What pension plan options are available for an S corporation?
Planning for retirement usually challenges people. And that planning gets even trickier for an S corporation business owner who needs to balance his or her retirement planning considerations with those of employees and with the peculiarities of Subchapter S of the Internal Revenue Code.
Accordingly, I want to talk about the common pension planning options available for and the issues relevant to businesses operating as Subchapter S corporations.
Some Background First
First, I want to make a couple of background comments in order to make this whole discussion more valuable. And here's my first comment: The tax savings you create by making a pension contribution are often only temporary. In other words, if you make a $10,000 pension fund contribution, that contribution lets you add a $10,000 deduction to your tax return. And the deduction very possibly reduces your taxes by $2,000, $3,000 or even more.
But remember that later on, when you withdraw that money from your pension account, you will pay taxes on the withdrawal. And while the taxes you pay on the back end may be less than the taxes saved on the front end, the difference may not always be that large.
Anyway, keep this issue in mind: A chunk of the apparent pension plan savings-sometimes a big chunk of the plan savings-gets paid back later on.
Here's a second thing to remember about pension plans. For small companies and their employees, the plans can be surprisingly expensive.
Even plans for very small businesses can cost the employer $2,000 to $4,000 annually for administration and insurance, for example. And nearly any plan that covers employees requires the employer to make contributions to employee accounts that quickly add up to at least 3% or 4% of the employee's wages.
Furthermore, many plans burden employees with high-cost investment options that eat up 10% to 30% of the employee's investment income. If your retirement savings earn you a 5% return and you pay a .5% management fee, the fee eats up 10% of your 5% return. If the fee equals 1.5%, the fee eats up 30% of your return.
The upshot? These costs can, if you're not careful, wipe out the true net savings a pension plan delivers to business owners-and sometimes even to employees. So you need to be careful.
And now we're ready to talk about the pension options you have if you own an S corporation.
Individual Retirement Accounts Don't Get Enough Respect
I want to start by putting out the idea that an Individual Retirement Account, or IRA, often represents a really good option for an S corporation owner.
First, you can save if you're single $5,500 to $6,500 a year if you make at least that much in your business. Over thirty years, using average rates of return, you can easily end up with around $400,000 at this savings level.
Note: I've got an free downloadable ebook, the Thirteen Word Retirement Plan, available at our Evergreen Small Business blog that explains how using an IRA can easily let you join the top ten percentile. You might be interested in looking at that if you're trying to get started with a retirement plan.
If you're married and your spouse doesn't work, you can usually double the annual savings amount, which means you're talking more like $800,000 in future savings. (You use a spousal IRA to get this doubling, though note that income restrictions may apply.)
Nevertheless, all in all, these are pretty good numbers. And in a sense, the IRA option (as compared to the other options a small business has) gets even better.
An IRA won't require pension plan administrative fees. An IRA won't require you to purchase fiduciary insurance for the pension plan administrator or the employer. And an IRA won't burden you with employer matching costs when you cover or are forced to cover employees under the small business pension plan.
In summary, then, an IRA often represents a solid pension plan option for small businesses and for S corporation owners.
SEP-IRAs May Be the Best S Corporation Option
Simplified Employee Pension Individual Retirement Accounts (also known as SEP-IRAs) sort of resemble IRAs.
With a SEP-IRA, the employee doesn't contribute to an IRA out of his or her wages. Rather the business contributes to the employee's IRA.
The contribution calculation works slightly different from an IRA. With a SEP-IRA, the business can contribute up to 25% of an employee's wages to the employee's IRA. If the employee makes, for example, $10,000, the employer can contribute up to $2,500 to the employee's IRA.
Contribution calculations for a shareholder-employee work the same way. If an S corporation pays a shareholder-employee $10,000, the S corporation can contribute up to $2,500 to the shareholder-employee's account. And if the shareholder-employee makes more, the S corporation may contribute more. If the shareholder-employee makes, for example, $200,000, the business can contribute up to $50,000.
Note: Tax laws limit the dollar amount of the contribution to $54,000 in 2017, but this amount gets adjusted regularly for inflation.
A SEP-IRA plan typically doesn't cost the employer any administrative fees and doesn't burden the employer with fiduciary insurance or similar costs. So that's good.
However, the business needs to use pension eligibility rules in line with what Congress decided was fair and acceptable to everybody involved. In a nutshell, the employer can exclude employees under the age of 21 and employees covered under a collective bargaining agreement. But anybody left over after these exclusions needs to be covered if they've worked during three of the last five years.
You can choose to be less exclusionary than described in preceding paragraph. But whatever your eligibility rules, for eligible employees you need to contribute the same percentage.
