Most remodeling company owners have no exit strategy; when they leave the business, their companies will cease to exist. They probably won’t be able to sell the business, and they likely will take few dollars with them after the final accounting. That means most owners have no equity in the company and won’t have those dollars available to provide income during their retirement years. But with sufficient capital and cash flow, owners might be able to fund a retirement plan for themselves and their employees.
On a personal level, saving for retirement is a necessity. On the company level, providing retirement benefits can keep qualified workers from leaving. Retirement planning allows dollars that would otherwise be taxed to be invested and grow on a tax-deferred basis. Taking dollars away from taxable income also lets the remaining income be taxed at a lower rate. And it lets you show employees you care about their future well-being.
The first step is selecting the most appropriate retirement plan or plans. The Economic Growth and Tax Relief Reconciliation Act of 2001 made retirement planning much simpler for all business owners and gave small-business owners opportunities not previously available to them.
For help in sorting through the options, Michael Pippin, president of Pension Service Design in Sutton’s Bay, Mich., recommends contacting an accountant and a financial planner. “These plans are complicated,” says Pippin, whose company administers 265 pension plans. “It’s good to get more than one person involved for the sake of a balanced view. Oftentimes I see horrendous problems when people stumble onto the first person they meet and establish a plan.”
He believes insurance companies and banks have a bias toward plans in which they might have a substantial investment. Insurance companies, for example, often offer plans with high surrender fees — penalties assessed by the insurance company if funds are removed from the account or transferred to another company — during the first five or seven years. “Agents are often the least well-trained in terms of plan design,” Pippin says.
Before initiating a company plan, you should understand plan costs and obligations. Some require annual contributions regardless of whether your company is profitable, while others offer more flexibility. In addition, you should thoroughly understand your personal and company finances. Can you afford to reduce your paycheck to pay for a personal retirement program, and does your company have sufficient cash flow to fund a program for all employees who meet plan criteria? Would you like to postpone capital expenses? As a business owner, you need to know the answers to these questions up front to derive maximum benefit at the least cost.
Individual retirement accounts
Known as IRAs, these retirement savings accounts can be started easily by any individual and are not sponsored by an employer. They also do not entail any contribution from an employer and are established through brokerage houses, banks, insurance companies and financial advisers. Firms that don’t yet have the means to establish a companywide retirement plan might start by educating employees about this option.
There are two types of IRA accounts:
Traditional IRA: As of 2002, contributions up to $3,000 per year (plus an additional $500 per year for account holders who will be age 50 before Dec. 31, 2002) are tax-deferred until funds are withdrawn at retirement. In addition, up to $3,000 can be contributed on behalf of a nonworking spouse. Contributions are tax-deductible from current income for those who are not active participants in a company retirement plan. Otherwise, deductibility is based on adjusted gross income.
Roth IRA: Contributions up to $3,000 per year in 2002 (plus an additional $500 per above) grow tax-free until funds are withdrawn at retirement. The contributions, however, are not tax-deductible.
Contributions can be made to both traditional and Roth IRAs provided the total annual contribution does not exceed $3,000 per individual. IRAs are fairly easy for individuals to manage.
SEP and SIMPLE IRAs
Both SEP (simplified employee pension) IRAs and SIMPLE (savings incentive match plan for employees) IRAs are designed for small businesses rather than individuals. The SEP IRA is the easier one to administer and maintain in terms of paperwork. Its ease of maintenance is matched by its flexibility: Annual employer contributions are not required, and the percentage of income contributed to the plan can differ from year to year.
Effective in 2002, an employer can contribute up to 25% of compensation, to a maximum of $40,000, to a SEP IRA. Employees cannot contribute. (A more complicated feature, Social Security integration, can be used to provide larger contributions to highly compensated employees.) Until withdrawn, all assets deposited into an employee’s SEP IRA grow tax-deferred.
With a SEP plan, any employee who has worked for the employer at least three of the preceding five years and earned a minimum of $450 in the current year is eligible. All contributions by the employer are immediately 100% vested, so employees can take the funds whenever they leave the company.
The SIMPLE IRA is designed for employers to make contributions that match employee contributions or to make contributions regardless of employee contributions. An employer who matches employee contributions must match up to 3% of employee contributions with an annual limit of $7,000 as of 2002. (Individuals 50 or older can add $500 per year as a “catch-up” contribution.) An employer who selects a non-elective contribution must contribute 2% of each eligible employee’s compensation with an annual limit of $4,000.
