OK, maybe they aren’t strange or even wonderful, but they are important. Join Tim Voigt one of the two founders of PensionWorks, a third party administrator for retirement plans. Tim is going to help us understand the rules and opportunities you have for using a retirement plan to provide a safety net when you start thinking about retiring from your business. The sad fact is you’ll probably not get enough money from the sale of your business to ride off into the sunset when it’s time to retire. Having a retirement plan with lots of cash in it can help provide a buffer that you’ll need when it comes time to retire. In today’s podcast you’ll learn:
- What a 401(k) plan is and what your options for funding your plan ar
- How you can put together a retirement plan that is tilted towards you.
- Why saving through a qualified retirement plan is usually a very tax efficient manner of saving.
- You’ll learn what a qualified plan is and what makes it tax qualified.
- What I can do if I want to save a lot more than $50,000 per year in my plan.
Narrator: Welcome to The Sustainable Business Radio Show podcast where you’ll learn not only how to create a sustainable business but you’ll also learn the secrets of creating extraordinary value within your business and your life. In the Sustainable Business, we focus on what it’s going to take for you to take your successful business and make it economically and personally successful.
Your host, Josh Patrick, is going to help us through finding great thought leaders as well as providing insights he’s learned through his 40 years of owning, running, planning and thinking about what it takes to make a successful business sustainable.
Josh: Hey, how are you today? This is Josh Patrick at askjoshpatrick. Our guest today is Tim Voigt from Pensionworks. I’m very excited and you should be too.
Tim is a founding partner. He and I have worked for—gosh, I don’t know, 20 years now together on a variety of retirement plans. One of the things that I’ve learned over the years is that there are very few of us who have a business or the business is going to get to retirement all by itself, so we need to be using other forms of investments outside of our business. And the first thing I’d like to see us do is start off with a retirement plan.
Now, Tim and Pensionworks is what’s called the third party administrator. He is probably the most knowledgeable person I know on the subject of retirement plans and, more importantly, how you can use a retirement plan to help you get to financial independence in a secure and safe manner.
Let’s bring Tim in and start the conversation.
Hey, Tim, how are you today?
Tim: Great, Josh. How are you doing?
Josh: I’m doing wonderful. Thanks so much for spending some time with us.
Let’s start off with the basics. I’m a business owner. I know I need to save for retirement and you’re going to say to me, “Well, the first thing you might want to think about is a 401K Plan.” So, what is a 401K Plan? How does it work? And how can it benefit me as a business owner?
Tim: Great question. So a 401K Plan, like any qualified plan in the for-profit arena, it has a trust. And it has a trust so that any money that you contribute into these plans can be essentially moved out of your company and into this tax-deferred trust. So, a contribution that the company would make into a plan for you and your employees, if you have some, is a tax deduction like an electric bill or something like that – you deduct it.
Josh: So, first of all, what is a qualified plan?
Tim: A qualified plan is a plan that does essentially three things. (1) It allows for a tax deduction for the contributions that go into it. (2) Those contributions are not income taxable to any other participants in the plan, currently. And (3) as the monies are invested inside the plan in the trust, the gains on those assets are not currently taxed. So that’s the big three – tax deductibility, lack of income taxation on the recipient of the money, and tax-free earnings as a gross.
Josh: I decide I want to do a 401K Plan. I want to put some money away for myself but I’m not wild about putting money away for my employees, why would I want to do that?
Tim: Well, the government says that you cannot discriminate in favor of the highly compensated people. You are, as a business owner, a highly compensated person. No matter what you earn, you own more than 5% of the company, you’re highly compensated. And if you happen to earn more than $120,000, you’re also considered highly compensated no matter what you own inside the company. So, in many cases where you have employees, you need to do something that’s considered by IRS to be sufficient to have the plan be non‑discriminatory in so far as all other employees are concerned.
Josh: But in fact, you can develop plans that are tilted towards me, as the owner of the company, can I?
