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There are several types of pension plans available to owners of small, closely held corporations. Qualified Plans have unique benefits in both tax savings and wealth accumulation. You can maximize the power of tax deferral, get higher returns on your investments and leverage your investments for even greater returns. Best of all, you have complete control over your money. You can borrow from your investments. Pension plans are safe from creditors and judgments. Additional benefits make these plans attractive to employees. Some plans offer incentives to encourage key employees to remain loyal, reducing turnover. The following information is not a total explanation of the subject. However, it does provide valuable, in-depth information but should be used only as a guide to pension planning. Contact Nevada Corporate Headquarters directly for additional information tailored to your individual situation.
Tax Deferral and the Rule of 72 Harnessing the power of tax-deferred income combined with compound interest can multiply your retirement income significantly. For instance, if your goal was to retire in 30 years with $1,000,000, it would take a monthly investment of $1644 at an annual return of 5% assuming a tax rate of 35%. Increasing the return to 12% results in a monthly payment of $699. But, if you had a 12% rate of return, with all taxes deferred until withdrawn at retirement, it would only require a monthly investment of $286, to grow to $1,000,000 in 30 years. Compound interest is calculated by dividing 72 by the interest rate to estimate the number of years required for your money to double.
SEP - Simplified Employee Pension (Plan)
A SEP plan can be set up for a one-person corporation or a sole proprietorship. Essentially, an employer sets up an account and makes contributions. The funds can be invested in a variety of investment vehicles including mutual funds, money market accounts and other investments. Annual contributions are limited to 15% of the owner's compensation or $24,000, whichever is lower. All contributions are deductible to the corporation. The SEP program is simple to set up and simple to administer. The plan is protected from creditors by ERISA.
401 (K) Plans
401(K) plans allow for an elective deferral of income based on a percentage of salary. 401(K) plans are subject to complex IRS rules, and total compliance can be difficult. There is also significant cost to setting up and administering the plan. This type of plan is not recommended for small companies or corporations. The first step in determining if a 401K plan would be right for your business is to complete a company census and have that document analyzed by a competent actuary or pension plan administrator or firm. The U.S. House recently voted to raise the limits on IRAs and 401(K) plans. Annual pre-tax contributions to a 401(K) plan will increase to as much as $15,000 by 2005. Presently, the maximum contribution to a 401(K) plan is $10,500. Also, the amount of annual pay on which total contributions are based would rise to $200,000 from $170,000.
SIMPLE 401(K) Plans This type of plan is similar to a 401(K) plan but with lower administration and set up costs. Many of the compliance issues with the regular 401(K) are not required with the SIMPLE 401(K) Plan. This works well for small companies with one or two highly compensated individuals or owners. Employee matching up to 3% of the qualified employee salary could possibly be required.
Defined benefit plans are the most advantageous plans for individuals who want to retire within 7- 15 years and have significant monies to contribute. All contributions are tax deferred and are a corporate expense. Defined benefit plans are set up to provide monthly benefits at retirement age, depending on the amount of contribution, anticipated rate of growth and years of service with the company. An actuary determines the contributions required to meet the goals of the plan. Defined benefit plans provide the greatest opportunity for contributions and deductions. If the plan is established when the owners are 40 or older, the benefits can be much larger than other types of plans. Defined benefit plans are more difficult to set up and require a professional administrator, but there are several variations on defined benefit plans. Additional benefits include the ability to contribute up to $10,000 on behalf of non-compensated family members, and loans (up to $50,000) against the plan are allowed. Defined benefit plans must file Form 5500 with the IRS and operate under a letter of approval, reviewed and submitted by an actuary.
Defined contribution plans do not promise specific future payments. Instead, they are based on a fixed contribution based on a percentage of compensation. Defined contribution plans can be profit-sharing, money purchase or employee stock ownership plans (ESOP). Contributions are limited to $30,000 per employee or individual. Profit-sharing plans are based on company profits and a percentage of an employee's compensation. The plan can require employees to become vested before they are eligible to collect any benefits from the plan. Money purchase plans are similar to profit-sharing plans with the exception of requiring a minimum fixed funding amount that cannot be easily changed or adjusted. The maximum contribution is 25% of compensation or $30,000 per year, whichever is lower.
ESOP Employee stock ownership plans require fixed contributions that are invested in the stock of the company on behalf of the employees. These plans are not practical for the small corporation or business owner.
Split-Dollar Insurance
Split-dollar insurance refers, not to a type of policy, but to a method of paying for a policy. In a split-dollar arrangement, an employer and employee agree to "split" both the cost (premiums) and benefits (cash-value and death benefits) of a permanent life insurance policy. The agreement between the employee and employer can take many forms. The elements found in split-dollar agreements are outlined below:
Policy Ownership
The two basic forms of policy ownership for split-dollar policies are: Endorsement Method: The employer owns the policy, but a written endorsement is added to the policy which splits the benefits between the employer and the employee. Collateral Assignment: The employee owns the policy and assigns certain interests in the policy to the employer as collateral for payment made by the employer.
Endorsement Method: The employer owns the policy, but a written endorsement is added to the policy which splits the benefits between the employer and the employee.
Collateral Assignment: The employee owns the policy and assigns certain interests in the policy to the employer as collateral for payment made by the employer.
