This is the time of year when, if you're a business owner, you realize two things: You are paying too much in taxes, and you're not putting away enough for your retirement.
So, what can you do about it?
You can solve both problems by having a retirement plan for your business. These retirement plans can take the form of money purchase plans, profit-sharing plans, Keoghs or SEP IRAs, among other things.
If you're not an expert in pensions, the various types of plans and their related issues can be pretty confusing. Over the course of the next few columns, I'm going to try to cut through some very complex issues to help you find the best course of action.
The maze of retirement plans all have four things in common:
- To get the full benefit of a plan, you need to put money into it each year.
You'll get a tax deduction for the amounts you contribute.
Your investments within the plan will grow tax deferred.
When you take the money out at retirement, you'll pay taxes in your regular tax bracket.
Before getting into specific plans, here are some basic concepts that will help you understand the overall picture.
A term you will always encounter when you discuss retirement plans is "qualified." That simply means that the
Internal Revenue Service
considers it a legitimate retirement plan. Among qualified plans, there are basically five categories:
- Defined contribution plan.
Defined benefit plan.
Money purchase pension plan.
Target benefit plan.
Once you understand these categories, you'll understand the basics of a specific retirement plan, such as an SEP IRA. So let's look at each of these categories.
This retirement plan provides an individual account for each participant, and benefits are based solely on the amount of money contributed to the participant's account. Defined-contribution plans encompass 401(k) plans.
Contributions to these plans are determined by a formula and not by actuarial requirements (target benefit plans are an exception), and benefits are not insured by the
Pension Benefit Guaranty Corp.
This is the kind of plan that guarantees an employee a monthly retirement income for life. The amount is determined by a formula, say, 40% of your monthly compensation. Normally, the plan uses an actuary every year to make sure it is properly funded to meet its commitments. Participants do not get a permanent right to the benefits until they have worked a minimum period of time. There is a schedule that defines how they become vested in this plan.
Money Purchase Pension Plan
A money purchase pension plan is a defined-contribution plan in which the company's contributions are mandatory and are usually based solely on each participant's compensation. Even if the company has no profits, a contribution must be made.
Target Benefit Plan
This plan is a combination of a defined-benefit plan and a money purchase plan. It's similar to a defined-benefit plan in that the annual contribution is determined by the amount needed to fund retirement at a specific age. An actuary works out the formula for this. But in the target benefit plan each contribution is made to a separate account for each participant. If the earnings of the fund differ from actuarial assumptions, the employer doesn't have to adjust the contributions made. Instead, participants will get an increase or decrease of benefits payable by the plan.
This is a defined contribution plan in which a company can make discretionary contributions. The company is not forced to make a contribution each year, and retirement benefits are based simply on the amount in the participant's account at retirement.
Over the next two weeks, I'll go into specifics of money purchase, profit-sharing, Keogh, SEP IRA and other types of retirement plans.
Have a great week!
Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at