This marks the third article in BaldwinClarke’s new series: Selecting a Business Retirement Plan. Early articles introduced key concepts, while later pieces highlight specific plan categories. This article focuses on flexible retirement plans.
Business owners might deduce a few takeaways from earlier articles. Retirement plans have evolved considerably in recent decades, more plans are available to businesses than ever before, and plan selection involves many factors. Armed with this context, owners can now review individual plan designs. This article highlights a popular subcategory: flexible retirement plans.
Economic tides are inherently volatile. Even the most stable businesses encounter rising costs, employee turnover, and supply and demand pressures. Other risks are unpredictable but no less impactful. Businesses that persevered through the 2008 Recession and COVID-19 Pandemic can attest. Still, private enterprise proves resilient time and time again. Sustainable businesses strike a careful balance between tenacity and risk management.
Annual profits are the lifeblood of companies. Thin margins dictate important decisions, such as whether to hire or fire, expand or cut back, pay bonuses or retain earnings. Sales are particularly difficult to predict in retail and service-oriented industries. Surprises occur irrespective of business models and revenue forecasts. Companies are understandably hesitant to extend additional commitments in an uncertain world.
Certain retirement plans suit dynamic circumstances. These plans have flexible funding requirements, allowing businesses to make contributions at their discretion. This arrangement also aligns employee incentives with those of the company, as research shows that employees perform best when there is a corresponding payout. The following sections focus on four common options: Profit-Sharing Plans, 401(k)s, Stock Bonus Plans, and Employee Stock Option Plans (ESOPs).
Profit-Sharing Plans
Profit-Sharing Plans are an intuitive and straightforward choice. Employers distribute profits to employee accounts on a discretionary basis. The design acknowledges the variable nature of business performance – some periods are profitable, and others are not. Owners evaluate their cash-flow and operating requirements, adding to accounts in good years and skipping contributions in down years. Companies receive an immediate tax deduction for these contributions. While Profit-Sharing Plans provide considerable flexibility, the IRS does require substantial and recurring contributions to keep the plan active. This rule is discussed later in the article.
Employees allocate contributions across several investment choices. Funds grow tax-deferred and are inaccessible until age 59.5 with few exceptions. Many companies impose additional vesting requirements to encourage employee retention. For these reasons, Profit-Sharing Plans are very common among companies with young workforces.
Profit-Sharing Plans are popular and easy to explain. They are also the foundation for other flexible plans, such as 401(k)s and Stock Bonus Plans, which provide additional features.
401(k) Plans
401(k) Plans are nearly ubiquitous across industries, and for good reason. These are simply profit-sharing plans that also allow employees to contribute. 401(k)s offer higher employee deferral limits ($20,500) than other tax-deferred plans, such as IRAs ($7,500).[1] Annual contributions can be significant when combined with company profit-sharing distributions.
The plan document outlines terms. Employees typically elect a specific contribution amount – or deferral percentage – at enrollment. This amount is deducted from each paycheck and allocated to a predetermined investment portfolio. Employees retain full flexibility to change deferral percentages and investment selections at any time.
There is no obligation for employers to contribute to a 401(k) Plan. However, many companies pledge certain amounts to attract and retain employees, provide additional benefits, and encourage plan participation. Some companies promise to match a certain percentage of each employee’s contributions. Others pledge a set contribution regardless of employee participation. Many companies, however, prefer the flexibility to make discretionary contributions as liquidity permits.
Stock-Based Plans
Certain plans are funded with employer stock rather than business profits. This preserves cash for emergencies, salary commitments, and growth initiatives. In some cases, stock-based plans also satisfy succession goals. The following section highlights two popular variants: Stock Bonus Plans and Employee Stock Option Plans (ESOPs).
Stock Bonus Plans are funded with company stock, stock equivalents, cash, or some combination thereof. Shares appreciate as the business value grows, tying employee incentives to the firm’s long-term success. Businesses can deduct employee stock distributions immediately.
Employee Stock Option Plans (ESOPs) modify this simple framework to accommodate liquidity and continuity goals. Leverage is perhaps the most significant feature. ESOPs can borrow money from a bank or financial institution to purchase company shares from owners. Owners transfer their shares to the ESOP in exchange for cash. The business then gradually pays back the initial loan from annual revenues. Over time, employees receive these shares based on factors such as compensation and length of service. As one might expect, ESOP arrangements are both costly and complicated. However, they are popular exit vehicles for private business owners.
Value extraction is a major obstacle for entrepreneurs. Many struggle to identify a willing buyer or competent successor. ESOPs accomplish both objectives by providing immediate liquidity and a gradual transition plan. Still, suitability depends upon the business owner and the nature of the business. A competent advisory team will outline available exit strategies, determine feasibility, and assess tax implications.
Plan Compliance
Compliance considerations accompany any retirement plan discussion. All four of the aforementioned plans are considered qualified plans. Article 2 of this series, “Key Considerations in Selecting a Business Retirement Plan,” highlights important liability factors for this plan category. The following section elaborates on several other constraints.
Flexibility has its bounds. It is true that company contributions to Profit-Sharing Plans, 401(k)s, and stock-based plans are discretionary. Owners can make additions when sales boom and forgo distributions when profits fall. This feature is highly appealing to tax-savvy business owners. However, favorable regulations often have caveats, and these plans are no exception. The full truth lies in the tax code.
The IRS requires flexible plans to make substantial and recurring distributions. There are no objective measures for this requirement. Instead, the government evaluates plans on a case-by-case basis, considering factors such as its history, contribution size, and overall fairness. Compliance is critical, as the IRS retains full authority to disqualify or terminate plans. An advisor can monitor plan activities and help maintain compliance.
Qualified plans also have nondiscrimination standards and top-heavy rules. These requirements ensure that all plan participants benefit fairly. Several different approaches can satisfy these guidelines, and professional guidance is again critical. Specialists help businesses maximize contributions for owners while satisfying compliance requirements.
Finally, a stock-based plan necessitates a business valuation. Value is easily determinable for publicly traded companies like Amazon and Apple. Their stocks trade on exchanges and share prices fluctuate with demand. Private companies, however, require an independent appraiser. BaldwinClarke offers decades of valuation expertise to small and mid-sized businesses.
This section merely scratches the surface of qualified plan rules. Additional regulations impact vesting, participation, and reporting. Businesses are wise to consult a team of professionals. [2]
Incentive Alignment
Humans are motivated by incentives, and the notion of work relies on a relatively simple bargain. People offer their time and services in exchange for wages. Studies suggest that people work harder when there is a prospect for higher pay or benefits. The theory holds that fair salaries, attractive benefits, and vacation time improve productivity. [3]
Profit-Sharing Plans, 401(k)s, and stock-based compensation can bolster workplace initiatives. By linking pay to company success, employees are encouraged to think and act like owners. Flexible retirement plans reward employees when their efforts translate to profits.
Bryce Schuler, CFP®
Financial Advisor
Baldwin & Clarke Advisory Services, LLC
Email: bryceschuler@baldwinclarke.com
[1] Contribution caps reflect 2023 limits.
[2] The next article covers simplified retirement plans, including Safe Harbor 401(k)s, Solo 401(k)s, SEP IRAs, and SIMPLE Plans. Streamlined rules and regulations render these attractive alternatives for small businesses and the self-employed.
[3] Expectancy theory suggests that individuals are motivated when they believe their efforts will produce desired outcomes, such as higher pay or rewards. In this context, compensation is an incentive for individuals to exert more effort and achieve better results.
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