Hybrid Retirement Plans: Small & Medium Business Tax Champions
Some small to mid-sized business owners have been forced to decide between the cost of offering a standard retirement plan and the limited value it provides their own retirement needs. The standard 401k doesn’t allow small to mid-sized business (SMB) owners to save aggressively for their own retirement while deferring taxes on a reasonable portion of their income. Many business owners are relying on the value of their business, and the sale price it will bring at retirement, for their long-term retirement planning. Hybrid retirement plans offer an alternative solution.
Plan advisors can build a hybrid plan using more than one kind of standard plan element to benefit both owners and employees. These plans leverage the tax code to offer owners both a tax advantage and the ability to save a disproportionate amount over a short period of time. At the same time, employees of these small to mid-sized businesses get a plan and matching funds they didn’t have before.
Conventional Small Business 401k Plans
Conventional defined contribution 401k plans typically offer matching funds, and are required to treat all employees the same, no matter their compensation level. ERISA requires all companies offering a conventional 401k plan to ensure that their plan doesn’t favor highly compensated employees (HCEs). Essentially, this means that the C-Suite, because of its higher salaries, can’t contribute more to its 401ks, percentage-wise, than the rest of the employees. ERISA wants relative fairness. This effectively limits the tax-deferred contributions each HCE can make and requires certain plan participation levels among all workers.
Traditional IRS Limitations
The IRS says that employees of any income level under age 50 can only contribute $18,500 a year in 2018. Those over 50 can put in up to $24,500. Small business owners can implement a Safe Harbor plan that has a matching funds requirement that exempts the plan from actual deferral percentage (ADP) testing. But even then, owners and highly compensated employees can only contribute a maximum of $55,000 each tax year. For truly small businesses, the costs of matching, the costs of administration, and the limited contribution levels can outweigh the advantages of tax-deferred savings. Conventional 401k plans don’t work well for small and medium firms with a higher ratio of owners to employees. Owners have had few options that allow them to save aggressively for retirement or defer taxes on a reasonable portion of their income.
Does your 401k plan do anything else?
The owner of a small to mid-sized business, or the partners in a small firm, needs a 401k plan to do more than the ‘usual’. After years of delaying saving for retirement to build and invest in a business, the owner needs to save more, faster. How can the owner put a disproportionate amount in the 401k plan? If the typical 401k plan can’t support the owner’s retirement planning, then the non-owner employees often don’t get the benefit of a 401k plan at all. Fortunately, there are hybrid plans available for small to mid-sized businesses that combine elements of both pensions and 401ks. These plans allow more owners to help themselves and their employees save for retirement effectively.
Hybrid Plan Elements
A ‘hybrid’ plan can turbo-charge retirement savings for small to mid-sized business owners who are approaching retirement. A profitable business and the right plan can allow them to save large amounts of money tax-deferred over a handful of years before retirement. A plan advisor can combine elements of the following standard plans into a hybrid plan. This gives owners and HCEs a range of savings possibilities each year while increasing matching to non-HCE participants by a comparatively modest amount.
- A robust defined benefit plan
- A defined contribution plan with age-weighting
- A New Comparability plan
- A cash balance plan
For example, a 60-year-old business owner making more than $250,000 a year could save more than $256,000 a year tax-deferred, as long as they match 5% – 7.5% of the non-HCE participants’ savings. Other factors apply that may change these numbers, of course, including age, level of income from the business, consistency of cash-flow or profits, and number of plan elements combined. A plan advisor can expertly mix standard 401k plan elements into a hybrid retirement plan. A custom, hybrid plan can secure retirement for the small to medium business owner who wants both tax-deferred savings and the proceeds of from the sale of their business.