Business owners have a large number of options when it comes to retirement plans. Not only do they need to decide which type (SEP, Simple 401k, Regular 401k, profit sharing, etc.), but they also need to consider the various providers, investment choices, and features that will be included with the plan.
Designing the best plan is as much art as science. Effective plan design considers all of the employer’s objectives. Those include maximizing contributions for the owner, retaining employees, and limiting the owner’s liability. The design also needs to consider the income of the owner and other employees, and the ages of the staff. Considering all the options, it is no wonder many employers end up with the wrong retirement plan for their unique situation. Depending on the circumstances, a business owner can potentially shelter over a hundred thousand dollars each year in a well designed plan.
Consider John Doe, 48, running a thriving small business for 30 years, generating income of $400,000 a year. He maxes out annual contributions to his 401k plan, but after looking at his tax bill he wonders if there isn't a better way. Making $400,000 a year and contributing $16,500 to his 401k plan (maximum in 2009), still leaves $383,500 of taxable net income.
A well-designed plan allows John to shelter an additional $100,000 per year, reducing his tax bill while increasing his retirement savings. With this approach, he puts $100,000 into a retirement plan this year; reduces his taxable income by $100,000 and still has the $100,000 to invest. If he had taken the money as income, he would only have about $60,000 since he would be responsible for $40,000 in taxes (assuming 40% in taxes). Additionally, money in a retirement plan grows faster than money outside of a plan because it is not taxed along the way. So if John Doe earns 10% in his retirement plan, he keeps the whole 10%. However, in a taxable account, he would only keep 6% since he would lose 40% to taxes. In this example, the difference is:
Earning 10% on $100,000 = $10,000
Earning 6% on $60,000 = $3,600
By choosing to shelter his income in a retirement plan instead of exposing it to taxes, John Doe‘s annual growth on that money is 278% higher. He will have to pay taxes when he withdraws the money in retirement, but by deferring the taxes he allowed that money to work for him until he’s ready to pay them.
Many 401(k) providers want you to use one of their pre-packaged retirement plans because it is much easier for them. However, by using a custom-designed plan, you can perfectly match your unique situation without any compromises. It is like the difference between a custom-tailored suit that fits you perfectly compared to an “off-the-shelf” model that fits you ok here and not so well there. Additionally, the custom tailored suit you had in your 30’s may not fit as well when you are in your 50’s. The same principle applies to a retirement plan. A quality plan consultant, like a good tailor, will ensure that your custom-designed solution continues to work for you as your needs change over the years.