Deferred compensation for small business owners?

[someguy]

Hi all, we are fortunate that our small business income continues to grow, but that leaves me dealing with higher and higher effective tax rates and looking for ways to defer more. Our savings percentage is very high (over 50%) so I believe that maximizing deferral of taxes will pay off, even if rates go up. We will continue to max out the regular and profit sharing of i401(k)s. Now I'm thinking about deferred comp plans but am a total newbie in this area, particularly as it might relate to the self-employed/small business owner.

Can anyone share direct experience or point me to good resources on the subject? Again, I'm especially interested in info for owners. Could I simply defer whatever income is left after paying business expenses and the i401ks that isn't needed for our personal expenses? It seems like a lot of the risks of a deferred comp plan wouldn't apply if you own and control the business?

 

[panacea]

I would suggest talking to a good CPA that has experience with small businesses. There are a number of options for deferring income, depending on the net income of your business and the number and status of your employees. SIMPLE, SEP, Solo 401(k), Defined Benefit, etc. Lots of questions to be asked and answered.

 

[someguy]

To clarify, by i401(k) I meant individual (aka solo) 401(k), which was determined as the the way to contribute the most tax-deferred to standard retirement. Comparing i401(k) to SEP, SIMPLE, etc. is pretty easy and straightforward. I get the impression deferred comp tends to fall into a completely different bucket since it is non-qualified.

Also, as I mentioned, I'm specifically looking for real life experience with such matters from fellow small business owners.

I would suggest talking to a good CPA that has experience with small businesses. There are a number of options for deferring income, depending on the net income of your business and the number and status of your employees. SIMPLE, SEP, Solo 401(k), Defined Benefit, etc. Lots of questions to be asked and answered.

 

[daylatedollarshort]

I don't have a deferred compensation plan but I hired an actuary from a pension consulting company to set up our small business retirement plan. If you talk to places like Fidelity they will tell you the kinds of plans they support, but maybe not tell you about everything you are legally eligible to do that they don't support. If your income is high enough and you can save enough maybe something like a personal defined benefit plan would work for you -

3 Stealth Retirement Savings Moves For The Wealthy - Forbes

 

[AnIntentionalRoad]

I set up a deferred comp plan for a company I owned and was able to contribute about 140k per year in it. But as we hired mote employees we had to offer a version of the plan to the employees that effectively eliminated any real financial benefit for the owner.

We paid about 10k to set up the plan BTW and had to retain a specialist attorney. If you have few employees, it is much more valuable.

 

[someguy]

Thanks for the feedback DLDS and AIR (I like that acronym!).

One thing I forgot to mention is that income is variable, so a defined benefit plan could be problematic. It seems like deferred comp plans are more flexible in terms of how much is deferred year to year, which is why I was originally thinking of that. Right now, we get about $100K/year tax deferred in a solo 401(k) (me plus spouse who contributes to the business, too).

AIR: Was the $140K/yr tax deferred and was that in lieu of things like solo 401(K) or in addition to? $10K plus ongoing specialist attorney hours is fairly high to shelter an incremental $40K, but if it's to shelter $140K more, then that is a deal.

 

[AnIntentionalRoad]

The 10k was a one time expense to draft the plan. It was a custom document and so there was quite a bit of flexibility in how it was drafted. After that, the annual administration was about 2.5k and was done by a firm that specialized in administering defined comp plans.

The 140k we contributed was tax deferred and was in lieu of any other plans. The reason it was limited for 140k was because there are tests conducted each year for "highly compensated" employees vs "non-highly compensated" employees and there is a ratio that has to be maintained as to how much is contributed to each group.

IE, the owners are generally the highly compensated employees and the rules require that if you contribute X to the owners's plans, then you also have to contribute some fraction of X to the each employee's plan. When you have a lot of employees, all of a sudden that adds up and quickly negates the tax benefit to the owners.

But, if it is just your wife and you, if IIRC, there were either very high limits or no limits on what you could contribute. My attorney related a story of a doctor in private practice with a very small staff who was contributing around 500k per year to her plan.

 

[someguy]

This sounds like something I need to look into for sure. Under what circumstances does the 2.5k annual admin fee continue? Until you stop new contributions, until you stop the business, until retirement, until the plan's assets are gone, or something else? Thanks again!

The 10k was a one time expense to draft the plan. It was a custom document and so there was quite a bit of flexibility in how it was drafted. After that, the annual administration was about 2.5k and was done by a firm that specialized in administering defined comp plans.

 

[Texas Proud]

It is probably better for a company with more employees.... but you can set up a non-qualified plan and bypass most of the rules that make you make it available to everybody...


