Most business owners have a dream. It’s to build a successful business, sell it for a zillion dollars and ride off into the sunset. The sad fact is that for the vast majority of business owners, this is just a pipe dream. In most cases, business owners will get less than 50 percent of their retirement income from the proceeds of the sale of their business—if they’re fortunate enough to sell it.
Many business owners have spoken with various advisors about diversification. Too often I see advisors warn owners how unsafe it is for the owner to have all of his or her assets tied up in the business. This conversation has merit, of course.
But, the conversation that resonates more is when I help owners understand that they won’t be able to leave their business if they think the business will provide all of their retirement income. This conversation always gets traction. If your client owns a business and employs fewer than 25 people, it’s very easy to design a retirement program that is almost irresistible for the owner.
It’s all about what the owner can get.
The first rule of retirement plan design is understanding that it’s all about what you, the owner, can put in your pocket. Most owners I know are also happy to include their employees when it makes economic sense to do so.
Let’s assume you are in a 37 percent marginal tax bracket, as are most successful small-business owners. If that’s true, your plan only needs to cost less than 37 percent for the employees before it’ll make economic sense for you.
For example, if you want to maximize a 401(k) and profit-sharing plan, you will be able to defer $56,000 per year. If the employee cost is less than $32,888, then the employer comes out ahead. The reason? If your client wants to save $56,000 in a taxable account, the tax cost would be $32,888.
When I’ve asked business owners if they’d rather give the government $32,888 or give their employees $32,888 while saving $56,000, it’s an easy answer. One hundred percent of the time the business owners will say they would rather give the money to their employees than to the government.
The Proper Question to Ask
Now that you’ve seen the power of a qualified retirement plan, you need to figure out how much you will save. The proper question here is, “Since you have no limits on how much you can save, how much do you want to put in your plan every year?”
As advisors, we too often decide for our clients how much they can or should save. This is actually a question that YOU should answer. If you are over 50 years old and have a company that employs fewer than 25 people, it’s easy to design a plan in which you can save as much as $225,000 per year in your account. I’ve rarely met a business owner who wants—or could afford—to save more than that in a qualified account.
Four Power Options for Business Owners
Here are four plans that I’ve discovered business owners find interesting:
- Simplified Employee Pension (SEP) plan — This is the simplest of all plans. It requires an equal contribution for all employees based on their salary. The owner can defer a maximum of $56,000 in this plan. From a tax/employee deferral analysis, it’s hard to make a SEP work with more than ten employees.
A SEP requires that you put the same amount of money away for each employee as a percentage of their salary. This will often cause the amount put away for employees to be larger than the owner’s deferral amount. Once a company reaches ten employees we start to look at 401(k) plans and profit-sharing plans as being more cost-effective for owner retirement savings.
- 401(k) plan — This plan is best for owners who want to save up to $25,000 per year in their account. You will want to provide a safe-harbor plan for this account. This allows the owner to defer the maximum contribution with no plan testing.
- Cross-tested profit sharing/401(k) plan — This plan uses age and salary as a method for putting together contribution amounts. The owner can defer up to $56,000 per year. Using a combination of a maximum 401(k) deferral and profit-sharing plan, the cost for all employees is often less than $32,888, which is the tax breakeven point.
- Cash balance — profit-sharing/401(k) plan — Say your owner wants to defer more than $56,000 per year and can reliably do so for at least five years. You can now consider a hybrid plan that combines a cash balance defined benefit plan with a cross-tested profit-sharing plan. The owner will be able to defer about $200,000 or more per year, with a significantly lower amount for the employees. This plan is the secret sauce for an owner who has not saved enough for retirement and has excess cash flow while running their business with little prospects for a great sale when they’re ready to transition their business
Don’t forget your spouse
If the owner’s spouse is not on the payroll, it’s pretty easy to justify adding the spouse to the plan for the amount that would be needed for the 401(k) deferral.
A financial plan is a crucial part of the private business planning process. I often do a rough plan on a legal pad to illustrate the problem the business owner has. I call it the four boxes of financial independence. Once I’ve gotten the attention of the owner we will then move to a formal financial plan.
I want to make sure you are moving in a direction that will get you to financial independence. A simple plan will help both of us understand that we’re making a wise decision.
All numbers are listed for 2019 tax year.
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