For example, if you've got three ineligible employees and two eligible employees, you don't have to contribute anything to the IRA accounts of the ineligible employees. But the percentages contributed to the IRAs of the eligible employees need to equal. In other words, if you contribute 25% to your SEP-IRA account, you also need to contribute 25% to the SEP-IRA of the other eligible employee.
Note: You can decide to contribute 0% to eligible employees' SEP-IRAs too. That's okay. You just need to make sure that no eligible employee receives a contribution. Or, restated, the zero contribution percentage needs to be used for every eligible employee.
Two final comments about SEP-IRAs: First, SEP-IRAs seem to me to work really well with S corporations because they effectively bump up compensation of shareholder-employees but in a way that doesn't increase shareholder-employee wages subject to the roughly 15.3% payroll taxes most people pay.
Example: A shareholder-employee who makes $40,000 a year and receives a 25%, $10,000 SEP-IRA contribution effectively makes $50,000 a year but she only pays Social Security and Medicare taxes on $40,000. Note, by the way, that this $10,000 contribution, if made over three decades, should grow into an retirement account balance of around $700,000.
A second, quick comment: Many small S corporations find that SEP-IRAs work well for years and years because no employee stays around long enough to become eligible. This is weird, I grant you. But I've seen this occur regularly. The college kid who works summers never comes back once he finishes school. The people one tends to hire in a small business may never stick around much more than a year, and so on. This phenomenon isn't something you can absolutely bank on... but you probably want to keep this subtle benefit at least in the back of your mind.
Simple-IRA: Lower Limits but Lower Costs
Lots of small business owners don't know about Simple-IRAs. And that's too bad. Because these pension plans sometimes work great for small businesses and most employees.
Simple-IRAs work like "lite" 401(k)s. With a Simple-IRA, employees decide to make a pre-tax contribution of up to $12,500 ($15,500 if aged 50 or older) to an IRA out of their wages. The employer then matches the employee contribution dollar for dollar up to 3% of the employee's wages. If an employee makes $10,000, for example, the employer will match, dollar for dollar, the employee's contributions but only up to $300.
The beauty of the Simple-IRA arrangement is that for the employer, no overhead costs (other than the match) occur. The employer is not, just to make this important point, paying two or three thousand dollars a year for administration of and insurance for plan.
And Simple-IRAs can work great for employees, too. A Simple-IRA doesn't practically limit most employees as compared to a 401(k) even though a 401(k) allows for higher balances. Most employees want to contribute something less than the $12,500 or $15,500 Simple-IRA limit. Further, a Simple-IRA should always provide employees with incredibly economical investment options like the Vanguard Group's low-cost index funds.
Note: Maxing out a Simple-IRA plan over 30 years, once you include the employer match, might easily produce an $850,000 future value amount. That's pretty good.
As with a SEP-IRA, an employee controls the Simple-IRA account. Note, though, that early withdrawal penalties for a Simple-IRA account are a little harsher during the first two years than for a regular IRA (25% instead of 10%).
Let me make one final comment concerning S corporations and Simple-IRA plans. With a Simple-IRA plan, typically most of the pension fund contribution comes from the employee and only a small match from the employer.
For example, if a shareholder-employee in a profitable S corporation makes $40,000 a year in wages, saves $10,000 of that into the Simple-IRA, and then receives a 3%, or $1200, matching contribution from the S corporation, only that last $1200 comes out of the S corporation's profits. The other $10,000 comes out of the shareholder-employee's wages.
This subtlety means that as compared to something like a SEP-IRA or, possibly, a 401(k) plan, an S corporation using a Simple-IRA will need to pay shareholder-employees more money subject to payroll taxes.
401(k) Plans Get Expensive Once You Add Employees
Many people know how 401(k) plans work. The employee, including a shareholder-employee, contributes up to $18,000 ($24,000 if aged 50 or older) out of her wages. The employer matches some portion of these savings according to a formula. For example, one common formula for safe-harbor 401(k) plans matches employee contributions dollar for dollar up to 4% of an employee's wages. And matching percentages can actually go as high as 25% of wages.
Example: If a shareholder-employee earns $40,000 as an employee, he or she can contribute up to $18,000 ($24,000 if aged 50 or older) out of wages. Then, as an employer the S corporation can do a 25%, or $10,000, employer match. That's a pretty big pension fund contribution--around $30,000 a year. Over thirty years and assuming average rates of return, someone might be able to end up with roughly $2,000,000 by running such a retirement savings program.
A 401(k) plan can work great for a one -person or husband-and-wife business operated as an S corporation. One-person and husband-and-wife 401(k) plans let the S corporation pay very large pension fund contributions on modest wages. The matching piece doesn't directly trigger additional payroll taxes because the match comes directly from the S corporation and not out of the employee's wages. Furthermore, one-person and husband-and-wife 401(k) plans often don't saddle the small business with expensive administration or pricey fiduciary insurance.