The one big problem is that the company gets to keep the money and you are a general creditor if it goes belly up....

 

[someguy]

Right, but if you in effect ARE the company, isn't some of that risk ameliorated? Obviously there is still some additional risk beyond a 401(k) situation -- e.g., some kind of massive lawsuit that wipes out company.

The one big problem is that the company gets to keep the money and you are a general creditor if it goes belly up....

 

[daylatedollarshort]

Another thing to consider is ERISA protection for your retirement plan - which ever you chose. I believe if you have just one non-spousal employee, regular 401K plans may be protected under the provisions of ERISA, while solo 401K plan are not because by definition you can't have any employees. This may or may not be an important issue for you depending on the state where you live and how much money is in your plan. I do not know anything about the asset protection aspects of deferred comp or defined benefit plans for your own company.

Also if you have your own 401K plan, within the legal limits you get to write a lot of the rules, like being able to borrow money from your plan instead of making a withdrawal, which can be an advantage if you need short term cash but do not want to create taxable income.

 

[Texas Proud]

Right, but if you in effect ARE the company, isn't some of that risk ameliorated? Obviously there is still some additional risk beyond a 401(k) situation -- e.g., some kind of massive lawsuit that wipes out company.

If you are the only employee... then it might not work... there is a big cost to set one up and do the paperwork...

From what I heard when it was present to me (in a meeting), they suggested a min of 200 employees to be cost effective with the top 10 or so people in the plan...


I will ask a question, because I do not think you said.... is the business in a C corp? If not, then this plan is not for you anyhow...

 

[someguy]

It's organized as an LLC. I've seen nothing to suggest that this would preclude a deferred comp plan?

If AnIntentionalRoad's prices are still valid (i.e., 10K up front and then around $3K/year to admin), then how would the cost not be worth it? I expect my marginal rate for fed+state to be about 20% lower in ER than it is now. If a deferred comp plan allowed fed+state deferral on, say, only $100K more than the i401(k), the tax savings would be $20K/year. If it allowed more like $300K/year more, that's a whopping $60K/year. If I worked 10 more years, that's $600K. My question about how long one must pay the $3K/year admin fee is still outstanding, but (600K-10K/3K) gives almost 200 years of admin fees before it doesn't make sense. Am I missing something?

If you are the only employee... then it might not work... there is a big cost to set one up and do the paperwork...

I will ask a question, because I do not think you said.... is the business in a C corp? If not, then this plan is not for you anyhow...

 

[AnIntentionalRoad]

Fees are charged annually for means testing, filing tax forms, etc. I imagine they are there until you shut the plan down.

 

[Texas Proud]

Fees are charged annually for means testing, filing tax forms, etc. I imagine they are there until you shut the plan down.

If it is a non-qualified plan, there is no means testing.... you can set one up with almost any rules, including who you want and excluding everybody else...

 

[Texas Proud]

It's organized as an LLC. I've seen nothing to suggest that this would preclude a deferred comp plan?

If AnIntentionalRoad's prices are still valid (i.e., 10K up front and then around $3K/year to admin), then how would the cost not be worth it? I expect my marginal rate for fed+state to be about 20% lower in ER than it is now. If a deferred comp plan allowed fed+state deferral on, say, only $100K more than the i401(k), the tax savings would be $20K/year. If it allowed more like $300K/year more, that's a whopping $60K/year. If I worked 10 more years, that's $600K. My question about how long one must pay the $3K/year admin fee is still outstanding, but (600K-10K/3K) gives almost 200 years of admin fees before it doesn't make sense. Am I missing something?

Math is bad.... you will have to pay taxes when you start taking the money...

Also, are you the only owner of the LLC I know very little about these plans, but did have a seminar on them a few days ago, so I am just slightly above knowing nothing... but, if there is someone else on the LLC and they do not put money in the plan.... some of your savings are going to them....

 

[someguy]

I estimated a 20% tax savings based on my marginal fed+state rate now being (e.g.) 45% versus 25% in ER. So I'm not assuming I "save" the whole 45% of my current marginal, only the difference between now and my lower ER rate.

And I think a 20% gap is conservative.... I think 50% vs 15% could be more realisitc.

Math is bad.... you will have to pay taxes when you start taking the money...

Also, are you the only owner of the LLC I know very little about these plans, but did have a seminar on them a few days ago, so I am just slightly above knowing nothing... but, if there is someone else on the LLC and they do not put money in the plan.... some of your savings are going to them....

 

[AnIntentionalRoad]

I definitely recommend talking to an attorney specializing in setting up deferred comp plans because there are so many different versions and ways to structure them.