The Challenge of Retirement Planning
It is a validated fact that most business owners in the U.S. have not saved enough money outside of their business to retire comfortably. Instead, they enjoy an upscale lifestyle while their company is doing well and plow earnings back into the business with a focus on growth. This behavior, over an extended period of time, risks not accumulating enough money for retirement and becoming totally dependent on the sale of the business in order to retire comfortably. What happens if the business does not sell, is forced into liquidation or simply fails to continue?
Not saving enough for retirement ranks among the top concerns for business owners of small- and middle-market companies
This is the primary reason so many business owners continue working well into their 70s and even early 80s. They cannot exit on their terms or schedule because they have not accumulated sufficient wealth outside their business to support their desired retirement lifestyle.
Instead, they become totally dependent on a “default” strategy, the presumed sale of their business for maximum value.
Depending on a “default” strategy is a gamble due to inherent risks:
- A “default” strategy provides no assurances. A selling price is influenced by independent factors—economic turmoil, capital markets, interest rates, your health, etc.
- A “default” strategy offers no certainty of finding a ready and qualified buyer at your planned departure.
- A “default” strategy offers no guarantees that a buyer will meet their financing obligations.
Every business owner needs to plan for the expected (retirement) and the unexpected (death or disability).
Many business owners face three key factors that fuel the concern of “not saving enough for retirement:”
- 65% to 85% of their net worth is locked up in their business—a non-liquid asset
- 54% intend to sell their business in order to retire
- A tsunami of retiring Boomer business owners will flood the market with businesses for sale —driving prices downward
Make No Mistake —The Boomer Tsunami Will Dilute the Market Value of Your Business
In 2006, 31% of all business owners in the United States were age 55 and older. That same year the first wave of Boomers hit the beach turning age 60 at the rate of 8,000 per day. With 78 million Baby Boomers in the United States, this trend will continue until 2024.
Robert Avery, an economist and demographic expert at Cornell University, predicts that this wave of Baby Boomers will transfer $10 trillion of wealth to later generations.
“This will be the most significant generational transfer of wealth in the history of our country.”
According to Avery, “the majority of Boomer wealth is held in 12 million privately-owned businesses, of which more than 70% are expected to change hands within the next 10 to 15 years.
This phenomenon has created a literal tsunami of Boomer business owner’s intent on exiting their businesses within the next 15 years.
Business Owner Retirement Strategies That Work
Business owners want to know if there is still time to save enough money for the retirement lifestyle they desire
There are two general types of qualified retirement plans: defined contribution and defined benefit.
Defined Contribution Plans, such as, profit sharing and 401(K) plans, have become the most popular among small- and middle-market businesses. However, if you find that you are within five to ten years of your retirement horizon, a defined contribution plan will fall short of helping you. Annual plan contributions are limited by IRS regulations and you have a relatively short time, five to ten years, to accumulate enough money to retire comfortably.
A Defined Benefit Plan is a better option provided your business is suitable to accommodate this type of retirement plan design. Annual contributions to a defined benefit plan are generally much larger than contributions to a defined contribution plan as they are based on a promised retirement benefit.
Characteristics of a Defined Benefit Plan
The Business Owner
At Business Exit Timing, LLC, we recommend plan design on the basis of business suitability, desired tax leverage, retirement objectives and time horizon.
- 1. Split Funded Defined Benefit Plan
- 2. 412(e)(3) Defined Benefit Plan
- 3. Benefit Focused Plan
- 4. Qualified Combination Plan
1. Split Funded Defined Benefit Plan
This plan design provides an additional feature to a traditional defined benefit plan—a pre-retirement death benefit. In a traditional plan the beneficiaries receive the participant’s account balance if death occurs before retirement. This balance may be insufficient to meet the family’s basic lifestyle needs. A Split Funded Defined Benefit Plan includes life insurance to fund a pre-retirement death benefit. Therefore, the plan participant’s beneficiary(s) will receive a death benefit in addition to the deceased participant’s account value—improved overall financial security.
2. 412(e) (3) Defined Benefit Plan
A 412(e) (3) is similar to a traditional defined benefit with an exception, the plan assets consist of products manufactured by a life insurance company, annuities and life insurance policies. This fully insured design permits large annual contributions, maximizes plan tax leverage and accommodates the accumulation of significant retirement assets—without having to depend on stock market cycles. It is important to choose a reputable life insurance company with superior financial ratings.
