Retirement Savvy: How To Reward An Olympian Effort
The Olympics is the basis for Brian Whitlock's advice on providing for retirement and the provisions in the tax codes that can be used to maximize them.
Entrepreneurs have had years of training in planning, budgeting, and being fiscally responsible with their businesses. Like the Olympians competing in Atlanta this summer, many will fail to win the Olympic gold; but, nonetheless, most will enjoy the thrill of the competition.
Athletes and business owners alike focus so much of their efforts on the competition that they are sometimes left financially and emotionally unprepared for their later years. Some advanced financial planning is in order if they are to reap the benefits they so richly deserve.
Owning up to it –
Zeus is a typical first generation business owner who has worked for many years to build his own business into something significant. Financially conservative, he has not overpaid himself, but rather has plowed the earnings and extra cash back into the business to keep overhead low, to expand inventory and receivables or to purchase equipment.
At 62 years old, Zeus sees himself slowing down over the next couple of years and turning the business over to Hercules, his 32 year old son. Only one obstacle stands in Zeus’ way – he needs money to live on. He has a modest amount of money in personal savings, profit sharing and IRA plans. However, that is his safety net, and he prefers not to touch these funds yet.
Earned income hassles –
The easiest way would be to simply continue to pay Zeus a salary. Nearly everyone would agree that Zeus is entitled to future salary based merely on his past contributions to the company. Morally they are correct; but the “Infernal” Revenue Code limits the company’s income tax deduction to what is reasonable compensation for Zeus’ services. Without written proof to document Zeus’ past undercompensation, his salary may need to be discontinued completely. Even if we can leap over the salary hurdle, the resulting payroll tax costs and the lost social security benefits may trip us up.
Here’s how.
• Payroll tax cost — If the company pays Zeus a salary for either current or past services, then both Zeus and the company will need to pay payroll taxes (i.e., FICA, MHIT, FUTA, and SUTA, workman’s compensation taxes) each year. If Zeus gets more than $75,000 each year, these payroll taxes will exceed $10,000 each year for the rest of his life.
• Lost social security benefits – Zeus has paid into the Social Security system for the last 40-plus years. Now he figures it is his turn. Beginning at age 65, Zeus will be eligible to receive nearly $1,300 per month ($15,300 per year) of Social Security benefits. However, Zeus is in for a surprise. Between the ages of 65 and 70, Zeus will lose some or all of his benefits if he receives “earned income” (i.e., salary, wages, bonus, etc.) in excess of $12,500 a year. For every $3 of earned income in excess of the limit, Zeus will lose $1 of Social Security benefits. So, if Zeus earns $60,000 or more, he will forfeit his entire annual benefits until age 70. Ouch! Zeus would get burned for $15,600 per year for 5 years - a total of $78,000 of lost benefits.
Unearned income benefits –
Unearned Income (i.e., dividend, interest, rent and retirement benefits) do not affect your Social Security benefits. The key to preserving Zeus’ Social Security benefits and avoiding the payroll taxes is to create unearned income rather than salary.
With a number of years to save, assets can be accumulated outside of the business (i.e., cash, equipment and real estate). As a person slows down, the interest or rent will replace the lost salary.
Zeus was so wrapped up in running the good race that he didn’t accumulate significant assets outside the business. Is it too late? No!
• Deferred compensation plan – Let’s convert the company’s moral obligation to Zeus into a binding written legal obligation. In exchange for Zeus’ commitment to work full-time for the next three years and train Hercules, the company agrees to pay Zeus a portion of his regular salary ($60,000) for the rest of his life.
The present value of the company’s promise is $600,000. If the accrual of that amount is spread over the three years that it will take Zeus to fully earn it, then it is equal to $200,000 per year. The payroll tax rules will require him to pay the Medicare (MHIT) tax each year as he accrues the $200,000 of deferred compensation. The total MHIT will be $5,800 per year for three years; but, that’s it. There will be no more payroll taxes now or in the future. This is a huge savings over the $10,000 payable taxes that would have been payable on continuing salary.
And the winner is –
What Zeus will be profiting from is called a non-qualified plan. Most business people are familiar with qualified plans (i.e., pension, profit sharing, 401(k), ESOP, etc.). The rules for such plans are stringent. All full-time non-union employees must generally be covered. The plan must be approved by the IRS and the Department of Labor. The trustee must receive funds annually and invest them within strict guidelines. The rules have become so onerous that many employers have reduced their participation in qualified plans.
However, the rules covering non-qualified plans are much simpler. Employers can discriminate and hand-pick the participants to the exclusion of others. The plan does not need to be funded or trusteed. Finally, after an initial one page letter, no government reports are required. The only significant difference between qualified and non-qualified plans is that the company must postpone its income tax deduction until the funds are actually paid (and taxable) to the employee.
The finish (or bottom) line is simple. If Zeus adopts a non-qualified compensation plan now, instead of paying himself a salary after age 65, he will save $90,600 by the time he reaches age 70 and more than $10,000 per year after that for the rest of his life.
Brian Whitlock, CPA, JD, LLM, is the Partner in Charge of Wealth Transfer Services at Blackman, Kallick & Bartelstein in Chicago, IL.Discuss