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BUSINESS PLANNING

Qualified Retirement Plans

Qualified retirement plans offer many tax benefits for business owners and their employees, but are subject to many rules and limits. There are two basic types of qualified retirement plans, each with many variations, twists and features. The defined benefit pension plan is funded to provide a specified benefit at a specific retirement age, based on actuarial assumptions. The defined contribution plan specified only the contribution going into the plan or, in the case of a profit-sharing plan, may leave contributions to an employer's discretion.

Decades ago defined benefit plans were quite popular with small but profitable businesses whose owners were in or approaching the second half of their working lives. But various tax law and regulatory changes systematically reduced the benefits of these plans by cutting down the amounts that could be contributed and increasing the overall cost to the business.

But, like a pendulum, the laws have swung back to become more liberal, resulting in a renewed interest in defined benefit plans and even a shift away from employer-funded plans in general. In many cases, these plans have been replaced by 401(k) or other defined contribution plans that leave much of the funding responsibility to employees. The tax law changes enacted in 2001 increased employee contribution limits, making defined contribution plans even more attractive. (See Chart 4)

Today’s plans are likely to provide for a more limited matching contribution (designed to encourage employee participation) as well as a lesser profit-sharing
contribution from the employer. Despite these changes, a defined benefit plan can still be a powerful tax-deferral strategy in the right situation.

Insurance within a Qualified Retirement Plan


From an income tax standpoint, the qualified retirement plan is not always the best owner for life insurance. The typical advantage of life insurance (death benefit proceeds free from income tax) is reduced when the policy is part of a qualified plan. On the other hand, tax deductible dollars can be used to fund the premiums. Thus, it may still be the vehicle of choice depending on where you place the bulk of your money.

As a business owner — even one who may have substantial wealth — you probably have money tied up in some or all of the following:

  • The business's assets
  • Qualified retirement plans or IRAs
  • Residences, vehicles or other personal assets,
  • Other real estate, and
  • Other investments you would not want to part with.
Chart 4
Feature of popular retirements plans
Plan type Funded by

Contributions are
tax-deductible

Maximum annual contribution /allocation
Defined benefits plan
Employer
Yes, to contributing employer
Contributions required to fund annual benefits, which can't exceed the lesser of $170,000 for 2005 (will be indexed for 2006) or 100% of includable compensation*
Profit-sharing plan
Employer
Yes, to contributing employer
Lesser of $42,000 per participant or 25% of includable compensation
401(k) plan (part of a profit-sharing plan)
Employees; employers can fund matching contributions
Yes, to contributing employees and employers
Employee deferrals — lesser of $14,000** plus $4,000 catch-up contribution for 2005 ($15,000 plus 5,000 catch-up for 2006) or 100% of includable compensation*
Roth 401(k) (effective 1/1/06)
Employees only
No
Combined with regular 401(k) limits
SIMPLE plan
Employees; with matching or nonelective contributions by the employer
Yes, to contributing employers
Generally employee pre-tax salary deferral contributions of up to $10,000** plus $2,000 catch-up for 2005 ($10,000 plus $2,500 catch-up for 2006); employer matching of 3% of compensation or 2% nonelective
Individual Retirement Account (IRA)
Individuals
Yes, unless participant is covered by another plan adjusted gross income exceeds certain levels
$4,000** also increased to $4,000 for nonworking spouses, plus catch-up amount of $500 for 2005 ($1,000 for 2006)
SEP IRA
Employer
Yes, to contributing employer
Lesser of $42,000 or 25% of includable compensation* (20% of earned income for self-employed)
Roth IRA
Individuals
No
Lesser of $4,000** (plus $500 catch-up in 2005; $1,000 catch-up in 2006) (reduced by any non-Roth IRA contribution) or 100% of individual's compensation for the year.
* Subject to $200,000 maximum compensation limit as indexed for inflation
** 2004 limit subject to adjustments under EGTRRA
Source: U.S. Internal Revenue Code

At the same time, your liabilities and responsibilities are free to grow like weeds. You may need to invest your cash flow back into business assets, fund your children's or grandchildren's education, fund the retirement plans mentioned above, pay for weddings and, of course, support a comfortable lifestyle. Meeting these demands often leaves fewer funds available for long term investments, including life insurance, than you would prefer to maintain.

Meanwhile, the qualified retirement plan you've been funding is sitting with liquid assets available for investment. Yet taking money from the plan may not make sense when you consider income tax obligations as well as the additional 10% early withdrawal tax that will generally apply if you are under age 591/2. Instead, the answer to your particular situation might be to buy life insurance within the retirement plan.

Chart 5
Retirement plan contribution limit increases
Year 401(k)s 401(k)s for taxpayers over 50 IRAs IRAs for taxpayers over 50 SIMPLEs SIMPLEs for taxpayers 
over 50
2004
$13,000
$16,000
$3,000
$3,500
$9,000
$10,500
2005
$14,000
$18,000
$4,000
$4,500
$10,000
$12,000
2006
$15,000
$20,000
$4,000
$5,000
indexed*
indexed*
2007
indexed*
indexed*
$4,000
$5,000
indexed*
indexed*
2008
indexed*
indexed*
$5,000
$6,000
indexed*
indexed*

1 Adjusted annually by the IRS based on the rate of inflation.
Source: U.S. Internal Revenue Code

If it makes sense to have insurance within the plan, you will need to address two key issues: Is insurance permitted under your plan and can proceeds be kept out of your taxable estate?

