In The Market

Now's the time to shop for a retirement plan. Find out which one's best for you.
Magazine Contributor
9 min read

This story appears in the March 1998 issue of Entrepreneur. Subscribe »

There's never been a better time to establish a tax-favored pension plan. The benefits are double-barreled for entrepreneurs. Setting up a qualified plan not only provides you with a tax deduction for the contributions you make on your employees' behalf, but the money you contribute to your own account is also deductible and is not included in your taxable income until withdrawn. (A qualified plan meets the requirements of the Employee Income Security Act and the Code.)

On top of that, your own contributions to your account are allowed to earn interest that's tax-deferred until you make a withdrawal. "The power of compounding with pre-tax money is very powerful," says Ward Bukofsky, a CPA with , California, accounting firm Braverman, Codron & Co.

Accountant Mark Cohen, a CPA with New York City accounting firm Newman & Cohen CPA PC, agrees. "We have some clients with several million dollars in their retirement plans thanks to regular retirement contributions and related tax deferral compounding."

Amassing this type of nest egg offers small-business owners a sense of security. "All businesses have ups and downs--and some don't make it,' says Joan Vines, a CPA with accounting firm Grant Thornton LLP in Washington, DC. By setting money aside in a qualified pension plan, it is safe from creditors' reach in the event your company runs into financial trouble. As a result, Vines says, "that money is going to be there even if the business is not."

The Taxpayer Relief Act of 1997 also makes it easier to set aside funds for retirement in both a company retirement plan, such as a 401(k), and an Individual Retirement Account (IRA). That's because the new law increases the income limits on deductible IRAs in stages for individuals who are active participants in a pension plan. This year, you can fully deduct a yearly IRA contribution of $2,000 if your adjusted gross income is $50,000 or less for joint filers and $30,000 or less for single filers.

Another important change: The new law permanently repeals the 15 percent excise tax on distributions from retirement plans (including both IRAs and qualified plans) that exceed $150,000 in any given year.

Joan Szabo is a writer in McLean, Virginia, who has reported on tax issues for more than 12 years.

What's The Plan?

Despite these benefits, small-business owners often struggle over whether to use profits to grow a business or administer a plan. But there doesn't have to be a choice. For example, with the use of a new, low-cost Savings Incentive Match Plan for Employees (SIMPLE), designed especially for small business, expenses can be held to a minimum.

If you've put off establishing a plan because of cost or complexity, now is a good time to examine the options available to you. "The sooner you start, the sooner you'll reap the benefits of a retirement plan," says Cohen.

Here's a brief rundown of the pros and cons of the major retirement plans:

  • SIMPLE: This is one of the newest plans and one of the most attractive options available to small-business owners with 100 or fewer employees. With a SIMPLE plan, you can decide whether to use a 401(k) or an IRA as your retirement plan.

A SIMPLE plan is just that--simple to administer. It doesn't come with a lot of paperwork or reporting requirements. If you establish one, you must provide a single report to the only when the plan is created.

Unlike a regular 401(k), making contributions is not optional with a SIMPLE plan. The employer must make contributions to the plan by either matching each participating employee's contribution dollar for dollar, up to 3 percent of the employee's pay, or by making an across-the-board 2 percent contribution for all employees, even if they don't participate in the plan. This can be expensive.

"[Another] trade-off for being simple is that the maximum amount each employee can contribute to the plan is only $6,000 a year," says Vines.

Tax consequences: The maximum contribution amount is one of the lowest of all available plans. Therefore, the tax deduction for the contribution will not be as great as it could be with some of the other plans.

  • Simplified Employee Pension (SEP): With this plan, you decide how much to contribute each year on behalf of each employee, or whether to contribute at all in a given year. Employees, however, cannot contribute any of their salary to their own accounts. In addition, if you decide to make a contribution, the same percentage must be applied to all eligible employees. The maximum contribution is 15 percent of an employee's salary or $24,000, whichever is less.

Tax consequences: The amount of the tax deduction for annual contributions to SEP accounts ranks just under a money-purchase plan or a profit-sharing plan.

  • 401(k) plans: Participants in a 401(k) have a percentage of pre-tax pay deducted from their paycheck and put into an account. The funds grow tax-deferred until they're withdrawn. One of the major benefits of a 401(k) plan for small-business owners is that you can establish the plan, but you aren't required to make contributions on your employees' behalf.

