Symposium on Money Management
Providing for Retirement with Deductible Dollars Ronald B. Garver, B.A.*
Nearly everyone has been reading in the paper, hearing on the news, or seeing on television, articles or observations regarding the Pension Reform Act of 1974. This new law went into effect on September 2, 1974, and affects virtually all qualified retirement programs except governmental or charitable organizations. The word qualified means those programs which meet the regulations, therefore deposits or contributions become an expense deduction to the individual, partnership, or corporation making the outlay; the investment earnings of the moneys so contributed are accumulated income tax free until distribution at a later date. Inasmuch as this law is so new all final regulations implementing the law have not, as of this writing, been issued. However, interim regulations covering most facets of the law have been issued and the intent of the law is well understood by those who deal with these types of programs. These points are brought out at this time as the law and its associated reporting is still somewhat fluid and subject to modification and change by the Congress and the regulating agencies of the Internal Revenue Service and the Department of Labor. We would therefore recommend that competent professional advice be sought before formally entering into such a program. Observations made in the course of this article, although valid currently, may be modified to some degree when final regulations are issued. Before we get into the meat of the various programs available to you, I would like to offer a general personal opinion. Many practitioners of these programs do not have a full understanding of the new law and therefore either show reluctance in recommending programs or advise against them because of imagined pitfalls created by the additional reporting and regulation required by the new law. The author feels very strongly that they are providing a nonprofessional disservice *Design Consultant, Pension and Profit Sharing Plans, National Associates, Los Angeles, California
Veterinary Clinics of North America- Vol. 6, No. I, February 1976
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to those who seek their advice. The new law was principally designed to curtail the many abuses in the multi-employer union negotiated plan and as such provides for minimum standards that all plans should meet. Nearly every plan currently in operation in the small, closely held corporation is already more liberal than the new law requires. In addition, plans for sole proprietorships and partnerships have been improved and a new method of providing for retirement has been developed for individuals who are not covered under a qualified program. In effect the new law offers more diverse and improved opportunities to accumulate funds under favorable tax treatment for eventual retirement. This article discusses the three forms of qualified programs: the Individual Retirement Account; Keogh Plans (HR-1 0) for sole proprietorships and partnerships; and corporate programs. Throughout this article ERISA is the acronym for the Employee Retirement Income Security Act of 1974 or the Pension Reform Act of 1974.
INDIVIDUAL RETIREMENT PLANS Beginning with taxable years after December 31, 1974, individuals who are not covered by a tax-qualified retirement plan or a governmental plan may establish an Individual Retirement Account. This provision covers sole owners, partners, and their employees as well as corporate employees. The only restriction is that they must not have actively participated in any tax-qualified or governmental retirement plan during the taxable year. The amount an individual may set aside in such an account is limited to the lesser of $1 ,500 or 15 per cent of his or her gross compensation or earned income. If an individual is married and the spouse works, each may set up his own plan, subject to the same limitations. (A spouse cannot take the deduction in a community property state merely because one-half of the other spouse's earnings belongs to him or her.) The contribution so made to an Individual Retirement Account qualifies as a recognized deduction from gross income on the individual's personal income tax and may be taken even if the individual has elected the standard deduction. In general these moneys must be placed in a domestic trust or in a custodial account. For the most part, this will mean the use of a bank, savings and loan, insurance company, or special government bonds account. An employee may establish a domestic trust for his employees and make deductible contributions to the individual employee's account or he may make a contribution to an employee's own established Individual Retirement Account. These contributions may be made on a selec-
PROVIDING FOR RETIREMENT WITH DEDUCTIBLE DOLLARS
159