Tim: Yes. There’s a number of things that you can do. In many cases, the business owner has a larger salary than most of the employees, so even if you’re giving a relative percent that’s the same to everybody, that percent when it’s bounced off of a bigger compensation amount is a larger dollar sum that goes into the business owner’s account. If you’re using a matching arrangement in your 401K Plan, where the business owner is allowed to make a contribution up to the IRS maximum, and those are now $18,000 a year. And if you’re over age 50, you can dump another $6,000 on top of that. So the business owner can put away $24,000 out of his pocket and into the plan. And that’s a direct taxable deduction for purposes of State and Federal income tax.
A business owner can also put his wife on the payroll for an amount slightly above $24,000 to cover FICA and FUTA and all that stuff. And she could or he could, depending on who the spouse is, make an additional contribution of $24,000 a year. So, right off the bat, we’re $50,000 into the plan for the owners and we haven’t spent a nickel on anybody else yet. The plan can be set up so that if they fail to make a contribution out of their own pocket, they don’t get any of the contribution that the company would put in on a matching basis. So, depending upon how you structure the plan, there’s a number of things you can do to, as you suggest, minimize or tilt the plan toward the owner’s favor.
Josh: So, the basic 401K Plan and let’s say you were over 50 years old, which I think most listeners to this podcast are, is about $50,000 and if they were to save that in a taxable account, they’d need to make about $80,000 first because they’d have to pay $30,000 in taxes to put $50,000 into their savings account. Is that about correct?
Tim: Yeah. That’s probably about right, given an average taxpayer. And then of course, you’ve got the issue of once you’ve got it outside the plan, whatever it earns in most cases is going to be continually taxable in terms of its gains. So that you have this continual taxable piece the has leaked out of the investible pot – outside the plan. Whereas, if it goes into the plan, you’ve now saved that $30,000 in taxes and you will save every penny thereafter in terms of taxes in so far as its growth is concerned.
And then, as you go to actually retire, you get to sprinkle it out over your remaining life expectancy which, you know, a person that’s 70 years old start in that distribution might have another 18 or 19 useful years according to the IRS’ tables, so you get to basically 1/19th out of what you’ve got in the pot rather than picking up a full $30,000 taxable shot right out of the box.
Josh: So, if I’m a business owner and I’m going to put $50,000 away for me. If my cost for my employees is less than $30,000, I’m coming out ahead of the game. Is that true?
Tim: Well, you are coming out immediately ahead of the game but at some point in time, you’re going to need to also pay tax on what you take out when you turn 65 or 68 or 70 or whenever it is that you’re going to take a distribution out of the plan. So, to make an apples to apples comparison, you’re probably going to want to make an estimate of what the taxable component of that’s going to be. So, you might say, “I have a $1 million in my plan now and I need to take it out. I’ve got 20 years to do it, so 5% a year. So I’m going to need to take $50,000 a year out and I’m going to pay taxes on the full $50,000 unless a part of the money that I put in was a Roth, but we can talk about that later.
Josh: No. We probably won’t talk about that. It’s a little bit more complicated.
I mean, I’ve done the analysis for this before and it’s a really good idea, if you own a business, to use a 401K at least as a savings vehicle. But let’s say that I say, “Okay, $50,000 is nice but I really want to save more money than that.” Is there something I can do after a 401K Plan?
Tim: You can add to that 401K Plan a profit-sharing component. Meaning, the corporation, or the partnership, or the sole proprietorship, or whatever the form that your business is can also add an additional piece. And that additional piece has a different IRS maximum to it. So if you’re keeping an eye on the maximums you’ve got a $24,000 salary reduction piece. You could get your total allocation up to about $59,000 less that $24,000. So that difference could be a profit‑sharing allocation. And the profit-sharing allocation needs to also follow the maxim that the plan shall not discriminate in favor of the highly compensated people. And there’s a whole bunch of artful ways that you can craft your profit-sharing component so as to look at it in a way that it meets the IRS’ objectives, so as not to be discriminatory in favor of the highly compensated.
