ADVISORS CONCEPTS

Volume I, Issue #3

November 5, 2004
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In our recent Network News issues we've been talking about things that individual business owners should be considering with regard to adopting or amending plans for the 2005 plan year.

As an advisor you should read those articles to see whether any of the thoughts being presented impact the plan in which you participate or the plans of any of your clients.  But, as we promised you, Advisors Concepts is designed to help you find ways to increase your fee income and/or assets under management.  This week we're going to help you focus on
 

The Exploding Small Business Market


Over the past decade the number of new small businesses is virtually exploding.  There are many reasons for this phenomenon, including:

  • Many employees who have been terminated have opted to become self-employed rather than becoming employees again.
     

  • The number of women who are creating their own businesses is growing every year.
     

  • Some retirees are opting to become entrepreneurs rather than couch potatoes.

    Since the average advisor is looking for a 6 - 7 figure relationship, the thought of prospecting for owners of new businesses might not seem too attractive.  I mean, how much will a new business owner be contributing to a qualified plan or SEP?  Probably not much.

    But if an advisor can find a unique way to develop a relationship with a family that has substantial assets it might be a totally different ball game.  Whatever small pre-tax contribution this new business owner might make to the plan may well be the tip of the iceberg.

    First, you have to recognize the opportunities when they present themselves, and separate the wheat from the chaff.  We will assume that your threshold of interest is a $100,000 relationship, recognizing that the starting point may be even higher for some of you.  That means that your target is a new entrepreneur or aspiring entrepreneur with at least a six-figure accumulation of assets.

    Next, you must bring something of value to the table that allows you to stand out in the crowd.  Hundreds of financial organizations distribute marketing pieces that say basically the same thing.  Because of your relationship with NRPTC, our concepts and documents can complement your own special attributes to create something unique.

    Let's try to identify some prospective clients from the three groups mentioned above.

     New businesses started by terminated employees

Many new businesses are extremely cash strapped. So they might not be a good target for this project.  But, persons who have recently been downsized or who have separated voluntarily from a corporate employer might be just who you're looking for.  These folks might be receiving substantial distributions from their employers' retirement plan.  There is steep competition for those rollover dollars which may be in the 6-figure range.  The financial industry spends billions of advertising dollars trying to attract those amounts into IRA rollover accounts.  So, if you're trying to attract large IRA rollovers, you're just another face in the crowd.

But, if you can determine that this person is interested in starting his or her own business, NRPTC might be able to add a few more arrows to your quiver. 

Example #1

Let's say that [Name] has been terminated after 15 years with the largest manufacturer in the area.  He receives a substantial severance payment and is also eligible to withdraw the $400,000 balance in his 401(k).  He is seriously considering starting his own business which requires about $50,000 in capital, but his only capital accumulation is the money in the 401(k).  If he withdraws any of that money to capitalize his new business, he must add the amount withdrawn to his federal taxable income.  And if he is not yet 59 1/2, that amount will also be subject to a 10% federal tax penalty.  Let's say that he's in the 35% tax bracket.  In order to get $50,000 in hand he would have to withdraw $90,909; pay federal income tax of $31,818, and a 10% penalty ($9,901) for a total of $40,909, leaving him with $50,000 in cash.  Now, that's quite a hit.  You suggest that he consider a unique plan that you can provide which will permit him to avoid that result.  It's the NRPTC qualified rollover plan.

Unlike an IRA, our qualified rollover plan must be adopted by an "employer".  So your client's first step would be to go through whatever formal steps are involved in initiating the business.  Once the business has been established it is permitted by law to adopt a qualified plan.  [Name's] small business could become a member of NRPTC and adopt a small business plan that permits rollovers and participant loans.  This would allow him to rollover his 401(k) distribution, then take a loan for up to $50,000.