tive and/or optional basis. If the employer does make a contribution, the contributions will be included in the employee's income, but the employee in turn can take the deduction for them. Employee and employer contributions in combination are still subject to the maximum limitation. The trust instrument for individual retirement annuity must contain the following: 1. Except in the case of a rollover contribution (to be explained later) no contributions which exceed $1,500 will be accepted on behalf of an individual during the taxable year. 2. No part of the trust fund will be invested in life insurance contracts (annuities and endowments excepted). Only the premium attributable to savings in the endowment is deductible. 3. The interest of the individual in his account is nonforfeitable. 4. The individual's account must be distributed to him not later than the end of the taxable year during which he attains age 70 1/2. (Rules on distribution will be discussed later.) The Individual Retirement Account is exempt from income tax. Therefore investment income earned from the account will not be taxed until distributed to the individual. However, the individual may not borrow from the account or use it as a collateral for a loan or the tax exempt status is destroyed. It will also disqualify the program resulting in constructive receipt of the entire account and will be taxed as ordinary income. In addition, a 10 per cent penalty tax is imposed if the individual is not 59 112 or disabled. Beware, do not use the account for personal reasons. In general, all amounts distributed are taxed as ordinary income. This is true as none of the moneys accumulated have ever been taxed. If a lump sum distribution is elected, it is not eligible for capital gains and the special averaging rules available to HR-10 and corporate plans. The five year income average rules for individuals are available. If an annuity is distributed, it will have a basis of zero and therefore is subject to tax as payments are received. Amounts so received are eligible for retirement income credit on your personal tax form . Distributions to a beneficiary are taxed in the same manner and are not exempt from federal estate and gift taxes. In the event of a premature distribution, a 10 per cent penalty tax is imposed. A distribution prior to age 591/2, unless he is disabled under annuity rules, is deemed to be premature. Two additional areas to beware are ( 1) an inadequate distribution to an individual once eligible and electing to receive benefits, and (2) excess contributions. To simplify matters, do not do either and seek professional guidance if you think that you may be doing either. Excise penalty taxes are applied in both cases to your personal detriment. A new tax free rollover provision in the law provides for a degree
160
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GARVER
of portability to the individual. It allows an individual under certain rules to transfer moneys from one individual retirement account or annuity to another such plan within 60 days after he receives it. Lump sum distributions from qualified corporate plans may be rolled over into an Individual Retirement Account under special rules and back into a qualified corporate plan. Such moneys in this kind of situation should be maintained in a separate account. If the individual wishes to make contributions to an Individual Retirement Account, a new account should be established for this purpose. Two general conditions must be met for an eligible tax-free rollover: the transfer must occur not later than the 60th day after it was received, and a tax-free rollover can occur only once in three years. Again, I would like to stress that when a rollover is contemplated, professional advice be sought beforehand because there are situations where it may be disadvantageous because of differing tax treatment. This is particularly true in the case of a rollover from a qualified corporate plan to an Individual Retirement Account. That we have not dwelt on government bonds that qualify for Individual Retirement Accounts does not imply they should not be considered; they generally will offer the greatest safety of the assets but for the most part a lower yield. The new law also will require some reporting but for the most part will be completed by the trustee-custodian/investor, as will the necessary section of your tax forms. We have attempted a general overlay of the impact of the Individual Retirement Account and feel that this particular vehicle will be attractive to those firms who do not feel a need for a contribution to a plan substantially in excess of $1,500 annually. An owner may select it for himself and not his employees. He may choose it fully for himself and partially or selectively for his employees on an optional basis from year to year. The use of an HR-10 (Keogh Plan) for sole proprietors and partnerships and a qualified corporate plan for corporations should be considered if a larger deductible contribution is desired. The tax treatment for HR-10 and corporate plans is also generally more favorable. Which plan would be best for you would be a judgment decision made by you in association with your financial or accounting counsel (Table 1).
HR-10/KEOGH PLANS ERISA extended the advantage of the Self-Employed Individual Tax Retirement Act of 1962 (HR-1 0/ Keogh Plans) by increasing the allowable deductible contribution from the lesser of $2500 or 10 per cent of earned income or compensation to the lesser of $7500 or 15 per cent
161
PROVIDING FOR RETIREMENT WITH DEDUCTIBLE DOLLARS
Table I.
