Your business is successful, and the days of plowing back profits for growth are in the past. The building and equipment is either paid for or being amortized. Now, one your biggest concerns is finding a way to minimize taxes.
For many construction businesses, the answer may be a tax-deductible qualified plan (called “qualified” because the contribution qualifies for an income tax deduction)—in other words, some form of a retirement plan.
A well-designed retirement plan, however, is neither about retirement nor about employee benefits as much as it is about paying yourself rather than the Internal Revenue Service (IRS). Keep in mind that all of the contributions of a qualified plan are income tax-deductible, and the invested assets grow on a tax-deferred basis. In addition, the plan assets are protected from the claim of judgment creditors under the Employee Retirement Income Security Act (ERISA), and the plan assets qualify for an income tax-free Individual Retirement Account (IRA) rollover.1
Construction business owners may wonder which plan is best for their particular situation. For the same reason the local car dealership has many different models and colors, plans come in many varieties as well. The reason: One size does not fit all.
Plans come in two general styles, defined contribution (DC) and defined benefit (DB). Defined contribution plans define the contribution one can make to the plan. The limits are 25 percent of covered payroll, not to exceed $52,000 for any one individual. Defined benefit plans define the pension income one will receive at a future date. Adequate funds must be contributed to provide for that future income.
These plans are all budget-driven. While we all would like to retire on $1 million per month, we all have a budget to work with. That budget will determine which plan is best.
For 2014, the maximum pretax employee contribution, otherwise known as a salary deferral, is $12,000. Catch-up contributions for those 50 and older are limited to $2,500. Designed for small business owners who don’t want to deal with retirement plan administration or non-discrimination tests, the SIMPLE is available for those whose companies have fewer than 100 employees. The company’s contributions must be fully vested immediately (i.e. a dollar-for-dollar match of up to 3 percent of an employee’s income or a non-elective contribution of 2 percent of pay for each eligible employee). You cannot sponsor a SIMPLE plan with another retirement plan.
Technically an expanded IRA, this employer-funded plan gives businesses a simplified vehicle for making tax-deductible contributions. Employer contributions are 100 percent vested from the start. In 2014, an employer’s annual contribution limit to a SEP-IRA can’t exceed the lower of $52,000 or 25 percent of an employee’s salary. The same annual contribution limits apply for the self-employed or sole proprietors.
The 401(k) comes in many varieties. Many people believe these varieties are the same, but, in fact, they have significant differences.
- Salary Deferral‑Only Structures – This type of plan has no employer contribution. The participating employee may defer 100 percent of W-2 income not to exceed $17,500 (2014 limits). For those 50 and older, an additional $5,500 “catch-up” contribution is allowed for a maximum deferral of $23,000.
- Safe Harbor – Maximum addition to one’s account is $27,900. A byproduct of the Small Business Job Protection Act of 1996, the Safe Harbor plan is attractive to a business owner. With a Safe Harbor plan, an owner-operator can enjoy higher contribution limits. Safe Harbor allows the owners to defer the full salary deferral limits even if employees contribute little or nothing.
- Safe Harbor with Discretionary Profit Sharing – The maximum addition to one’s account is $52,000. While the Safe Harbor feature allows owners to make their full salary deferrals of $17,500 ($23,000 for those 50 and older), the maximum allowable contribution to one’s account is $52,000 ($56,500 for those age 50 and older). The difference lies in the employer’s discretionary profit-sharing contribution. The operative word is “discretionary,” as the employer has no obligation to fund the additional contribution from one year to the next. Take advantage of the deduction in profitable years, and disregard the contribution when cash is needed for other purposes, such as expansion, new equipment, etc.
- Roth Feature – In addition to the options above, a 401(k) plan may have a Roth feature. In other words, the employee’s salary deferral can be made with after-tax monies. The advantage is that all the future qualified withdrawals can be income tax-free (yes, the account’s earnings too).
Defined Benefit Plan
When you’ve already done the 401(k) and you need a larger annual income tax deduction, the defined benefit plan may be the answer. Consider that these plans allow for annual income tax deductions of, in some cases, as much as $250,000. But, that is the most one can do, and you can design the plan for a lesser contribution. As stated earlier, these plans are budget-driven, so determine the desired annual contribution, and have the plan structured to absorb that amount. One aspect of defined benefit plans that is important to remember is that the contribution is mandatory. In other words, design your plan with the understanding that this contribution must be made for several years. However, for those with consistent earnings and recurring tax bills, it is worth considering.
Many business owners falsely believe that these retirement plans do not fit their situation. Some might say, “Construction is volatile. In good years, it’s good, and in bad years, it’s awful!” Only after analysis of the facts and circumstances are the advantages apparent. Have a responsible pension consulting firm, in conjunction with your CPA or other competent professional advisers, and analyze your circumstances so you can make an informed business decision on what plan is best for you.
1RMDs, or required minimum distributions, must commence no later than April 1 of the year following the year one turns 70½. RMDs are taxable as ordinary income.