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CHAPTER 1
Introduction to Tax-Advantaged Plans
For many years Congress has recognized that saving for retirement is a worthwhile social objective that should be encouraged by government. Retirement plans have actually been available for many years. In 1875, The American Express Company set up the first employer-provided retirement plan in the nation. Just a few years later, the Baltimore and Ohio Railroad established a plan funded by both employee and employer contributions. Pensions became increasingly popular in America over the next few decades.
Through the use of various tax incentives, the federal government has encouraged the growth of private pension and profit-sharing plans. Millions of companies have adopted them because they enable the company to save taxes and the employees to accumulate money for retirement. The widespread adoption of tax-advantaged retirement plans by both large and small businesses is its own testimonial to the attractiveness of such plans. However, the complexity of the tax laws governing these plans has often discouraged employers, especially the small business employer, from establishing these types of plans. The purpose of this book is to simplify these rules and regulations in order to help the business owner or manager understand the extraordinary benefits of these types of programs. After all, the most important aspect of any business is the bottom line. These types of plans can have a significant and positive impact on that bottom line. A taxadvantaged retirement plan is an invaluable tool in any business for enhancing revenue.
A retirement plan can be adopted by a business whether it operates as a corporation, a subchapter S corporation, a partnership, an LLC, or a sole proprietorship. Once the objectives to be achieved have been determined, then a plan can be selected to help fulfill them. There are many types of tax-advantaged plans from which to choose. For example:
Defined Benefit Plans
A defined benefit plan is what most people think of as a pension plan. The benefit is defined in a formula, and contributions are made every year on a regular basis to accumulate a sum of money in order to be able to pay that benefit.
Defined Contribution Plans
The trademark of a defined contribution plan is that the annual contribution is determined by a formula, and the ultimate benefit depends upon the investment returns of the plan:
Profit-Sharing Plans
The most common defined contribution plan is the profitsharing plan. Generally, contributions are the same percentage of each employee's compensation. These plans permit the company to make contribution as a defined percentage of profits, and contributions can be skipped, reduced, or changed from year to year.
Money Purchase Pension Plans
A companion plan to the profit-sharing plan is the money purchase pension plan. Contributions are determined by using a fixed formula based on a percentage of compensation, and the ultimate benefit depends strongly on the plan's earnings.
Target Benefit Plan
The target benefit plan calculates a fixed annual contribution amount based on actuarial assumptions. A target benefit plan allocates contributions to separate participant accounts and the value at retirement is based on the investment growth in the account.
401(k) Plans
The Cash or Deferred Arrangement (CODA), most commonly referred to as a 401(k) plan allows contributions to come from employees, rather than the company. Through salary reduction agreements, employees elect to reduce their salaries by a certain percentage and that amount is contributed to their accounts in the plan.
Simplified Employee Pension (SEP) Plans
To establish a SEP, employees set up Individual Retirement Accounts (IRAs) into which the employer makes contributions. Once the contribution is placed in the employee's account, it belongs to the employee.
Financial Freedom
Financial freedom is one reason many people become business owners. Of course, it is also the primary reason why most employees are even working. However, for many Americans in the workforce today, financial freedom is increasingly more difficult to obtain. Taxes reduce what an individual can save now, while inflation practically guarantees that even more money will be needed later. What can a person do? It is certainly not practical to try to change the tax laws, and the hard realities of retirement will always exist. But there are ways to reduce current taxes and help plan for a secure retirement.
Three Ways to Take Money Out of a Business
If an owner of a business wants to take money out of the business, he has three options:
1. taking the money out as dividends from a corporation
2. taking it as a salary
3. taking the money and putting it into a qualified retirement plan
Throughout this book, I use the words "he, him, himself," etc. in their everyday androgynous sense of "he or she, him or her," etc...because the alternatives tend to produce tedious reading. While the first two options may sound good, the tax consequences could change anyone's mind. For example, assume that an individual wanted to take $25,000 from his business. The table on the following page shows what would be netted under the three options. Taxes dramatically reduce the share in all but the third option.
Why?
Qualified Plans are Tax-Deferred Money in a qualified retirement plan is not taxed until withdrawn. This means that 100% of an individual's money is working for him, compounding free of taxes until withdrawn. Qualified plans are a great way to take money out of the business and allow both the owners and the employees to save for retirement.
Tax Facts of Taking Money out of a Business
|
| Corporate Dividend | Salary/Income | Qualified Plan |
|
Profits | $25,000 | $25,000 | $25,000 |
|
Corporate Tax | $3,750 | $0 | $0 |
|
Personal Tax | $9,000 | $9,000 | $0 |
|
Net After Tax | $12,250 | $16,000 | $25,000 |
Assumptions: 15% corporate tax rate; 36% individual tax rate It is no wonder that millions of employers have used the tax saving benefits available to them in retirement plans to build a strong foundation for the financial future of their employees and themselves.
Since all good things have limits and restrictions, the following chapters of this book will seek to explain, in a very simplified manner, the rules and regulations governing these types of tax-advantaged plans.
Whether an employer's objectives are to get the largest tax deduction on a contribution possible, to provide a program for employees' retirement, or to pass the costs of contributions on to employees through a salary deferral arrangement, there is a plan that is right for every business.