Growth of $1,000 a Year Invested at 8 Per Cent*
YEARS
PRINCIPAL
5 10 15 20 25 30 35 40
5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
VALUE
6,335 15,645 29,324 49,422 78,954 122,345 186,102 279,781
*For different deposit levels apply appropriate ratio, i.e., for $800 multiply by .8, for $1,200 by 1.2, etc.
of earned income or compensation. In addition new favorable rules for taxing lump sum distributions have been extended to cover Keogh plans. A new type of plan is now available for the self-employed in the form of a defined benefit plan not subject to the $7500 or 15 per cent limitaion. In general all other rules and plans applicable for the selfemployed remain relatively the same. For purposes of the antidiscrimination rules, only the first $100,000 of income is used in determining the percentage limitation as to existing Keogh money purchase or profit sharing plans so that an individual earning is excess of $100,000 will have to contribute at a 71/2 per cent rate in order to take advantage of the full $7500 deduction. In the case of the new defined benefit plan only the first $50,000 of earned income or compensation can be used in determining the benefit to be earned for retirement and its computed contribution. Up to $100,000 of earned income or compensation can also be used at a proportionately reduced formula of benefits. In order to qualify for a Keogh plan an employer must establish a trust account and plan that qualifies under the rules of the Code as administered by the Internal Revenue Service. The trustee is generally a bank or a bank as a custodian for some other investor medium (mutual funds/brokerage firms), insurance companies, or a savings and loan institution. Investments are generally limited to the vehicles offered by the trustee with an optional right to invest in insurance contracts. The general advantages of a Keogh plan over an Individual Retirement Account are the increased deductions available to the employer with regard to his own account and the more favorable tax applicable on lump sum distributions. Consideration of expense associated with other employees is also a factor in the adoption of a Keogh plan as, in order to qualify, all em-
162
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ployees with at least three years of service must be included in a plan at proportionate benefits on a nonforfeitable basis. This means that if an individual owner earning $50 ,000 wishes to set aside 15 per cent of his earnings or $7500 he must also set aside 15 per cent of the earnings of each employee who has been employed by him for three years and must continue to do so on the same basis that contributions are made in the future. The types of plans are the same as before: money purchase plans (a required contribution set by plan formula within the limits established by the code); profit sharing plans (a discretionary contribution determined by the owner-employer from year to year); and a new plan available commencing on January 1, 1976 called a defined contribution plan. If an individual is covered under more than one HR-10 plan the aggregate of the plans is subject to the maximum limitations. Mandatory employee contributions are effectively precluded if an owner participates in a plan. Voluntary contributions are allowed only if there are common employees covered in addition to owneremployees and are limited to the lesser of $2500, 10 per cent of earned income, or the rate of voluntary contributions permitted to be made by employees other than owner-employees. Do not make excess contributions to such a plan; there are penalties involved on a cumulative basis and the problems correcting such an excess contribution, which can be corrected, are great and are not worth the expense. Seek competent advice if such an error is made mistakenly. Tax free rollovers are available to HR-1 0 plans as discussed under Individual Retirement Account plans. Rollovers are allowed from Individual Retirement Account plans to HR-10 plans and from HR-10 plans to Individual Retirement Account plans. Do not rollover owneremployee funds from an HR-10 plan to another HR-10 plan or from an HR-10 plan to a qualified corporate plan as the entire distribution is apparently taxable. Apparently a qualified corporate distribution may be rolled over into an HR-10 plan without incurring a taxable event but this is currently unclear. The new defined benefit plan is a very desirable addition to the plans available under HR-10. This type of plan has always been available to corporate employers and has been widely used to the benefit of corporate owners particularly in the closely held corporation which is not unlike the sole proprietorship or partnership. · This plan provides for an increment of retirement benefit to be earned as a percentage of his earnings for each year of participation in the plan. The allowable percentage is based on the age at which his participation begins (Table 2). The contribution to pay for this benefit is not limited to the $7500!15 per cent rule and at most ages actually exceeds it. To determine the contribution, certain actuarial (mathemat-
163
PROVIDING FOR RETIREMENT WITH DEDUCTIBLE DOLLARS
Table 2.