Josh: So, if we did this and I’m the owner of the company, I have a spouse and I put $60,000 in my plan and my spouse puts $25,000 in their plan, if I can do the arithmetic for that, it looks like I can put away about $85,000 into my account every year, is that true?
Tim: Yes, it is. That’s pretty close.
Tim: And depending upon what the demographics in the company are, if it’s just you and your spouse, you could arrange your compensation – assuming they’re sufficient, to both put $59,000 away.
Josh: And if we did that, then we’re looking at let’s say $120,000 which means that we’re going to be saving on taxes. You know, for us to put the same amount away in a taxable account would require us to earn somewhere around $190,000 so we’re saving approximately $70,000 in taxes.
Tim: Per year, less the earnings.
Josh: Less the earnings, right.
And if we were to say, “Well, gee, if I put away less than $70,000 for my employees the government’s sort of subsidizing their contribution again?
Josh: That sounds like a pretty good deal to me. So, if I can put $120,000 a year away, with no earnings. If I do that for 10 years, I’ve saved $1.2 million.
Tim: You have.
Josh: And there aren’t a whole lot of businesses out there that if I go and sell it, I’m going to net $1.2 million after I sell it. It seems to me that a retirement plan is probably as important, if not more important than the value of your business.
Tim: I think if you look at a business that’s making regular contributions that are substantial and re-occuring into a plan like that, even a buyer of the business will look at that and say, “Gosh, here is regular re-occuring cash that’s gone into a plan over the last 10 years. If I’m going to buy this business. There’s some ability to look at that and be comfortable and confident that even though it’s not going into the new owner’s retirement plan, it’s perhaps help paying for the old owner’s interest in the business such that at some point in time, the new owner can have a plan and do the same thing.” So I think it makes good business sense as well, the demonstration of that kind of commitment to a plan for yourself is also a demonstration that the business has the wherewithal to do that and it stands up as a milestone for bankers, accountants and buyers alike.
Josh: Cool. That sounds like a really good thing. So, Tim, I’m a really successful business, I’m making a ton of cash. $120,000 is nice but I want to save more, what can I do now?
Tim: You can, over the top of your 401K Plan, put in kind of a hybrid defined-benefit plan that’s called a Cash Balance Plan.
Josh: So can you define what a Cash Balance Plan is because now we’re starting to get very confusing.
Tim: Without going too far into the weeds, basically your 401 K Plan is a defined contribution plan. Meaning that when a sponsor company makes an addition to the plan by virtue of a contribution, they’re defining the input – the dollars going in.
Whatever the participant in the plan plus his financial advisor can grow those dollars to, inside that account, is not part of the deal. Meaning, the definition of a defined contribution plan is the input. Whatever the money can grow to, there’s no limit but the government does put a limit on the input. For example, $59,000. You can’t put any more than that away. If you can make 40% on that a year, you get to keep it all but you are limited by the input.
A defined benefit plan, on the other hand, you can put away whatever it takes to fund the promised benefit under the terms of the plan. However, the IRS limits what that benefit could be. So, depending upon your age and depending on the plan’s formula, you might have a contribution to a cash balance plan anywhere from $150,000, say at age 50 to 51, up to maybe $285,000 in your late 60’s. This could be on top of a 401K plan. So in addition to that, you could put away your $24,000 and it could be on top of a profit sharing plan in which case, in addition to that you could put away another $32,500 or so.
Josh: So we’re talking about between $200,000 and $350,000 that somebody could actually save into a cash balance hybrid plan with a 401K and profit sharing?
Josh: So, this sort of plan seems, to me, to be perfect for somebody who is in their mid- to late-50s and just hasn’t saved enough for retirement, has the cash available and really needs to catch up.
