Wednesday, November 23, 2011

Small Business Taxes

Importance of Protecting and Promoting Small Business Qualified Retirement Plans - Retirement Plan Contributions to 401(k)/Profit Sharing Plans Should Not Be Cut Back

          The deduction for retirement plan contributions is not a tax expenditure, only a tax deferral

            In the discussion on how to raise revenue (and possibly lower tax rates), the deduction for retirement plan contributions has been treated the same as other tax expenditures in the tax code.  This is a mischaracterization - retirement plan contributions are eventually brought into income, along with any earnings.  The only loss to the government with respect to the deduction for retirement plan contributions and tax free growth inside the plan is the time value of money.  But the potential detrimental impact on savings by Americans due to a reduction on contributions to retirement plans could be huge.

A recent study prepared for the American Society of Pension Professionals & Actuaries (ASPPA)[1]  quantifies the “real” cost of this so-called tax expenditure.  This study reflects the value of the retirement plan tax expenditure to be roughly 55 – 75% lower than estimates by the Joint Committee and the Treasury. This study assumes that people will enjoy lower income tax rates during retirement than when contributions are made to the retirement plan.  This assumption increases the value of the “tax expenditure.”  Many experts believe, however, that tax rates are going to be higher for most taxpayers in the future because the tax rates are at historic lows and because of our country’s desperate need for revenue.  Thus, some experts believe the “real” cost of the retirement plan tax expenditure is even lower than that set forth in the ASPPA report.

There are 670,000 private-sector defined contribution plans covering 67 million participants and over 48,000 private-sector defined benefit plans covering 19 million participants. The U.S. private retirement plan system paid out over $3.824 trillion in benefits from 2000 through 2009 and U.S. public sector plans paid out $2.651 trillion during the same period.  All of this money was brought into income and subject to regular income tax rates (the only exception would be money that was contributed on an after-tax basis).

In the upcoming debate on deficit reduction, the retirement plan system should not be used to generate revenues, particularly when the savings are illusory due to artificial budget time frames which ignore reality.

          Impairing Americans’ ability to save for retirement now could be devastating for their retirement security in the future

Longer life expectancies are requiring increased retirement savings. Additional health expenses will be incurred by these increasingly elderly retirees. The present qualified retirement plan system has been very successful in providing retirement security. To protect the retirement security of small business employees, the small business voluntary retirement plan system must be promoted.  It is essential that the current contribution limits be maintained and not reduced.  Congress should do everything possible to encourage the adoption of 401(k), profit sharing, defined benefit or cash balance plans by small businesses.  Contribution limits on SIMPLE or other IRA based plans should not be increased, however, since these plans allow easy withdrawal access to IRA owners  prior to retirement and provide neither ERISA safeguards nor preselection of prudent investment choices or investment education.  They are good starter plans and should be used to draw small businesses into the qualified retirement plan system. Data shows that the most effective way for people to save is through payroll deduction.  Employees are far more likely to save in a 401(k) plan than in any other vehicle, including an IRA.

          The tax incentives inherent in the retirement plan system are the primary motivation for small business owners to sponsor retirement plans and thus cannot be cut back without imperiling the system.  If the tax advantages are cut back at a time when income tax rates are reduced (particularly when combined with favorable capital gains and dividend rates), small business owners will be incentivized to freeze or terminate the company’s retirement plan. Most small business owners view the meaningful contributions that are made for the non-key employees as the price of admission to be able to save for retirement in a tax advantaged manner for the key employees. From time to time, economists, particularly those who work with or for the government, claim that if the small business did not sponsor the retirement plan, the small business owners would pay the employees their regular compensation plus the amount that would have gone into the retirement plan for them.  These economists would say that this is true because this is the real value of the employee to the small business.  These economists are clearly not small business owners.  When a small business closes down the retirement plan, the owners are not likely to increase the pay of the non-key employees to take into account the loss of the plan contribution, rather the owners will take the amount that would have been contributed to the non-key employees as additional compensation for themselves, or take this money and reinvest it in the company. The early 1980s demonstrated that the small business retirement plan system is largely dependent upon tax incentives.  Because of the onslaught of laws that occurred at that time which decreased benefits for the key employees and increased contributions for non-keys while increasing administrative burdens, small business owners determined that the costs outweighed the benefits to be derived  for the key employees.  Accordingly, existing plans were terminated in droves and new plans were not established.  We don’t have to guess what will happen if the tax incentives are removed from the underpinning of the small business qualified retirement plan system – all we have to do is look back to the 1980s to see what will happen. A small business will go through a cost-benefit analysis to determine whether to sponsor a qualified retirement plan.