Splitting The Cost (Premiums)
Dividing the cost of a policy can be done in any manner desired. Listed below are several typical payment arrangements:
A. Classic Method
Employer pays an amount equal to the annual cash-value build-up.
Employee pays the balance.
B. Equity Method
Employee pays an amount equal to the value of the economic benefit received.
Employer pays the balance.
Making The Payment
Employer-Pay-All: The employer pays the entire premium; the employee pays tax on the value of the economic benefit.
Executive Bonus Plan:The employer pays a bonus to the employee. From the bonus, the employee pays the economic benefit portion of the premium. The bonus payment is a deductible expense to the employer and taxable income to the employee. Some agreements provide an extra bonus amount to cover the additional tax due.
Splitting The Benefits
As with the premium payments, the employer and employee can decide to split the benefits of a policy (cash values and death benefits) in any way they wish.
A. Classic Method
Employer's Share: The employer receives the greater of the cash value or the total premiums paid.
Employee's Share: The employee's beneficiary receives the balance of the proceeds, i.e., the face amount less the amount repaid to the employer.
B. Equity Method
Employer's Share: The employer receives the total amount of the premiums it has paid.
Employee's Share: The employee's beneficiary receives the balance of the proceeds, i.e., the face amount less the amount repaid to the employer.
A. Fringe Benefit: Since the employer can pick and choose those employees who will benefit, split-dollar can be used to attract and retain key executives.
B. Estate Planning: When the estate is sufficiently large to incur a Federal estate tax, i.e., a taxable estate in excess of $675,000, an estate owner may consider removing life insurance from his or her estate. A popular method of reducing death taxes is the irrevocable life insurance trust. Split-dollar arrangements can be used to reduce the out-of-pocket costs of the insured.
A popular method of reducing death taxes is the irrevocable life insurance trust. Split-dollar arrangements can be used to reduce the out-of-pocket costs of the insured.
C. Business Continuation: In a family-owned business, there is a risk of adverse tax treatment when the corporation redeems the deceased owner's stock. IRC Sections 302 and 318. The proceeds of corporate owned life insurance might also create a corporate AMT problem. Under a corporate stock redemption, the surviving stockholders would own stock worth more but with an unchanged cost basis. These problems can be eliminated by using a cross-purchase buy-sell agreement funded with life insurance. Differences between the owners in age and/or percentage of ownership may cause the life insurance premiums to be expensive for some stockholders.
A split-dollar arrangement may be used to assist each stockholder in purchasing enough insurance on the other stockholder(s).
D. Group Term Replacement: Due to non-discrimination rules, the amount of group term insurance available to key executives may be limited. With a split-dollar plan, the executive can have increased protection now, plus substantial benefits at retirement age.
Split-Dollar Insurance Funding An Irrevocable Life Insurance Trust
Since estate taxes are imposed on all the assets inside an estate, many people prefer to reduce these taxes by arranging to have some of their assets outside of the estate. One method of achieving this is the irrevocable life insurance trust, a type of trust designed primarily to own life insurance policies. At death, the policy proceeds are used to provide additional dollars for estate liquidity needs. Such a trust takes maximum advantage of the gift tax laws and, at the same time, ensures that the proceeds of any policies inside the trust are received free of income and estate taxes. A split-dollar life insurance arrangement can help a key employee achieve this important estate planning goal.
During Life In general, the following steps would be taken:
The employee establishes an irrevocable life insurance trust.
The trustee of the trust obtains life insurance on the life of the employee, naming the trust as beneficiary of the policy.
The employer and the trust enter into a split-dollar agreement, providing for a sharing of the premiums and death benefits of the policy owned by the trust. Typically the trust will pay that portion of the premium equal to the "economic benefit" received. The employer pays the remaining balance. As a part of the agreement, the trust assign to the employer the right to collect the premiums paid, at the death of the employee.
The employee gifts funds to the trust, to allow the trust to pay its portion of the premium. The employer may, if desired, "bonus" sufficient funds to the employee to cover these gifts.
At Death
The insurance company typically returns to the employer the total premiums paid by the employer.
The balance of the policy proceeds are paid directly to the trustee of the irrevocable life insurance trust. The trust may then lend the funds to the employee's estate or may use them to purchase assets from the estate. The executor would then have the cash necessary to pay the estate settlement costs without increasing the taxable estate.
Ultimately, assets in the trust are distributed to the employee's beneficiaries.
A Key Person/Retirement Benefit Combination -The purpose of this technique is to protect the corporation in the event of the loss of a key employee while binding the employee to the corporation until retirement by providing a substantial tax favored build-up available at that time.
How It Works
Prior To Retirement
Owner: Employee owns policy from the beginning. Beneficiary: Corporation is named beneficiary of its agreed-upon interests in the cash values and death benefit.
Premium Payer: Corporation is receiving the economic benefit and is responsible for paying the PS 58 rates. Employee pays any balance.
Reverse Split-Dollar Agreement: Limits rights to internal values (i.e., right to borrow, assign, withdraw, etc.) until termination of plan.
At Retirement
Employee/Owner simply changes the beneficiary. The agreement expires, eliminating restrictions on the values. There is no further economic benefit to the corporation. Nothing is owed to the corporation.
At Death
The death benefit is received by beneficiaries free of income taxation but is a part of the employee's estate (less the portion paid to the employer).
Besides protection from the loss of a key person, other corporate uses include:
