There is a trap with the new tax law for small business retirement plans.
The new tax law that benefits many pass through businesses has created a conundrum for owners and their retirement plans. Here’s the problem and possible solutions:
The new law has created a problem for small businesses who qualify for the 20% tax deduction for pass through entities (e.g manufacturers, distributors, and certain service businesses). Many of them are organized as Sole Proprietors, S Corporations and Partnerships. Their new tax deduction of 20% in the contribution year would be disadvantageous to these owners in the future.
Why? The risk is that their retirement withdrawals will be taxed at a much higher tax rate!! The problem is known as a “mismatch” in tax rates, as noted in the NAPA article on 12-13-17 written by Nevin Adams, JD – http://www.napa-net.org/news/technical-competence/legislation/conferees-come-terms-tax-reform/.
For 401(k) plans, there is a way to mitigate this problem by offering a ROTH election to participants so that in effect their contributions would be taxed at the owners and employees current tax rate, and upon qualifying conditions in the future, the withdrawals are tax-free in retirement. The election bypasses the risk of paying higher tax rate upon retirement distributions made.
PSP and Cash Balance Plans
For Profit Sharing Plans (PSP) and Cash Balance Plans, neither of these plans allow for ROTH elections. If there is a reasonable risk of higher future tax rates upon withdrawals, many business owners may give pause as to fund the retirement plan contributions. For example, if their tax rate on withdrawals expect to be higher than 20%, the owner may consider freezing and ultimately terminating the PSP or Cash Balance Plan.
Cash Balance plans have been very popular to assist small business owners accumulate extraordinary amounts to fund their retirement after many years of putting every penny of their hard work back into the business.
A possible solution for these plans would be for business owners to consider termination of their PSP or Cash Balance retirement plan and establish 401(k) plans with the ROTH election for the foreseeable future in which the new tax law is in effect.
For more information and discussion of your facts and circumstances, please contact our office for a confidential meeting.