Benefit Accrual Table*
AGE AT ENTRY
APPLICABLE PERCENTAGE
30 35 40 45 50 55 60 and over
6.5 5.4 4.4 3.6 3.0 2.5 2.0
*Percentage for interim ages. to be issued . Table valid through 1977 and thereafter until changed.
ical) computations must be followed in accordance with the regulations (Table 3). The actuarial parameters include government mortality and interest tables of December 1973. The benefit accrual is a percentage of the employees' annual or monthly compensation; the percentage factor is determined by age at the time of commencement; the annuity purchase rate (the cost of a $1 of annuity at retirement) is based on the later of a straight life annuity at age 65 or five years of plan participation; the benefit accrual equates to a benefit of career average earnings; and the
Table 3.
Calculation of Benefit*
Age 40 Compensation Benefit accrual rate Annual benefit Years to 65
100% maximum allowed by law Age40 Compensation Benefit accrual rate Annual benefit Years to 65
100% maximum allowed by law Age 40 Compensation Benefit accrual rate Annual benefit Years to 65
100% maximum allowed by law
$50,000 4.4 2,200 25 $55,000 $50,000 $75,000 2.93 2,200 25 $55,000 $75,000 $100,000 2.2 2,200 25 $55,000 $75,000
*It is to your advantage to maximize your income to the $100,000 level to maximize your benefits and contributions an!=~ to reduce your cost associated with respect to other employees.
164
RONALD
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GARVER
percentage factor applies to the benefit to be earned not to compensation, for determining a contribution; accrual rates are adjusted for increases in compensation within the limits, and reduction of benefits on account of Social Security is prohibited. The law places maximum benefits that can be earned to the lesser of $75,000 or 100 per cent of the participant's average compensation during his highest three years. A $10,000 annual benefit may be earned notwithstanding the 100 per cent limitation. As is evident in Table 4, the defined benefit plan is probably going to be a better vehicle to prepare for retirement at all levels of income (including those under $50,000, as the $7,500 figure is also reduced proportionately) and at all ages above 36 or 37 without insurance and at all ages with insurance. Table 5 illustrates the improved contribution limits available under HR-10. Many firms which have considered incorporating in order to take advantage of more liberal benefits available to qualified corporate plans will wish to re-evaluate their thoughts in view of the new benefits available under HR-10 and thus avoid the initial and continuing expense of incorporating. This is not to say that incorporating is not a desirable course but it is felt it should be viewed in consideration of other factors considered beneficial to operating as a corporate entity unless contributions are desired in excess of those now available to HR-1 0 plans. In closing this section I would like to reiterate the importance of seeking professional advice in this area because mistakes in design can be costly and not readily seen. Are you maximizing your deductions? Are you minimizing the expense associated with others covered under your plan? Are you getting the largest per cent of the dollars being expended? Unless done by a professional, these mistakes are a hidden loss of benefit for yourself for each year you make contributions; thus your mistake is compounded.
