Many employers contemplating the establishment of a profit sharing plan mistakenly think its contribution must be allocating in a uniform manner among participants. It is a fact that the allocation may not discriminate in favor of owners and highly paid employers. The rank and file employees must be treated fairly. Thus, the Plan must meet certain non-discriminatory test in order to be a qualified plan.
Additionally, in the context of a defined contribution plan, the amount of the employer's annual contribution to the plan is discretionary. In the event of a year in which profits are less than for most years, the employer may skip making a contribution or contribute much less than it normally does.
Age-weighted and new comparability allocation methods may be tested for non-discriminatory purposes on either a benefits or a contributions basis. An example for an age-weighted allocation is given below to point out why testing on a benefits basis is not discriminatory in situations in which there are discriminatory among the ages of participants.
We will look to a subcontractor, owner of the employer, age 55 and his helper age 30. The owner has ten years left before he attains age 65. Under the age-weighted method of allocating employer's contribution, the employer must pass the General test using "cross-testing" (i.e., projected future benefits derived from the present-day allocation to the helper muster be comparable to projected future benefits derived from the present-day allocation to the owner.
If we use the same "testing age" (i.e., 65) and the same interest rate and mortality assumptions, both the owner and the helper are to receive comparable benefits at age 65. However, the lump sum accumulations to pay those benefits must also comparable. In order to accumulate comparable lump sums at age 65, using the same interest (between 7.5% and 8.5%) and the same mortality assumptions, the annual allocations for the owner must be much larger than those for the helper. Not only is the lion's share of the employer's contribution allocated to the owner, the total contribution both of them is much smaller because of the young age of the helper. Most small business owners see this as a win-win situation.
Following is an illustration of the power of interest compounding and the importance of investing early in life:
Bill invest $2,000 at the beginning of each year beginning at age 19 and continuing through age 26. Bill makes no additional investments to the account after age 26. For simplicity, we assume Bill's account earns 10% annually, compounded annually. At age 65, Bill's account balance is $1,035,160. Bill's total investment for the eight years totaled $ 16,000. Money earned on money is the wealth creator.
Phil begins investing $2,000 at the beginning of each year at age 27. Phil continues investing $2,000 annually through age 65. Phil's account balance after his investment for age 65 is $883,185. Phil's total investment is $78,000 over 39 years. Again, money earned on money is the factor that creates wealth.
Traditionally, employer contributions to a profit-sharing plan are allocated to participant's accounts in proportion to the ratio of that participant's compensation bears the total of all participants' compensation. The maximum annual contribution the employer is allowed to make to the plan is 25% of total compensation.
There is a more equitable variation for allocating the total contribution among plan participants. It is called an age-weighted profit sharing plan. As its name suggests, an age-weighted profit-sharing plan is one that takes age into account in the formula for allocating employer contributions as well as relative compensation. This results in higher contribution allocation for older workers than younger employees. Most "founders" are older than the other workers. They, therefore, receive a greater allocation of the employer contribution. Additionally, the long serving employees tend to also be older, thus, the faithful are rewarded with a larger allocation than workers who are more recently hired.
In order to allocate benefits in an age-weighted manner and still comply with the rules that govern tax-qualified retirement plans, an age-weighted profit sharing plan must be a "uniform points plan" in which each employee is allocated points based on age, service, and compensation. The employer contribution is allocated in proportion to each employee's total points. The result often is the owner is credited with as much as 90% of employer contribution.
This arrangement is not unfair. For example, the retirement benefit at age 65 for the 50 year old owner will be much less than the retirement benefit of a 25 year old participant at his/her age 65. There is, indeed, magic in compounded earnings.
Yes, a traditional profit sharing plan can be converted into an age-weighted plan.
Since attempting to adopt an age-weighted profit-sharing plan requires special planning, please do not hesitate to call us to make an appointment so that we can assist you in adopting and implementing this type of plan.
Gains or losses on the sale of breeding stock or dairy animals are not reported on Schedule F, Profit or Loss from Farming. These are reported as capital gains and losses.
Why is this important? Farm income is reported on Schedule F. Schedule F income is subject to both federal and state income taxes as well as federal self-employment ( FICA and Medicare) taxes. If the farm is operated as a sole proprietorship or partnership, which most are, the SE tax is 15.3% per cent of net farm income (7.65 per cent employee's portion plus 7.65 percent employer's portion). If the farmer reports gains on sale of breeders on Schedule F, he or she will pay self-employment tax on income not subject to self-employment tax. Additionally, gains on sale of breeders and capital gain not ordinary income.