Tim: The “have the cash available” part is really, really important because most defined contribution plans are extremely discretionary in terms of how much you put away. So, if every year’s a good year and it’s not a problem, that’s one thing. But if your business kind of goes up and down a little bit and you take a big bonus in some years and you don’t take much of a bonus in other years, then a cash balance plan can be a bit of a problem because it is not particularly discretionary. There needs to be a fairly steady cashflow to sustain the contributions that you are promising to make under the terms of the plan.
Josh: So, the good news for most of our listeners is if they’re over 55 and they’ve been in business for over 25 years, my bet is an awful lot of them have figured it out and they’ve gotten to the point with their business where their profits become relatively predictable. And if somebody is making, let’s say for fun, $400,000 or $500,000 a year, they can live on $200,000 a year. A cash-balance plan along with a hybrid plan might make a lot of sense for them.
Tim: Absolutely. Again, because the defined benefit or the cash balance plan is considered a pension plan, the benefits have to be definitely determinable. The plan needs to be permanent, substantial and continuing – in the words of the IRS. Now, that sounds pretty ominous but what it really means in practice is you need to have about a four- or five-year duration of the plan from start to finish. And you need to make a contribution to keep the plan going but it maybe doesn’t need to be quite as large as maybe the contribution that you make in year 1 and 2, might have been. You could structure the plan, so maybe you make a huge contribution in year 1 and a little bit less in year 2. And then there’s some funding things that you can play with to get it up there a bit in year 3 again. And then you cut back a bit in year 4. So, you have some flexibility but it’s best not to go into the plan without having a real steady cashflow and a commitment to make sure that that cashflow is earmarked for the plan’s contributions.
Josh: So, Tim, if you have a company with 25 employees or less, it seems to me the right question to be asking about a retirement plan isn’t “What type of plan I should have?” The right question to be asking is “How much money do I want to save on an annual basis?” And from there, we get to work with somebody like you and figure out what plan works the best. Would that be correct?
Tim: That is a really excellent way to begin the process of “How do I do this?” Typically, the assignments that come to us are essentially, I have a person who has a company, who has a big year and wants to put a big contribution into the plan. And that’s how it begins. And so, what I’ll do is to get a bunch of demographic information and find out who the rest of their employees are. How much the employees are earning. How long they’ve been there. What they do. Who’s important in terms of the ongoing nature of the company. And get an idea about what, if everything lined up properly, the sponsor of the company and the plan would like to put in for each one of these people – by name, by person.
And so, with that information, now I’ve got the ingredients to bake the cake and we place some kind of proforma “what if” games, coming up with different structures and scenarios and costings so that it’s an exercise that basically educates the sponsor on how the allocations work, what it means to have a bunch of people in the plan that are a whole lot younger or a whole lot older in terms of plan costs. And, just in general, gets them comfortable with the big picture as it moves through time to ensure that they don’t have to be experts in how the plan works but they really need to be cognizant about what their responsibilities are in terms of funding it and in terms of caring for it.
Josh: Tim, this has been a really meaty conversation. Unfortunately, we are out of time. I am going to bet there are some of our listeners who would love to get in contact with you and learn more about what they can do with their company. And if they wanted to, how would they find you?
Tim: On the web, pensionworks.com. P- as in Peter, E-N-S-I-O-N-W-O-R-K-S.COM or pensionworksinc. Or a phone number is 802-861-7658.
Josh: Thanks so much, Tim.
And for those who are listening, I can tell you that pensionworks is a great organization to work with. I highly recommend them. I’ve been using them with my clients for over 20 years and can just tell you they do great work.
So Tim, thanks so much for your time today. I really appreciate it and hope to speak with you soon.
Tim: My pleasure, Josh. Thank you.
Narrator: You’ve been listening to The Sustainable Business Podcast where we ask the question, “What would it take for your business to still be around 100 years from now?” If you like what you’ve heard and want more information, please contact Josh Patrick at 802‑846‑1264 ext 2, or visit us on our website at www.askjoshpatrick.com, or you can send Josh an e-mail at firstname.lastname@example.org.
Thanks for listening. We hope to see you at The Sustainable Business in the near future.