3. Benefit-Focused Plan
Benefit-Focused Plans have recently evolved as the new type of plan for wealthy business owners who might otherwise avoid defined benefit plans. Avoidance was based on the fact that the cost of installing and administering a plan outweighed the benefits owners derived.
This changed in 2008 when the Pension Protection Act of 2006 modified the rules for funding defined benefit plans. The outcome enabled business owners and their families, as well as key employees, to benefit the most from employer contributions to the retirement plan. In addition, within IRS guidelines, owners now have the flexibility to designate who participates in the plan at their companies. This is why these new plans have been dubbed “benefit-focused plans.”
Benefit-Focused Plans allow business owners the largest corporate tax benefits of any qualified retirement plans. They can literally double corporate tax deductions when compared to traditional defined benefit retirement plans making them very useful in adroit income tax planning.
Life insurance is part of the funding mechanism for the plan structure. Insurance premiums are fully tax deductible by the employer as plan contributions. Insurance proceeds can provide tax-free benefits to beneficiaries for either a pre- or a post-retirement death of a plan participant. Proceeds can also be designated to fund a buy/sell agreement for succession and/or estate planning.
4. Combination Plan
A Qualified Combination Plan coordinates the use of a 401(k) profit-sharing plan with a defined benefit plan. The defined benefit plan can be one of two designs featured above. The combination of a 401(K) profit sharing plan and a defined benefit plan can position business owners to maximize the advantages of both plans in order to:
- Accumulate significant retirement savings within a shorter time frame
- Cost-effectively meet the non-discrimination rules for qualified plans
- Add tax-deductible contributions to their retirement savings
- Provide personal life insurance using pre-tax dollars
- Protect their retirement plan assets from creditors of the business
In a combination plan approach, the employer can install a defined benefit plan primarily for the owner(s) and a 401(k) profit-sharing plan for the remainder of the employees.
For this reason, a business owner with 10 or more employees may find a Qualified Combination Plan more attractive than a stand-alone defined benefit plan.
Supplemental Retirement Accumulation Plans
If a qualified retirement plan is not economically feasible, consider a creative supplemental retirement accumulation plan.
It is important to distinguish supplement retirement accumulation plans from qualified retirement plans. Supplemental plans are not as tax advantaged as qualified retirement plans. Qualified retirement plans have additional tax incentives because they are labeled “qualified” meaning they meet IRS and Labor Department requirements for favorable tax treatment. However, supplemental plans do have an advantage over qualified plans in that they tend to be much more flexible and they are less expensive to administer and maintain.
With a supplemental approach, accumulated assets can be used to work in conjunction with proceeds from the sale of the family business. This combination will help to ensure that the retiring business owner has sufficient assets to meet retirement income objectives. It will also lessen the dependency of relying exclusively on the sale of the business for the maximum value—a “default” strategy—in order to retire comfortably.
Three supplemental retirement plans you should investigate are:
- Executive Bonus Plans
- Individually Owned Life Insurance Plans
- Accounts Receivable Financing Plans
Executive Bonus Plan
An Executive Bonus Plan is an effective financial tool that enables a business owner to take control of their retirement planning.
Individually Owned Life Insurance Plan
Life insurance is a commonly used and easily implemented supplemental retirement income accumulation strategy. Life insurance is a tax-efficient way to accumulate supplemental retirement assets specifically due to the fact that:
- Policy cash value enjoys tax deferred growth
- Distributions from cash value can be received income tax free
- Life insurance is an exempt asset in many states from business creditors and litigants
- Death benefit proceeds can be income tax free to beneficiaries
Accounts Receivable Financing Plan
In this plan a business owner personally secures a loan from a third-party lender using the business accounts receivable as the primary collateral for the loan. Loan proceeds pay the premiums for an Individually Owned Life Insurance Policy. The policy cash value is assigned to the lender as secondary collateral for the loan. After an accumulation period of at least 15 years, the owner can access policy cash values to repay the loan. The collateral assignment is terminated and the business owner then owns an unencumbered policy. The remaining policy cash values can be used to create a stream of tax-free supplemental retirement income.
- Plan premiums are funded from sources outside the business eliminating the need to use business working capital or creating a strain on business cash flow
- Policy cash value enjoys tax-deferred growth
- Distributions from cash value can be received income tax free
- Life insurance is an exempt asset in most states, protected from business creditors and litigants
- Death benefit proceeds can be income-tax-free to beneficiaries
For small- and middle-market business owners, running a successful business is just the first hurdle to achieving financial security. They still need to keep their eyes focused on the finish line.