Retirement Plans – The Best Tax Shelter
If you want to minimize your income taxes while maximizing your wealth, consider starting a company retirement plan. Not only will you be able to attract and keep better employees; you’ll also be able to use the plan for your own tax-sheltered retirement savings. Even better, there are several different plan types to choose from, each offering distinct beneﬁts. One of them will surely suit your current ﬁnancial situation and your long-term goals.
Pension rules are among the most complicated, even within the confusing world of tax laws. The different tax aspects of retirement plans can be daunting, and small missteps can bump your plan into the nonqualified category. Before you set up any retirement plan, call in an experienced professional to guide the way.
All retirement plans fall into one of two basic categories: qualiﬁed and nonqualiﬁed. The biggest difference between the two comes down to taxes; qualiﬁed plans get preferential tax treatment, and nonqualiﬁed plans don’t. After that breakdown, retirement plans can be separated into deﬁned beneﬁt, deﬁned contribution, or hybrid. Deﬁned beneﬁt plans focus on the eventual payouts and base your current contribution on the payments you want to get in retirement. Deﬁned contribution plans set aside a ﬁxed dollar amount or percentage of salary now, with no thought to how much will be available for distributions later on. Hybrid plans, as you might guess, offer some combination of deﬁned contributions and deﬁned beneﬁts.
As with most things, retirement plans come with both advantages and drawbacks. On the downside, retirement plans take a lot of time to set up and manage. Also, there are fees, including those for a professional adviser, and account fees for the company that houses the plan, to name just two. On the plus side, you can score some substantial tax beneﬁts for your company—a sort of reward offered by the government to encourage employers to offer retirement plans. When your plan is based on proﬁts (such as a proﬁt-sharing plan), it helps motivate you and your employees. Speaking of employees, this beneﬁt can help you seal the deal with the people you want to hire. Finally, you get to save for your retirement as well.
Nonqualiﬁed retirement plans don’t meet all the ERISA (Employee Retirement Income Security Act of 1974) and IRS guidelines, so they lose out on some important tax beneﬁts. They can, however, offer substantial deferred compensation to upper-level employees. That’s the main reason they don’t qualify; their aim is to give extra pay to a few elite executives, not everyone at the company. You would use one of these plans as an incentive for a truly valuable employee; by shifting some of his pay into the future (that’s deferred compensation), there’s a better chance he’ll stick around.
On top of that, you can use deferred compensation for yourself and your co-owners as well; that strategy can help ease your tax burden now, since income taxes won’t kick in until you get the payments. The downside, and there is a big one, is that your company doesn’t get a tax deduction now; it has to wait until payment is actually made.
Nonqualified plans come with some pretty unusual names. For instance, “golden handcuffs” describes a plan that encourages long-term employment by promising payments if the employee sticks around. Other common nonqualified plans come with equally colorful names: rabbi trusts, golden parachutes, and top-hat plans, for example.
If you’re looking for a current tax deduction for your company, a qualiﬁed plan is the only way to go.
Qualiﬁed retirement plans have to meet all the requirements set out by the IRS and ERISA in order to be eligible for four substantial tax beneﬁts:
- As the employer, you get an immediate tax deduction for the company’s contributions into the plan.
- The income earned inside the retirement plan (such as interest, dividends, and capital gains) isn’t taxable to the company at all.
- Employees—which includes you if you have a corporation—don’t have to pay income taxes on any of the money contributed to the plan for them (either their own contributions or the company’s).
- Distributions from the plan (such as retirement payouts) receive special tax treatment, except under some speciﬁc circumstances.
The most basic rule of qualiﬁed plans is that the beneﬁts have to be similar for everyone, and not weighted heavily in favor of the top dogs at the company (that includes you). When tax advantages are a priority, as they often are for young companies, stick with a qualiﬁed plan.