Your employees fund their 401(k) accounts with voluntary contributions. The maximum amount they can contribute yearly is the lesser of $10,000 or 25 percent of compensation. In addition, plan participants can borrow from their accounts before retirement--if the 401(k) is set up that way.

If you decide to establish a 401(k), both you and your employees must follow some fairly strict nondiscrimination rules, which require annual mathematical calculations to determine allowable contribution amounts. The aim is to make sure highly compensated employees aren't allowed to make substantially larger contributions than rank and file employees.

Tax consequences: The tax deduction for annual contributions to a 401(k) is also slightly less than a profit-sharing plan or a money-purchase plan.

  • Profit-sharing plans: One of the most popular plans for small-business owners, profit-sharing plans let you either make or not make contributions based on your own standards, such as company profits for the year. Maximum contributions can't exceed 15 percent of compensation or $24,000 per employee, whichever is less. If you do contribute, you must use the same percentage for all employees.

Cohen says the small-business owner's ability to borrow from a profit-sharing plan is a major attraction. "Small-business owners who have set up partnerships or C corporations, have been in business for several years, and have built up some assets in their profit-sharing plan can borrow the lesser of 50 percent of their vested benefit or a maximum of $50,000," says Cohen. "[This option] provides a ready source of capital that the owner can use to grow the business." The loan must be repaid over five years.

Tax consequences: The amount of the deduction for annual contributions to a profit-sharing plan is similar to that of a money-purchase plan.

  • Money-purchase plans: While these are the best options in terms of your deduction, they are sometimes less attractive to small-business owners than profit-sharing plans because they require employers to contribute to each employee's account every year. In addition, the percentage contributed must be the same for all employees and can't vary from year to year. The maximum contribution is the lesser of 25 percent of salary or $30,000. Employers often combine a money-purchase plan with another retirement option, such as a profit-sharing plan, to increase their tax deduction and keep the required contribution to a minimum.

Tax consequences: With a money-purchase plan, it's possible to make one of the largest contributions to a pension plan (up to $30,000 for the business owner), and thus receive one of the largest tax deductions. This is only possible if all the requirements of these plans are met.

  • Keogh plans: These plans are designed mainly for--but aren't limited to--people who are self-employed. You can also set up a Keogh if you own an unincorporated business, such as a partnership or limited liability company. If you have employees, they must be allowed to participate in the Keogh plan.

Keoghs are generally profit-sharing plans or money-purchase plans. They are especially appealing to high-income sole proprietors or other small-business owners because a money-purchase Keogh lets you make a maximum annual contribution of $30,000. In addition to your ability to defer a good deal of income with this type of plan, you also receive a sizable tax deduction for the contribution. Banks, brokerage houses and insurance companies can help in establishing a Keogh.

Tax consequences: A Keogh money-purchase plan is the same as a standard money-purchase plan except it's easier to make pension contributions and take the deduction (up to $30,000) if you are a highly-compensated business owner with no employees.

The IRA Route

If your company is not in a position to offer a plan, it makes good tax sense for you and your employees to consider contributing to a standard IRA or one of the new IRAs created by the Taxpayer Relief Act.

With the Roth IRA, named after its principal sponsor, Sen. William V. Roth Jr. (R-DE), annual contributions are not tax deductible, but you will be able to withdraw money without paying taxes if certain conditions are met. (See "11th Hour," December 1997.)

"Taking advantage of the Roth IRA might be more attractive than contributing to a 401(k) plan for some taxpayers," says Vines. "If you go into a 401(k), you get a deduction on the front end, so when you start taking out the money, it's all taxable. Some taxpayers may conclude it's better to forgo the deduction on the front end than to have free earnings coming out."

As you can see, pension plan options are plentiful. Don't delay--get the benefit of tax savings while you watch your nest egg grow.

Contact Sources

Braverman, Codron & Co., 450 N. Roxbury Dr., 4th Fl., , CA 90210, (310) 278-5850

CCH Inc., (847) 267-2484,

Grant Thornton LLP, (202) 967-0580, fax: (202) 967-0582

Newman & Cohen CPA PC, (212) 967-0580, fax: (212) 967-0582


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