I’m going to try to summarize here the rationale behind my caution, because hidden small business pension plan costs can really sabotage what you’re trying to do.
A Quick Word about the Deferral Benefit
Can I, however, make a quick comment about the tax-deferral benefit you get from these plans?
Last week’s blog post discusses that issue and even provides an Excel workbook you can use to model scenarios that resemble your own specific situation. But the thing you should make sure you’re alert to is this: The tax deferral benefit doesn’t equal the reduction in taxes you see when you make a contribution.
The actual benefit you get can be, often is, less than that. In fact, if you pay the same top tax rate on the money you put in and pull out of the IRA or 401(k), you may see not any benefit to the deferral.
Note, by the way, that most people do get a benefit from the tax deferral—a benefit that bumps their retirement income by ten or twenty percent. (So $30,000 becomes $33,000 or $36,000.)
But that bump isn’t so big that you and I can ignore the hidden costs. We need to be careful.
And now let me identify the three big hidden costs…
Hidden Cost #1: Higher Payroll Taxes
A first hidden cost: You need to be careful that you don’t intentionally or inadvertently bump your federal and state payroll taxes in an effort to get larger pension plan deductions.
For example, you would never willingly add a spouse to your company’s payroll and pay a 15% tax on their earnings to get a pension plan deduction.
This gambit, in every case I’ve ever looked at, destroys the value of the tax-deferral. Go ahead, check the math if you can’t believe this is true. But what you’ll find, almost surely, is what I’ve found the last two or three hundred times I’ve checked.
Hidden Cost #2: Meaningful Administrative Costs and Fees
Another hidden cost pops up if you’re looking at options like a regular small business 401(k) plan. And by regular, I don’t mean a plan for just the owner or the owner and his or her spouse. I mean a plan that works for a handful of employees including the owner.
I think you’ll find that the administrative costs and fees of running one of these plans eat up the tax deferral benefit you hope to get with the 401(k).
In other words, you can probably set up a no-cost Simple-IRA plan for employees and for yourself and contribute (in 2016) $12,500. The other option would be to set up a 401(k) plan and pay, say, $3,000 or $4,000 a year and (for 2016) contribute $18,000.
The problem? The tax deferral benefit you get by bumping up your savings from $12,500 to $18,000 doesn’t offset the $3,000 to $4,000 a year you’ll pay for the plan.
And by the way, be cautious about any plans that don’t burden you with a $3,000 or $4,000 annual fee. If you’re offered a plan that costs only $500 or $1,000 a year, that might work great. But it may also be that the investment products inside the 401(k) plans bake in hidden fees that quickly add up to more than the $3,000 or $4,000 you would have paid if you’d just taken care of everything upfront and in the sunlight.
Note: Based on the troubles and tribulations we see small business clients go through when they don’t outsource payroll, we really recommend people outsource payroll to a national provider like ADP or Paychex or Gusto Payroll or QuickBooks Online Payroll. And what we’ve seen with these options is that you want to pick the seemingly expensive 401(k) plan the payroll vendor offers so you get access to good, high-quality, low-cost investment choices—like Vanguard’s Target Retirement Funds.
Hidden Cost #3: Recognizing the Permanency Requirement
Let me share one other hidden cost of a common popular pension plan choice: the solo 401(k) plan (also known as a Uni-K plan at some financial service companies and as an Individual 401(k) plan at other financial services companies… er, all trademarked phrases are the property of their respective owners… Yadda, yadda, yadda.)
But here’s the cost I’m talking about. Whenever someone (like me) points out that something like a SEP-IRA or Simple-IRA has no administrative fees or costs while a small business 401(k) plan often does, a critic will (correctly) say, “Well, my one-person 401(k) plan doesn’t cost me anything.”
This statement can be true. No argument there. But what this person probably doesn’t know are two important realities. First reality: If the firm hires another employee, the one-person 401(k) plan won’t work, and the new replacement 401(k) plan will require that $3,000 to $4,000 a year in fees.
The second reality: If the business owner cancels the 401(k) plan because he or she now doesn’t want to cover employees, very possibly (maybe probably?) the firm violates the permanency requirement. Which is bad. And which may cause the pension plan to unravel. Here’s the relevant blurb copied from the Internal Revenue Manual—the rule book an auditor will use to audit your small business including your pension plan if it comes to that:
Permanency Requirements/Reasons for Termination
- A plan must be established with the intent to be a “permanent” not “temporary” program (Treas. Reg. 1.401-1(b)(2)).
- Review Form 5310 lines 4(d), 5(a)(2) and 5(a)(3) to determine how long the plan has been in existence.
- If a plan terminated within a few years after its adoption, the employer must give a valid business reason for the termination. Otherwise, there is a presumption that the plan was not intended to be a permanent program from its inception. Courts have held that when a long established plan terminates without a valid business reason, it does not affect its qualification under IRC 401(a). See Rev. Rul. 72-239, 1972-1 C.B. 107.
Note: You can get some additional information about the permanency requirement here.
The hidden cost here, then, is that even a pension plan that’s “free” today may burden a small business with pension plan costs in the future. And you want to think about those, too.
A Couple of Suggestions for Small Business Owners
Can I give you a couple of suggestions based on the information and ideas already shared?
If you’re a one-man or one-woman operation and know for sure you always will be, I think you can use a one-person 401(k) plan (as long as you choose an administrator who gives you good, cheap investment options).
If you’re a one-man or one-woman operation and think you might very possibly hire someone down the road, I’d look carefully at the option of using a SEP-IRA plan. (I’ve got a longer discussion of this suggestion here from our www.scorporationsexplained.com site.)
Finally, if you’ve got employees already, I bet you can’t beat the option of using a Simple-IRA pension plan. Even if you can’t save quite as much as you want, the savings in pension administration costs will more than make up for the smaller tax deferral benefit.
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