Can A Retirement Plan Hold Life Insurance?


In general, profitsharing plans, including 401(k) plans, may be used effectively for buying life insurance. Many profitsharing plans permit these purchases at the participant's election. Including such a provision in a plan can be important because it will allow you to design a program that fits the needs of one key plan participant without doing the same for everyone.

The amount in a profitsharing plan that can be used to buy life insurance is subject to what is known as the incidental death benefit rule. It states that anything up to 50% of the cumulative employer contributions to the account may be used to buy whole life insurance; up to 25% can be used for term insurance or universal life.

Although the rule's cumulative nature often allows enough room for planning, some exceptions can provide even more room. You can also simplify things by using all of any amounts that have been in the plan for at least two years, and you may use the entire account balance of any participant who has been in the plan for at least five years.

Bottom line: If you are aware of the restrictions, you should generally be able to accomplish your insurance goals within a profitsharing plan. Other types of retirement plans, however, may not be as flexible.

Keeping Qualified Plan Insurance Proceeds Out of Your Taxable Estate


In general, all amounts in a qualified retirement plan are part of your taxable estate. Thus, proper planning is important to ensure that insurance proceeds won’t become part of your estate. Otherwise it
may face a larger than necessary tax burden. Remember, the estate tax is repealed only for 2010. So you must assume there will be at least some estate tax in effect at the time of your death. The ideal insurance policy to use within a profit-sharing plan may be a “second-to-die” type, which pays proceeds only after the death of both the plan participant and his or her spouse. These policies are typically designed as follows:

If the participant dies first, the only amount included in the estate will be the policy's cash surrender value, because the proceeds are not yet payable. This is, in general, a relatively small amount. The policy should then be transferred to an irrevocable insurance trust designated by the participant. Transferring the policy to an insurance trust keeps the eventual proceeds out of the spouse's estate. The only cost comes from including the policy value (cash surrender value, not face amount) in the participant's taxable estate.

If the participant's spouse dies first, the participant should immediately remove the policy from the plan and transfer it by gift to an irrevocable trust. Distributing the policy to the participant results in income tax and a potential penalty tax. In the alternative, participants can buy the policy from the plan for its fair market value.

The participant must then live for at least three years after the transfer to the trust to keep the proceeds out of his or her estate. The transfer to the trust is a gift, measured by the policy's fair market value — generally the cash surrender value at transfer. Annual gift tax exclusions and the lifetime gift tax exemption can be used to minimize the transfer's gift tax burden.

Distribution Planning

Retirement plans have been excellent tax advantaged investment vehicles for many years, and many businesses have taken full advantage of the opportunity to contribute large amounts and let them grow tax deferred.

The result is that today, in many closely held businesses, the owners and key employees who are nearing or have reached retirement age have built up very substantial sums within qualified retirement plans, including IRAs.

What’s so terrible about this financial bonanza? Nothing, except for the income tax that will need to be paid, and likely the estate taxes, too. In a nutshell, qualified retirement plans are subject to federal income taxes at rates of up to 35% in 2005 and to state income taxes in some states. Even with certain deductions, and not counting any state taxes, the effective tax rate may be close to 70% after income and estate taxes before this money finds its way to the next generation.

If you plan to retire and live off your plan distributions, the total tax burden won't be so bad. But if you won't need all of your retirement plan funds, an important question arises: What can you do to lessen the overall income and estate tax burden on the money you will not need and will eventually pass on to your heirs?

The answers to this question are complex and should be analyzed on an individual basis. You will need to consider the amounts in your qualified plans and IRAs, your age, your spouse's age, your income needs, and your estate planning goals. Generally:

  • If you or your spouse live a long life (to age 90, for example), you will almost certainly be better off if you postpone taking distributions until required, and then take the minimum required amount. As a general rule, deferring the income tax and getting additional years of tax deferred income and/or appreciation will yield the best results.
  • If neither you nor your spouse live as long a life, a portion of the plan assets will probably end up being distributed directly to your beneficiaries — and will be taxable to them at their income tax rates. Consider whether this will create an advantage or a disadvantage.
  • Even if you bet on living a long life, other factors could possibly shift the advantage toward taking money out faster and sooner (perhaps beginning in your 60s, rather than at age 701/2). Such factors generally hinge on your ability to achieve estate planning goals that would not be possible without the use of this money, such as:
  • Using the funds (after paying income tax) to make gifts that qualify for annual gift tax exclusions or even establishing an FLP, or
    • Using the funds (after paying income tax) to purchase life insurance in an irrevocable life insurance trust (ILIT).
    • A projection of the after tax amount left for your heirs will sometimes dictate taking the money out sooner than required if you will then be able to do something with it that will also save estate taxes.

You may have an additional option to roll over existing qualified plan balances or IRAs to a Roth IRA. This may be the best option of all, but you only qualify if your adjusted gross income is under $100,000 and you don't file your tax return as married filing separately. You must also be willing to pay taxes on any previously untaxed contributions and the IRA's earnings up front.

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