QUALIFIED CORPORATE PLANS Contrary to the many individuals who felt that ERISA destroyed the advantage of the private pension plan, benefits and deductions are in nearly every case bigger and better. I say this providing you deal with someone who has a thorough knowledge of the law and how to properly design a plan to take advantage of new areas of benefit available. This is true at nearly all levels of income up to about $400,000 annually. The types of plans available are the same under the new law as under the old. New rules have been applied to them in order to qualify and receive favorable tax treatment. You may still adopt a money
"'tt
:0
0
Providing for Retirement with Deductible Dollars Ronald B. Garver, B.A.*
Nearly everyone has been reading in the paper, hearing on the news, or seeing on television, articles or observations regarding the Pension Reform Act of 1974. This new law went into effect on September 2, 1974, and affects virtually all qualified retirement programs except governmental or charitable organizations. The word qualified means those programs which meet the regulations, therefore deposits or contributions become an expense deduction to the individual, partnership, or corporation making the outlay; the investment earnings of the moneys so contributed are accumulated income tax free until distribution at a later date. Inasmuch as this law is so new all final regulations implementing the law have not, as of this writing, been issued. However, interim regulations covering most facets of the law have been issued and the intent of the law is well understood by those who deal with these types of programs. These points are brought out at this time as the law and its associated reporting is still somewhat fluid and subject to modification and change by the Congress and the regulating agencies of the Internal Revenue Service and the Department of Labor. We would therefore recommend that competent professional advice be sought before formally entering into such a program. Observations made in the course of this article, although valid currently, may be modified to some degree when final regulations are issued. Before we get into the meat of the various programs available to you, I would like to offer a general personal opinion. Many practitioners of these programs do not have a full understanding of the new law and therefore either show reluctance in recommending programs or advise against them because of imagined pitfalls created by the additional reporting and regulation required by the new law. The author feels very strongly that they are providing a nonprofessional disservice *Design Consultant, Pension and Profit Sharing Plans, National Associates, Los Angeles, California
Veterinary Clinics of North America- Vol. 6, No. I, February 1976
157
158
RONALD
B.
GARVER
to those who seek their advice. The new law was principally designed to curtail the many abuses in the multi-employer union negotiated plan and as such provides for minimum standards that all plans should meet. Nearly every plan currently in operation in the small, closely held corporation is already more liberal than the new law requires. In addition, plans for sole proprietorships and partnerships have been improved and a new method of providing for retirement has been developed for individuals who are not covered under a qualified program. In effect the new law offers more diverse and improved opportunities to accumulate funds under favorable tax treatment for eventual retirement. This article discusses the three forms of qualified programs: the Individual Retirement Account; Keogh Plans (HR-1 0) for sole proprietorships and partnerships; and corporate programs. Throughout this article ERISA is the acronym for the Employee Retirement Income Security Act of 1974 or the Pension Reform Act of 1974.
INDIVIDUAL RETIREMENT PLANS Beginning with taxable years after December 31, 1974, individuals who are not covered by a tax-qualified retirement plan or a governmental plan may establish an Individual Retirement Account. This provision covers sole owners, partners, and their employees as well as corporate employees. The only restriction is that they must not have actively participated in any tax-qualified or governmental retirement plan during the taxable year. The amount an individual may set aside in such an account is limited to the lesser of $1 ,500 or 15 per cent of his or her gross compensation or earned income. If an individual is married and the spouse works, each may set up his own plan, subject to the same limitations. (A spouse cannot take the deduction in a community property state merely because one-half of the other spouse's earnings belongs to him or her.) The contribution so made to an Individual Retirement Account qualifies as a recognized deduction from gross income on the individual's personal income tax and may be taken even if the individual has elected the standard deduction. In general these moneys must be placed in a domestic trust or in a custodial account. For the most part, this will mean the use of a bank, savings and loan, insurance company, or special government bonds account. An employee may establish a domestic trust for his employees and make deductible contributions to the individual employee's account or he may make a contribution to an employee's own established Individual Retirement Account. These contributions may be made on a selec-
PROVIDING FOR RETIREMENT WITH DEDUCTIBLE DOLLARS
159