Most cash method farmer-most are- raise their breeding and dairy stock. As cash method taxpayers, they currently expense rather than capitalize and depreciate the cost of feed, vet bills, etc. In the year these expenses are incurred. These raised animals have no depreciable basis. Breeders purchased basis is the amount the farmer paid for the stock.
When a raised breeder two or more years old is sold, the total selling price is capital gains taxed at -0-%, 15% or 20% depending on the taxpayers tax bracket. Capital gains are not subject to the 15.3% self-employment tax.
Purchased breeders' cost is depreciated upon sale, the depreciation taken over the year of ownership is re-captured as ordinary income (not subject to self-employment tax) to the extent of the gain on the sale. The excess above re-captured depreciation is taxed as capital gain.
All of the gains from sales of raised breeders is capital gains.
FIRST, WHAT IS NOT A SELF-DIRECTED IRA ?
Many investors think that since they have a choice between Mutual funds, Exchange-Traded Funds, stocks and bonds, that these traditional IRA Trust or custodial accounts are self-directed. NOT SO.
In a true self-directed IRA, you may invest in just about anything other than life insurance and collectibles. Many alternative investments (alternative to traditional investments such as stocks and bonds) provide greater diversification for the portfolio when combined with some part of the portfolio made up of stock and bond mutual funds or ETF's
You have a voice in the part of the portfolio that contains investments that you know. If you are astute in managing rental estate, you may have some or all of your IRA funds invested in properties that you select.
You must first find an IRA trustee that allows such an arrangement. The Trustee wil allow you to use a self-directed IRA and, also, allow you to choose the real properties of your choice.
Other alternative investments you may choose are:
* Raw land
* First and second mortgages
* Options to buy and sell real estate
* Private Placements L.L.C.
* Precious metals
As you hve probably surmised by now, you have to know what you are doing. Self-directed is just that self-directed. You are required to select the investment you want your trustee to buy, you choose the investments to sell and when. You become the investment manager of your self-directed IRA.
In the traditional IRA setting, the portfolio manager makes these decisions alone.
These alternative investments do not decline in value at the time of a bear market for stocks and bonds. Thus, you may expect a winner in your portfolio regardless of the ups and downs of the market.
Be aware of the pitfalls associated with self-directed IRAs. You and your family may not use the assets contained in the portfolio (e.g., the beach house cannot be rented by you).
Additionally, self-directed IRAs are hands-on arrangement. Most of the management duties (e.g., buying and selling properties, etc.) are your responsibilities.
The self-directed IRA trustee will help you to obey the rules and avoid prohibited transactions.
My recommended trustee for your self-directed IRA is The Entrust Group, www.the entrust group.com, 1-800-392-9653. No, I have no connection with this firm.
If you operate your business as a sole proprietorship and have no employees, you man hire your spouse and adopt a Health Reimbursement Plan and deduct insurance premiums and medical expenses on your business form instead of the itemized deduction schedule. This strategy will work for sole proprietors and farmers.
The term of art is a Section 105 plan. The benefits of the plan are best for sole proprietors and farmers that have no eligible employees.
How does a Section 105 Plan work.
* Hire your spouse to do work for your business
* Institute a Section 105 Plan which allows your Schedule C or Schedule F business to reimburse the spouse for insurance premiums and deductibles and Co-payments the spouse pays
* Do the reimbursement monthly backed up with documentation
* Have the spouse file with the business weekly signed time sheets
* The reimbursements may be considered spouse's total compensation
* If medical reimbursements are the total pay, Form W-2 is not required
* If a Section 105 Plan is established, it must include all eligible employees, thus, it works best where the spouse is the only eligible employee
What are the benefits of a Section 105 Plan ?
* The business may deduct the reimbursement on Schedule C or in the case of a farm Schedule F.
* The deduction reduces income for both income tax purposes as well as self-employment ( FICA and Medicare) purposes
* The employee - spouse does not report the reimbursement as income
* Medicare premiums may also be reimbursed
* Dental and eye care are medical expenses
* Mileage reimbursed at the applicable rate per mile is also a medical expense
* Medical expenses incurred on behalf of the employee spouse, the employee-spouse and dependent qualifies for reimbursement, children up age 27 do not need to be a dependent to qualify for reimbursement