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Downside: Two Reasons That Problems Arise
1. Choosing the wrong plan
Business owners often adopt a prototype retirement plan without thoroughly considering what kind of retirement plan they want. They go to their local financial advisor and get into a “one size fits all” plan, often in insurance-based products where everyone gets the same benefit. Although they may need a different type of plan if their primary objective is to maximize the benefits for the owners, getting out of a plan can be complicated and expensive.
Nonprofits need to be especially careful in selecting their plans. For one thing, nonprofits have limited ability to offer “nonqualified” deferred compensation plans to attract top talent such as for a university president or hospital CEO. Their plans need to be carefully tailored to comply with the rules. On the other hand, some nonprofits have additional choices of plans not available to other employers. Nonprofits that are tax exempt
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under IRC Section 501(c)(3) can offer a 403(b) plan (alternative to the 401(k) without the special 401(k) discrimination rules).
2. Sloppy implementation and operation
Business owners can find themselves with an invalid plan if they begin making contributions and collecting dollars from employees before finalizing their documents. This includes formally signing the documents and having minutes of a board of directors meeting to adopt the plan. If the plan is found to be invalid, the business owner may have to return the money, unwind the plan, and deal with penalties from the IRS. A really late adoption may cause the employer to lose a valuable tax deduction for its contributions to the plan.
Sloppy record keeping is another common problem for business owners. Business owners frequently underestimate the record-keeping requirements and find themselves unable to satisfy the nondiscrimination tests or make the required allocations and calculations. They may miscalculate contributions, inadvertently exclude employees, or fail IRS nondiscrimination rules. These things happen, Carol says, but the employer should try to minimize them. Sometimes business owners will go for plans that offer “bundled services” including record keeping, without realizing that they have signed up for insurance products with “back loads” (fees due upon sale) and termination charges. If a record-keeping problem develops, they may incur a substantial fee to change record keepers.
Upside: Four Choices That Reflect Careful Plan Selection and Design
1. Defined benefit plans
Carol sees a big upside in defined benefit plans, especially for business owners over age 50. Defined benefit plans allow
150 Tips to Avoid Common Mistakes in Retirement Plans
business owners to put away far more retirement dollars than any other retirement plan. Defined benefit plans work best when the owner is older than most of his or her employees. Many business owners are afraid of defined benefit plans because of the annual commitment to funding the plan. The annual funding commitment can be adjusted by amending the plan to change the benefit formula, changing the actuarial assumptions, and selecting actuarial funding methods that allow flexibility. So, it is really not as rigid a funding commitment as it appears.
There is even less of a financial commitment for a small professional services organization. There is an exemption from Title IV of ERISA for plans that cover professionals (e.g., doctors, lawyers, architects, accountants) that allows such plans to be terminated without being fully funded. So, the employer can terminate the plan and walk away.
2. New comparability plans
Carol sees a lot of small businesses adopting new comparability plans because they are flexible and focus on the owner. A new comparability plan is an aggressively discriminatory profit-sharing plan that allows an employer to contribute at a higher rate for the owner or highly compensated employees than for lower paid employees. Sometimes a new comparability plan goes so far as to specify individually the contribution level for each participant in the plan. A new comparability plan satisfies IRS rules that prohibit discrimination in favor of highly compensated employees by cross-testing, a technique that compares the amount of retirement benefit that will be payable at retirement instead of the amount of contribution that is made for each employee. A new comparability plan works best when the owner is older than the rest of the employees. Because a new comparability plan is a profit-sharing plan, it
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does not require the same level of commitment as a defined benefit plan. It can be terminated at any time and does not require a fixed level of funding each year. The downside is that the limits on contributions are much lower than under a defined benefit plan, especially for an older owner.
3. Age-weighted profit-sharing plans