Neither a SEP nor a SIMPLE IRA would do since those plans don't permit participant loans (and the SIMPLE IRA wouldn't even permit the rollover from his 401(k)).  If he's planning to make contributions and/or elective deferrals to the plan he could adopt a qualified profit sharing plan, possibly even the new "Little-K" (NRPTC's owner-only 401(k)).  But let's say that he just wants to do the rollover and take a loan, with no contributions to the plan.  Technically, a traditional or Little-K profit sharing plan won't do.  Although an employer can decide on a discretionary basis from year to year whether to contribute to a profit sharing plan, the employer must establish a record of "substantial and recurring" contributions to a profit sharing plan.  This is a requirement of law that applies to all qualified profit sharing plans.  So if a profit sharing plan is adopted and there are no contributions ever made, if the IRS were to audit the plan they could disqualify it for all years of its existence, resulting in substantial tax and penalty.

The NRPTC qualified rollover plan is a money purchase plan with a zero employer contribution formula.  It's sole purpose is to accept rollovers and/or after-tax employee contributions.  Now a lot of folks will tell you that you must make contributions to a money purchase plan every year.  That's only if the plan calls for a contribution.  The law permits a money purchase plan to have a zero contribution formula (a little known fact).  NRPTC has taken advantage of that rule to create a plan that involves no employer contributions, but accepts rollovers and after-tax employee contributions.  It also permits participants to take loans.  We sometimes call this our "qualified employee savings plan".  Plan participants are permitted to borrow up to 50% of their plan balance, subject to a maximum loan of $50,000.  So, in order to borrow $50,000 he would have to roll at least $100,000 from his 401(k).  Now that you're "in the door", you can have a discussion about managing his plan investments, net of the loan (that's $350,000).  Whether he rolls the full $400,000 to the qualified rollover plan or rolls over the $100,000 on which the loan will be based, and puts the other $300,000 in an IRA is inconsequential.

By the way, he might be able to refer you to some of his colleagues who are in the same position.


 Women Entrepreneurs -

 

In recent years, the majority of the new businesses being formed are owned by women.  These range from household activities that are turned into small enterprises to organizations that eventually evolve into major manufacturing or service companies.  There was an interesting article in the Wall Street Journal on October 21st ("The Carriage Trade:  Stay-at-Home Moms Get Entrepreneurial") that talks about many women who have left the corporate work force to become stay at home moms with businesses.  Because many of them have participated in their former employers' 401(k) (or other) plan, they are not unfamiliar with the benefits of tax-favored savings.  But, like most small business owners, they are unaware that the rules applicable to owners with small business retirement plans are far more advantageous than those that apply to employees participating in a business' plan.  This is especially true in the case of employers that adopt the prototypes sponsored by NRPTC.

As previously mentioned, the prospect of seeking relationships with new firms is less than exciting for the average financial planner.  But there are factors related to many women's situations that might represent a golden opportunity.  Once again, an NRPTC small business plan might be just the tool to open that door.

Here are a few of the points related to women who are prospective entrepreneurs that you might want to focus on.

·  What is the person's background?

  •  If she is starting the business after leaving the workforce there might be potential for a rollover from her previous employer's plan to a small business plan.
     

  • If she is a divorcee, she might have received a distribution from her husband's IRA or employer plan that could be rolled into a small business plan.
     

  • If she is a widow, she might be the beneficiary of her spouse's IRA or employer plan.  Those funds could be rolled to her small business retirement plan.
     

  • Does she have a husband who is the family's primary "bread winner"?  If so she might be able to hire him.  This could dramatically increase the amount by which the family's federal taxable income may be reduced (see example below).
     

  • Does she have a husband who was terminated from employment and, having exhausted other resources is about the take a taxable distribution from his IRA (see example below).

    It should be noted that women who are new business owners have a tendency to network more than their male counterparts.  This could be the source of referrals.