tive and/or optional basis. If the employer does make a contribution, the contributions will be included in the employee's income, but the employee in turn can take the deduction for them. Employee and employer contributions in combination are still subject to the maximum limitation. The trust instrument for individual retirement annuity must contain the following: 1. Except in the case of a rollover contribution (to be explained later) no contributions which exceed $1,500 will be accepted on behalf of an individual during the taxable year. 2. No part of the trust fund will be invested in life insurance contracts (annuities and endowments excepted). Only the premium attributable to savings in the endowment is deductible. 3. The interest of the individual in his account is nonforfeitable. 4. The individual's account must be distributed to him not later than the end of the taxable year during which he attains age 70 1/2. (Rules on distribution will be discussed later.) The Individual Retirement Account is exempt from income tax. Therefore investment income earned from the account will not be taxed until distributed to the individual. However, the individual may not borrow from the account or use it as a collateral for a loan or the tax exempt status is destroyed. It will also disqualify the program resulting in constructive receipt of the entire account and will be taxed as ordinary income. In addition, a 10 per cent penalty tax is imposed if the individual is not 59 112 or disabled. Beware, do not use the account for personal reasons. In general, all amounts distributed are taxed as ordinary income. This is true as none of the moneys accumulated have ever been taxed. If a lump sum distribution is elected, it is not eligible for capital gains and the special averaging rules available to HR-10 and corporate plans. The five year income average rules for individuals are available. If an annuity is distributed, it will have a basis of zero and therefore is subject to tax as payments are received. Amounts so received are eligible for retirement income credit on your personal tax form . Distributions to a beneficiary are taxed in the same manner and are not exempt from federal estate and gift taxes. In the event of a premature distribution, a 10 per cent penalty tax is imposed. A distribution prior to age 591/2, unless he is disabled under annuity rules, is deemed to be premature. Two additional areas to beware are ( 1) an inadequate distribution to an individual once eligible and electing to receive benefits, and (2) excess contributions. To simplify matters, do not do either and seek professional guidance if you think that you may be doing either. Excise penalty taxes are applied in both cases to your personal detriment. A new tax free rollover provision in the law provides for a degree
160
RONALD
B.
GARVER
of portability to the individual. It allows an individual under certain rules to transfer moneys from one individual retirement account or annuity to another such plan within 60 days after he receives it. Lump sum distributions from qualified corporate plans may be rolled over into an Individual Retirement Account under special rules and back into a qualified corporate plan. Such moneys in this kind of situation should be maintained in a separate account. If the individual wishes to make contributions to an Individual Retirement Account, a new account should be established for this purpose. Two general conditions must be met for an eligible tax-free rollover: the transfer must occur not later than the 60th day after it was received, and a tax-free rollover can occur only once in three years. Again, I would like to stress that when a rollover is contemplated, professional advice be sought beforehand because there are situations where it may be disadvantageous because of differing tax treatment. This is particularly true in the case of a rollover from a qualified corporate plan to an Individual Retirement Account. That we have not dwelt on government bonds that qualify for Individual Retirement Accounts does not imply they should not be considered; they generally will offer the greatest safety of the assets but for the most part a lower yield. The new law also will require some reporting but for the most part will be completed by the trustee-custodian/investor, as will the necessary section of your tax forms. We have attempted a general overlay of the impact of the Individual Retirement Account and feel that this particular vehicle will be attractive to those firms who do not feel a need for a contribution to a plan substantially in excess of $1,500 annually. An owner may select it for himself and not his employees. He may choose it fully for himself and partially or selectively for his employees on an optional basis from year to year. The use of an HR-10 (Keogh Plan) for sole proprietors and partnerships and a qualified corporate plan for corporations should be considered if a larger deductible contribution is desired. The tax treatment for HR-10 and corporate plans is also generally more favorable. Which plan would be best for you would be a judgment decision made by you in association with your financial or accounting counsel (Table 1).
HR-10/KEOGH PLANS ERISA extended the advantage of the Self-Employed Individual Tax Retirement Act of 1962 (HR-1 0/ Keogh Plans) by increasing the allowable deductible contribution from the lesser of $2500 or 10 per cent of earned income or compensation to the lesser of $7500 or 15 per cent
161
PROVIDING FOR RETIREMENT WITH DEDUCTIBLE DOLLARS
Table I.
