Small Business Owners

Pension Planning for Small Business Owners

On this page, you can find some general information on how to handle retirement planning for your small business.

Types of Retirement Plans

Defined Benefit Plans

Defined Benefit Plan

A Defined Benefit Plan is a retirement plan that provides guaranteed retirement benefits to the owners and employees of a company, provided annual premium contributions have been funded. The plan may be funded with, but not limited to, life insurance and annuity contracts.

Fully Insured Defined Benefit Plan

A 412(e)(3) Fully Insured Defined Benefit Plan is a retirement plan that provides guaranteed retirement benefits to the owners and employees of a company, provided annual premium contributions have been funded. The plan is funded solely with life insurance and annuities, or annuity only contracts, offering minimum guaranteed interest rates.

Cash Balance Plan

A Cash Balance Plan is a defined benefit plan that provides benefits to participants in the form of hypothetical account balances normally stated as a dollar amount or a percentage of compensation. Each year, eligible participants receive their benefit in the form of a pay credit and an interest credit that is added to their hypothetical account. However, the plan is still funded like a traditional defined benefit plan with funds going into a pooled account.

Defined Contribution Plans

Profit Sharing Plan

A Profit Sharing Plan is a defined contribution plan in which the employer makes discretionary contributions. A key advantage is flexibility in determining the annual contribution. The maximum annual employer deduction for contribution is 25% of eligible compensation. There is also a maximum individual contribution limit. The individual limits are adjusted annually for cost-of-living increases.

401(k) Profit Sharing Plan

A 401(k) Profit Sharing Plan allows employees to defer a portion of their income (tax deferred) to the plan while also allowing the employer to fund a matching and/or discretionary contribution. The salary deferrals are always 100% vested. They are limited to the lesser of 100% of the employee’s compensation or the current year’s dollar limit. Participants age 50 or older may make an additional “catch-up” deferral. These thresholds are adjusted annually for cost-of-living increases. A matching contribution by the employer may be included based on the salary deferrals. The matching allocation formula varies according to the employer’s funding objectives and may be discretionary. Highly compensated employees’ deferrals may be limited, and retirement benefits are impacted by investment returns. 401(k) Plans also must satisfy nondiscrimination testing requirements.

Safe Harbor 401(k) Profit Sharing Plan

The Safe Harbor 401(k) Profit Sharing Plan is designed to eliminate the nondiscrimination testing imposed by traditional 401(k) Plans and allow every participant, including the owners, to defer up to the maximum limits. In order to maintain the “safe harbor” status, the employer must make a 100% vested “safe harbor” contribution with one of the following two options: a 3% of compensation contribution to all eligible employees; or a matching formula equal to 100% of salary deferrals up to 3% of compensation and 50% of salary deferrals between 3% and 5% of compensation. Retirement benefits are impacted by investment returns.

Elements of Retirement Planning

Tax-Deductible Premiums

Because the premiums are generally tax-deductible, it can be a cost-effective method of purchasing life insurance

Income Tax Advantage at Death

Policy proceeds in excess of the policy’s cash value are tax-free to the policy beneficiary at death

Reduced Personal Expense

Using life insurance as a plan funding option may reduce the need for participants to spend personal income on insurance premiums.

Pre-Retirement Death Benefit

Life insurance within a qualified plan can provide additional protection to the participant’s family if the participant dies prior to retirement.

Easily Understood Benefit

Life insurance provides a tangible benefit to eligible employees, including those who are just starting out or those with minimal accrued benefits.

Conservative Plan Funding

Compared to more aggressive options, using life insurance is a conservative approach to qualified plan funding.

Guaranteed Issue and Simplified Issue

Participants with health concerns may be able to purchase a limited amount of guaranteed or simplified issue insurance.

Questions and Answers

Q: How is a traditional profit sharing plan contribution allocated among the employees?

A: Generally, all employees receive the same percentage of salary as their share of the contribution. No particular employee can be favored because of their salary level, age, length of service or contribution to the profits of the business.

Q: What is a cross-tested profit sharing plan?

A: Cross-tested allocation formulas may be based upon age or classification groups. Nondiscrimination is tested by comparing benefit projections of participants rather than contribution levels. Thus, participants are not allocated the same percentage of salary.

Q: What is a cross-tested age-weighted profit sharing plan?

A: A plan allocating the contribution on the basis of age that favors older employees.

Q: What is a cross-tested classification group profit sharing plan?

A: This type of plan allows more flexibility than an ageweighted plan. Employees are divided into classification groups and each class may receive an allocation different than the others. Two or three groups may be created with each group receiving a different allocation. The advantage of this plan design is the allocation flexibility previously unavailable within a traditional profit sharing plan.

Q: Can a firm change an existing traditional profit sharing plan to a cross-tested plan?

A: Yes. Usually the plan can be amended to change the allocation formula to a cross-tested plan. The existing plan is not terminated, only the method of allocation is amended.

Q: Should every existing profit sharing plan change to a cross-tested plan?

A: Whether a cross-tested plan would be appealing to a business depends upon two factors. The objective of the employer is of primary importance. If the owner wants all employees to receive the same percentage of pay as their share of the profit sharing contribution, then a traditional plan will accomplish this. If, however, the owner prefers that not everyone receive the same share, the options available under these plans are significant.