    Example #2

    [Name] was a 48 year old mid-level executive for a large Midwestern firm before she left to establish her own business.  Three years ago she had borrowed $50,000 from her employer's plan.  The outstanding balance is now $23,000.  The balance in her 401(k) is $140,000 including the $23,000 loan balance.  If she takes a full distribution from the plan she will receive only $117,000 ($140,000 minus $23,000), but the Form 1099-R that she and the IRS will receive will reflect a distribution of $140,000 because she will be "deemed" to have received the outstanding loan balance.  If she rolls the $117,000 cash proceeds to an IRA she must add the $23,000 to her federal taxable income, and pay an additional 10% penalty ($2,300) since she is under age 59 1/2.

    If she adopts the NRPTC prototype qualified plan, she could make a direct rollover of the entire 401(k) balance of $140,000, including the $23,000 note to her new plan.  This avoids the inclusion in income and the 10% penalty.

    Example #3

    [Name] operates a small business out of her New York City apartment.  She has net income of about $30,000/year.  Her husband, who is age 50, was an executive with a firm, where he earned $160,000 annually as the Chief Accountant until he was terminated in 2003 in a corporate downsizing.  He has been unsuccessfully seeking a comparable position throughout 2004.  In the meantime the family has been living on his severance payment, [Name's] small business income and the couple's savings. Her husband now has prospects for a new position that will be opening up in about four months.  Other than borrowing from family members, the couple's only remaining liquid assets are in the IRA established when he rolled $350,000 from his former employer's 401(k).  If he withdraws the $40,000 that they need to live on for the next months from his IRA, that amount would be included in the couple's income and there would be a 10% penalty.

    You suggest that [name] hire her husband to handle her books.  Let's say that his compensation will be $200/month.  As an employee he would be eligible to roll any part or all of his IRA into [Name's] qualified plan.  Since he needs $40,000 to tide them over until his new job begins, he could roll $80,000 into her plan and borrow the needed $40,000 with a 5-year repayment.

    Example #4

    [Name] was widowed in 2003 when her husband and brother were killed in a tragic auto accident.  The brothers were partners in a business which had adopted a SEP several years ago.  She had taken over the business after their death.  And she plans to make contributions to her own SEP account beginning next year. [Name] had been designated as beneficiary on both of their accounts.  She and her husband had lived in an apartment for years, but she recently saw the cutest little house that she's decided to buy.  She had inherited $120,000 from each account.

    You advise her that although she might decide to contribute to the SEP for herself, she might find it useful to adopt a qualified plan as well, creating a QUASEP.  She could then roll all or any part of the $120,000 from her husband's SEP account into her qualified plan account.  None of the amount inherited from her brother-in-law's SEP-IRA may be rolled to her plan since only a surviving spouse is permitted to rollover inherited funds.

    After completing the rollover she may borrow up to $50,000 from the qualified plan with no tax or penalty implications.  And, there's an additional benefit.  Normally the law requires participant loans to be repaid within 5 years.  But that restriction doesn't apply if the proceeds of the loan are used to acquire the principal residence of the participant.  That means that the repayment period could be similar to that of other real property loans (i.e., 15 - 30 years).

     



 Retirees Who Become Entrepreneurs

A growing number of persons who have retired are opting to establish their own small businesses.  Some do so for economic reasons; others because of opportunities that they perceive; and still others simply because they want to remain active.  Whatever the reason, these are often the best prospects of all.  They are more likely than many of their more junior counterparts.  Hopefully they have a substantial accumulation of assets set aside for their retirement.

As we did in the case of the women entrepreneurs, above, let's focus on some of these folks common denominators. [By the way - the focal points that we're providing are not intended to be an exclusive list.  We're sure that you can think of many more considerations, pro and con.]

 

  • Unlike employed individuals persons who are fully retired (with no earned income) are unable to take advantage of most of the tax-favored savings vehicles available under the law (such as IRAs and employer-sponsored plans).  You, as advisor, should emphasize the additional benefits available to them by adopting a small business retirement plan.
     

  • Persons who reach age 70 1/2 are not permitted to contribute to an IRA on a pre-tax basis, but no such restriction applies in the case of a qualified plan or SEP.
     

  • Persons who are age 70 1.2 are required to begin distributions from traditional IRAs (but not Roths) and employer sponsored plans. 
     