Growth of $1,000 a Year Invested at 8 Per Cent*
YEARS
PRINCIPAL
5 10 15 20 25 30 35 40
5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000
VALUE
6,335 15,645 29,324 49,422 78,954 122,345 186,102 279,781
*For different deposit levels apply appropriate ratio, i.e., for $800 multiply by .8, for $1,200 by 1.2, etc.
of earned income or compensation. In addition new favorable rules for taxing lump sum distributions have been extended to cover Keogh plans. A new type of plan is now available for the self-employed in the form of a defined benefit plan not subject to the $7500 or 15 per cent limitaion. In general all other rules and plans applicable for the selfemployed remain relatively the same. For purposes of the antidiscrimination rules, only the first $100,000 of income is used in determining the percentage limitation as to existing Keogh money purchase or profit sharing plans so that an individual earning is excess of $100,000 will have to contribute at a 71/2 per cent rate in order to take advantage of the full $7500 deduction. In the case of the new defined benefit plan only the first $50,000 of earned income or compensation can be used in determining the benefit to be earned for retirement and its computed contribution. Up to $100,000 of earned income or compensation can also be used at a proportionately reduced formula of benefits. In order to qualify for a Keogh plan an employer must establish a trust account and plan that qualifies under the rules of the Code as administered by the Internal Revenue Service. The trustee is generally a bank or a bank as a custodian for some other investor medium (mutual funds/brokerage firms), insurance companies, or a savings and loan institution. Investments are generally limited to the vehicles offered by the trustee with an optional right to invest in insurance contracts. The general advantages of a Keogh plan over an Individual Retirement Account are the increased deductions available to the employer with regard to his own account and the more favorable tax applicable on lump sum distributions. Consideration of expense associated with other employees is also a factor in the adoption of a Keogh plan as, in order to qualify, all em-
162
RONALD
B.
GARVER
ployees with at least three years of service must be included in a plan at proportionate benefits on a nonforfeitable basis. This means that if an individual owner earning $50 ,000 wishes to set aside 15 per cent of his earnings or $7500 he must also set aside 15 per cent of the earnings of each employee who has been employed by him for three years and must continue to do so on the same basis that contributions are made in the future. The types of plans are the same as before: money purchase plans (a required contribution set by plan formula within the limits established by the code); profit sharing plans (a discretionary contribution determined by the owner-employer from year to year); and a new plan available commencing on January 1, 1976 called a defined contribution plan. If an individual is covered under more than one HR-10 plan the aggregate of the plans is subject to the maximum limitations. Mandatory employee contributions are effectively precluded if an owner participates in a plan. Voluntary contributions are allowed only if there are common employees covered in addition to owneremployees and are limited to the lesser of $2500, 10 per cent of earned income, or the rate of voluntary contributions permitted to be made by employees other than owner-employees. Do not make excess contributions to such a plan; there are penalties involved on a cumulative basis and the problems correcting such an excess contribution, which can be corrected, are great and are not worth the expense. Seek competent advice if such an error is made mistakenly. Tax free rollovers are available to HR-1 0 plans as discussed under Individual Retirement Account plans. Rollovers are allowed from Individual Retirement Account plans to HR-10 plans and from HR-10 plans to Individual Retirement Account plans. Do not rollover owneremployee funds from an HR-10 plan to another HR-10 plan or from an HR-10 plan to a qualified corporate plan as the entire distribution is apparently taxable. Apparently a qualified corporate distribution may be rolled over into an HR-10 plan without incurring a taxable event but this is currently unclear. The new defined benefit plan is a very desirable addition to the plans available under HR-10. This type of plan has always been available to corporate employers and has been widely used to the benefit of corporate owners particularly in the closely held corporation which is not unlike the sole proprietorship or partnership. · This plan provides for an increment of retirement benefit to be earned as a percentage of his earnings for each year of participation in the plan. The allowable percentage is based on the age at which his participation begins (Table 2). The contribution to pay for this benefit is not limited to the $7500!15 per cent rule and at most ages actually exceeds it. To determine the contribution, certain actuarial (mathemat-
163
PROVIDING FOR RETIREMENT WITH DEDUCTIBLE DOLLARS
Table 2.