Employees are not immediately eligible for participation in a SIMPLE IRA. Only those who earned $5,000 in any two preceding years and expect to earn at least $5,000 during the current year may participate. SEP is better for a sole practitioner; SIMPLE is better for an employer with a few employees who have low incomes. The lower their salaries, the lower the employer’s match.
Qualified retirement plans
Often known as Keoghs, these plans allow for larger contributions than SIMPLE or SEP IRAs. They are the preferred plan for a company with few employees whose owner has a relatively high, stable income. However, Pippin cautions, “Starting a qualified plan is a commitment not easily gotten out of.” Unlike IRAs, Keoghs require that documents be filed annually with the government — and the Internal Revenue Service looks unfavorably on owners who start and suddenly stop plans. The IRS can even disqualify plan contributions and payroll deductions if auditors don’t believe a plan was established for the long term.
While there are a few types of qualified retirement plans, the Tax Act of 2001 allows for the most flexibility and the highest contribution with a profit-sharing plan. In this instance, an employee can contribute up to 100% of compensation, up to $40,000 annually. In turn, the employer can deduct up to 25% of total participant compensation from his/her business taxes.
Employers can set eligibility standards for employee participation within limits: An employee must have zero to two years of service, with a year of service defined as working from zero to 1,000 hours. In addition, employers can require that employees attain age 21 before being eligible to participate.
The employer also must select a vesting schedule — the time period that plan participants must work before they are entitled to the plan account balance. Specifically, the employer can select immediate vesting, a three-year cliff (100% vesting after three years of service, partial vesting until then), a five-year cliff or even variable vesting (for example, 20% after two years, 40% after three years, etc.).
A qualified retirement plan usually is “the best way to build wealth for retirement,” Pippin says. Employees can get their money easily, and even poorly run plans work. When a business owner retires and the company closes, the owner and the employees have more options for distributing or transferring the assets in a qualified retirement plan than with any other program.
A 401(k) plan is most appropriate for larger firms that can afford an administrator to handle detailed IRS reporting requirements and have an office that can complete at least some of the paperwork.
Because the reporting requirements can get people in hot water if the regulations are not followed to the letter, Pippin says 401(k) plans are not suitable for many businesses.
A 401(k) plan lets employees contribute up to $11,000 per year (with an additional $1,000 “catch-up” provision for employees 50 and older). The company may match some portion of employee contributions (the first 3% of employee salary deferrals, for example).
While employee contributions are 100% vested from the beginning, employer contributions are vested according to the plan’s vesting schedule. Distributions from the plan before age 59 1/2, other than for certain hardship reasons, typically result in a 10% withdrawal penalty.
The assets, though, can be rolled over to an IRA account if an employee changes jobs.
Summary of retirement plan features
The options listed below are the most likely to be selected by remodeling firms. Other retirement planning options are available, including plans that are age-weighted or have defined benefits.
Fees, costs and cautionary notes
Selecting a company retirement plan rather than an individual retirement plan puts the company owner in a position of fiduciary responsibility, mandating that regulations be rigidly followed.
SEP and SIMPLE IRAs can be maintained easily by a company bookkeeper who is shown the reporting requirements when the plans are enacted.
Profit-sharing plans and 401(k) programs require substantially more work and the retaining of a third-party administrator who probably will charge at least $1,200 annually to ensure that the company complies with the appropriate pension regulations, laws and standards. For instance, not filing a Form 5500 with the U.S. Department of Labor’s Pension and Welfare Benefits Administration can result in a fine of up to $25,000, says Samuel Butts, a Nashville, Tenn., attorney who specializes in pension law.
Because the company owner often is the plan trustee, sponsor, administrator, custodian and investment manager in addition to a participant, Pippin warns that some company owners come to believe that nobody else has any rights to the pension plan and commit attitude fraud. Funds can be deducted from employee paychecks but never deposited into their plan accounts, an act that could trigger an IRS or Department of Labor investigation.
Finally, employers and employees should understand that most retirement accounts include withdrawal penalties if funds are removed before the account holder turns 59 1/2 (or within a certain time period after the plan is started). Funds also might be taxed at current income tax rates in the year they are removed from the retirement account.
While certain withdrawals may be permitted (hardship, education, first-time home purchase), individuals should not open or contribute to a retirement account unless they are reasonably certain the funds they contribute will not be needed before retirement.
Funding a retirement plan can be the best decision a business owner makes. Savvy remodelers who know their company numbers and get the right advice can fulfill a lifelong dream after a lifetime of work: a quality retirement with no change in lifestyle.