  • Persons of retirement age are more likely than their younger counterparts to be widows and widowers.  They may have inherited retirement savings balances from their spouses, which may be rolled to a small business plan.  (See comments in example #4, above.)
     

  • Many retirees may find it advantageous to be able to move substantial amounts from their taxable investments to after-tax accounts which provide tax-deferral and, possibly, the tax-free distribution of earnings.
     

  • Since persons of retirement age often incur greater medical costs, they need to be aware of the impact their federal adjusted gross income (AGI) on the deductibility of these expenses.
     

  • Retired persons can significantly reduce their federal AGI by making pre-tax contributions to employer sponsored plans.  This might reduce or eliminate the amount of their social security benefits that would be subject to federal income tax.
     

  • Grandparents can reduce their own taxable income and help their grandchildren with educational costs by employing them, and possibly making them eligible to participate in their small business plan.

    Example #5

    [Name] age 67, has been retired for several years.  He has approximately $750,000 in his traditional IRAs.  He has been netting a few thousand dollars per year in a small business that he's started in his retirement years.  He has been contributing to a Roth IRA based upon this self-employed income.  He now has a substantial need for cash, and is seriously considering withdrawing from his traditional IRAs.  Since he is not yet age 70 1/2, he is not yet required to take any distribution.  And, since he is over age 59 1/2 his distributions would only be included in income, but not subject to a 10% penalty.

    You suggest that he adopt a qualified rollover plan (see comments in example #1, above).  He could borrow up to $50,000 with no tax impact.  That money could be sued for any purpose, and it would avoid some of the "stealth" taxes.  For example, if [Name's] income is sufficiently low, he can avoid paying income tax on his social security benefits.  But a taxable distribution from his traditional IRA could also trigger taxation of his social security.

    If, like so many retirees, he has substantial health care costs, the deductible amount is limited to the excess over 7.5% of his federal AGI.  So, a taxable could negatively affect the amount that's otherwise deductible. By taking a plan loan, he would avoid that result.

    If the purpose of the loan is to purchase his primary residence, the repayment period could extend well beyond the 5 year standard of other plan loans.

    Example #6

    [Name] and his wife have gone into partnership in their retirement years.  Their joint net income from the business is approximately $80,000/year.  The remainder of their income, which is from investments totals less than $30,000/year.  They have been contributing the maximum allowed by law to their Roth IRA for several years, and have indicated that they would contribute much more if not restricted by law.  In fact, they have been reading, with great anticipation, the articles about the Lifetime Savings Accounts that had been proposed by the Bush administration.

    They have been contributing to a SEP.  Their contribution each year has been at the maximum permitted by law, which is 25% of their "earned income", which is less than 20% of the partnership's net profit.

    You suggest that they adopt a "qualified person savings account" (which is the same plan as the "qualified rollover plan" mentioned in example #1, above. It's just that the plan is being adopted for a different purpose, savings accumulation rather than rollover and loan).  The couple could contribute to this plan concurrently with the SEP.  That wouldn't increase their pre-tax limit, but would create a vehicle for after-tax contributions.  While total contributions could equal 100% of each spouse's compensation, the [pre-tax portion would be limited to 25%.

    The couple could opt to contribute a full 100% of each spouse's compensation on an after-tax basis, up to a maximum of $41,000 (the 2004 limit) per spouse.  So, if the net profit is $80,000 each spouse could contribute almost $40,000.

    But, that's only the beginning of the good news.  Each spouse could take a distribution from the qualified rollover plan and roll it into a traditional IRA. If they have already strip mined the entire taxable element from all of their IRA and SEP accounts (by way of rollover to their small business plan, if necessary) they could then make a tax-free conversion to their Roth IRA.

    In effect, between the conversions from the small business plan the annual contributions to their Roth accounts, the couple could add over $90,000 to their Roth IRAs each year.

    We'll be discussing "strip mining" IRAs more in a future issue of     Network News.



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