Benefit Accrual Table*
AGE AT ENTRY
APPLICABLE PERCENTAGE
30 35 40 45 50 55 60 and over
6.5 5.4 4.4 3.6 3.0 2.5 2.0
*Percentage for interim ages. to be issued . Table valid through 1977 and thereafter until changed.
ical) computations must be followed in accordance with the regulations (Table 3). The actuarial parameters include government mortality and interest tables of December 1973. The benefit accrual is a percentage of the employees' annual or monthly compensation; the percentage factor is determined by age at the time of commencement; the annuity purchase rate (the cost of a $1 of annuity at retirement) is based on the later of a straight life annuity at age 65 or five years of plan participation; the benefit accrual equates to a benefit of career average earnings; and the
Table 3.
Calculation of Benefit*
Age 40 Compensation Benefit accrual rate Annual benefit Years to 65
100% maximum allowed by law Age40 Compensation Benefit accrual rate Annual benefit Years to 65
100% maximum allowed by law Age 40 Compensation Benefit accrual rate Annual benefit Years to 65
100% maximum allowed by law
$50,000 4.4 2,200 25 $55,000 $50,000 $75,000 2.93 2,200 25 $55,000 $75,000 $100,000 2.2 2,200 25 $55,000 $75,000
*It is to your advantage to maximize your income to the $100,000 level to maximize your benefits and contributions an!=~ to reduce your cost associated with respect to other employees.
164
RONALD
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GARVER
percentage factor applies to the benefit to be earned not to compensation, for determining a contribution; accrual rates are adjusted for increases in compensation within the limits, and reduction of benefits on account of Social Security is prohibited. The law places maximum benefits that can be earned to the lesser of $75,000 or 100 per cent of the participant's average compensation during his highest three years. A $10,000 annual benefit may be earned notwithstanding the 100 per cent limitation. As is evident in Table 4, the defined benefit plan is probably going to be a better vehicle to prepare for retirement at all levels of income (including those under $50,000, as the $7,500 figure is also reduced proportionately) and at all ages above 36 or 37 without insurance and at all ages with insurance. Table 5 illustrates the improved contribution limits available under HR-10. Many firms which have considered incorporating in order to take advantage of more liberal benefits available to qualified corporate plans will wish to re-evaluate their thoughts in view of the new benefits available under HR-10 and thus avoid the initial and continuing expense of incorporating. This is not to say that incorporating is not a desirable course but it is felt it should be viewed in consideration of other factors considered beneficial to operating as a corporate entity unless contributions are desired in excess of those now available to HR-1 0 plans. In closing this section I would like to reiterate the importance of seeking professional advice in this area because mistakes in design can be costly and not readily seen. Are you maximizing your deductions? Are you minimizing the expense associated with others covered under your plan? Are you getting the largest per cent of the dollars being expended? Unless done by a professional, these mistakes are a hidden loss of benefit for yourself for each year you make contributions; thus your mistake is compounded.
QUALIFIED CORPORATE PLANS Contrary to the many individuals who felt that ERISA destroyed the advantage of the private pension plan, benefits and deductions are in nearly every case bigger and better. I say this providing you deal with someone who has a thorough knowledge of the law and how to properly design a plan to take advantage of new areas of benefit available. This is true at nearly all levels of income up to about $400,000 annually. The types of plans available are the same under the new law as under the old. New rules have been applied to them in order to qualify and receive favorable tax treatment. You may still adopt a money
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