          How  many employees are actually covered by the qualified retirement plan system?   Many knowledgeable people believe the qualified retirement plan system covers about 50% of employees. A recent study,[2] which used actual data from W-2s rather than relying upon employees’ responses, found 77 % of all employees who work in companies with 10 or more employees are offered a retirement plan and of these employees, 62% made 401(k) contributions.  What was startling is that when asked only 49% of these employees thought they were contributing.   [This means that 13% of all employees making 401(k) contributions through payroll deduction didn’t even remember that they were making these contributions!]  Note that this survey did not analyze the actual numbers for retirement plan contributions made by the employer because this data is not reported on the W-2.  One has to assume this number would be even greater than the 77% number because many employees who receive employer contributions cannot afford or choose not to make 401(k) contributions and many small businesses offer profit sharing plans without a 401(k) feature.  If an employee can’t remember that he or she reduced his/her take home pay to make a contribution into a retirement plan, it is even more likely that this employee forgot that the employer was making a contribution to the plan on his/her behalf.

The size of the company makes a significant difference.  W-2 data, which is accurate only to 401(k) plans, reflects that 46% of small businesses with more than 10 employees but less than 25 offer a retirement plan.  The same data reflects that 60% of small businesses which employ 25 employees but less than 50 offer a retirement plan. 70% of small businesses which employ 50 employees but less than 100 offer a retirement plan.  84% of businesses with more than 100 employees offer a retirement plan. There is no further breakdown given for over 100 employees so we don’t know how many small to mid-size businesses – often defined as up to 500 employees offer plans compared to the large businesses. 

However, only 34% of small businesses which employ fewer than 10 employees offer a retirement plan.  The data, however does not take into account that in the first 4 years of a company’s existence, 40% of all new start ups fail.  One would assume that most start ups fall in the under 10 employee group.  It is not surprising, then that there is a lower level of sponsorship of retirement plans for the under 10 employee group when taking into account the precarious nature of most “new” small businesses.  

Nevertheless, these numbers reflect that the small business retirement plan system is successful by any measure as far as delivering benefits for small business employees.  Further, most small business plans are adopted by the small business to provide a tax advantaged way for the owners to save for their and the other key employees’ retirement.  The rules with respect to retirement plans force the owners to make significant contributions for the non-highly compensated employees.  Thus, in the small business qualified retirement plan world it is not unusual for the company (not the employee) to make contributions for its employees in the 3 – 8.5% of compensation range. 

This data also ignores the fact that not all employees meet the retirement plan eligibility requirements.  Part-time employees, employees under age 21 and transient employees are generally not eligible to participate in a retirement plan.  The statistics cited for the low retirement plan coverage, however, most often include the entire workforce and do not differentiate between the entire workforce and that percentage of the workforce that is actually eligible to participate in a retirement plan. When these ineligible employees are excluded, the coverage numbers again improve quite dramatically.

A qualified retirement plan, whether small or large, creates significant rights for the plan participants and generates significant costs for the company. Funds in a retirement plan are not tax sheltered, rather they are tax deferred until the participants receive them, at which time they are brought into the participant's gross income.  Those who specialize in the small business retirement plan area know that those plans which benefit the owners of small businesses also provide significant benefits for the non-highly compensated employees.

[1] Xanthopoulos and Schmitt, Retirement Savings and Tax Expenditure Estimates, ASPPA May, 2011 
[2] Dushi, Iams and Lichtenstein, Social Security Bulletin, Vol. 71 No.2 2011,  Assessment of Retirement Plan Coverage by Firm Size, Using W-2 Tax Records

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