Note: You do need to be careful about setting compensation to adequate levels in a one-person or husband-and-wife 401(k) plan. Tax law requires the compensation to be at least equal to the sum of the employee contribution and the employee match. You cannot, for example, pay your 40-year-old spouse $20,000, have your spouse withhold $18,000 for an employee contribution, and then provide a 25%, or $5,000, employer match. The $18,000 employee contribution plus the $5,000 employer match equals $23,000, which exceeds the $20,000 in compensation.
However, while 401(k)s may work great for one-person and husband-and-wife 401(k) plans, they often don't work as well for S corporations with more than just shareholder-employees for two reasons. First, the matching percentage needs to be used for every eligible employee. Accordingly, in practice, 401(k) plans for S corporations with several employees often use a safe-harbor matching percentage like 4%.
Unfortunately, for S corporation shareholder-employees, a modest 401(k) matching percentage means that most of your 401(k) contribution comes from money you're paying payroll taxes on. This undesirable element also exists, as noted earlier, when you use a Simple-IRA plan.
A second problem: Typically, the small company 401(k) plan costs too much considering the modest incremental improvement you get over, say, a Simple-IRA. Commonly, for example, the small business finds itself paying $2,000 to $4,000 a year once all the administrative and insurance costs are tallied.
Small company 401(k)s can also suffer from another weakness--at least when viewed from the employee's perspective. Often the investment choices within the plan aren't that economical. As compared to the choices such an employee has in an equivalent Simple-IRA plan, for example, the small company employee may pay (indirectly) another .25% or even .5% in annual fees. This maybe doesn't sound like a lot. A half a percent extra expense on a $10,000 is only $50 the first year. The problem is that these fees grow over time as the account balances grow. When the employee has a $100,000 balance in his or her 401(k), he or she may be paying an extra $500 a year. Ouch.
Defined Benefit Plans - The Nuclear Option
Describing a defined benefit plan is a little tough. But I want to say that though usually impractical for S corporations, sometimes a defined benefit plan works really, really, really well for an S corporation shareholder-employee.
A defined benefit plan uses formulas that calculate the pension fund contribution required to deliver a specific "defined" benefit. For example, the defined benefit plan might say that someone who's worked for themselves for several years making, say, $60,000 a year, gets a $60,000 pension in retirement.
The defined benefit plan's formula might then say that this person's employer (this would be the S corporation of course) can contribute $90,000 a year to the employee's defined benefit pension plan account.
A defined benefit pension plan contribution is very S corporation "friendly" because the deduction appears on the S corporation's tax return and should logically reduce the payroll taxes the shareholder-employee pays.
Obviously, the large annual contributions possible make defined benefit plans attractive in some situations. (Note that you need both the money necessary to make the big contribution and the capacity to continue making the big contribution for several years in a row.)
While these plans aren't cheap (count on spending as much as you would for a 401(k) plan) and while they do require the employee to cover eligible employees (basically anyone who's working 1000 hours or more a year), in some small S corporation situations, the plans produce massive tax deferral.
Note: The stereotypical situation where a defined benefit plan makes sense is when a one-person or husband-and-wife S corporation want to save lots of money, are aged fifty or older, and then have only very young other employees.
Final Clarifications Related to Pensions and S Corporations
Three final clarifying comments about S corporation pension planning...
First, only the wages paid a shareholder-employee get used in the pension calculations. The distributive share (whether positive or negative) doesn't really matter.
For example, if a shareholder-employee earns $20,000 in wages but then gets allocated a $500,000 distributive share, the shareholder has $20,000 in earned income. That $20,000 is the "earnings" value that gets used in the various pension contribution formulas described in the preceding paragraphs. The fact that the shareholder-employee also received a $500,000 share of the profits is irrelevant.
A second comment-which you may need to prove to yourself using your actual situation's numbers: Rarely do you save money in an S corporation pension by bumping the shareholder-employee's wages so you can save more into a pension.
For example, yes, if you use something like a SEP-IRA, you can save more into your pension if you bump your wages from $40,000 to $100,000. You might in this situation be able to bump up your pension contribution from $10,000 to $25,000. However, the incremental payroll taxes associated with this bump in earnings would be roughly $9,000. And probably the SEP-IRA doesn't really truly save you enough money to make paying an extra $9,000 in payroll taxes worthwhile.
And a third and last comment: Tax laws set out a permanency requirement for qualified retirement plans. In other words, when you set up a pension plan, you're supposed to set it up as a more or less permanent or at least long-term solution. Practically speaking, and this is only fair if you think like an employee, people need the pension plan to be around long enough to work for their retirement planning.
You want to consider the permanency requirement as you think about setting up a retirement plan for your small business. Specifically, you almost certainly want a pension plan that'll work for several years and in most of the likely scenarios you see for your business.
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