retirement. The average life span of a cash balance plan is seven to ten years.
Ed and Bill are both within a couple of years of retirement, so this may not be the optimum vehicle for them because of the associated cost and funding requirements. But a cash balance plan may be something to keep in reserve for Ed’s sons, Chase and Ryan. They will be taking over the business in a few years and will certainly be looking to increase their retirement savings later in their careers.
Other Retirement Plan Options
Backdoor Roth. For all parties involved, a backdoor Roth IRA may be an effective long-term tax savings strategy. With a backdoor Roth, individuals who earn too much to contribute to a Roth IRA can instead contribute to a traditional IRA and then convert that amount—in some cases, tax-free—to a Roth IRA. This strategy is complex, so it’s important that you understand the rules and evaluate each individual and situation separately.
For example, Ed’s wife, Janice, has a sizable rollover IRA ($650,000) from a previous employer. Here, the backdoor Roth strategy may not be advantageous due to the tax implications and her income bracket. For Ed and Janice’s children (Chase, Ryan, and Katherine) and for Thompson Electric’s key long-term employee (Tony), however, the strategy may be sound. There would be a number of options to consider, including:
- Current access to a company retirement plan and if that plan has an employer match
- Current salary and tax bracket versus future earnings potential and tax bracket
- Other IRAs or IRA-based retirement plans that the individual may hold
- Vesting schedules associated with current workplace retirement plans
Rollover strategies. If Janice were to roll her existing IRA into her 401(k) with her current employer, she could delay required minimum distributions for this IRA at age 70½ if she were still working. Keep in mind that the rollover into the qualified retirement plan would need to happen the year prior to the year the client turned 70½.
Increasing contributions at bonus time. Ryan and Chase should also look to increase their 401(k) contributions at bonus time to help alleviate the higher tax rate that often affects employee bonuses. Most companies allow employees to modify their 401(k) deferral percentage if or when bonuses are paid.
What’s the Goal?
The above-referenced retirement strategies can be a great starting point to the retirement plan discussion when you have clients who are small business owners. By first understanding their retirement goals, you can then help them find the appropriate solution and work toward the retirement vision they’ve worked so hard to achieve.
What other retirement plan options do you offer to your small business owner clients? Have you successfully formed relationships with third-party administrators? Please share your thoughts with us below!
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.