A Pension Play For Small Fry

A controversial approach to setting up retirement plans that is highly advantageous

to business owners but criticized for being discriminatory to employees has been given a green light by Congress. Much to the surprise of pension experts, proposed language that would have disallowed "age-weighted" plans was stricken from pending legislation earlier this fall. For the time being, certain small-business owners can set up retirement plans that shelter a great deal of their own income from taxes while making minimal contributions for their employees.

Whether you install a defined-benefit plan that pays workers a fixed amount once they retire or a defined-contribution plan where you make payments into a retirement account while the employee is working, pension laws require that owners treat employees fairly. But there are several ways to test what is fair. By using a method usually reserved for defined-benefit plans called cross-testing, defined-contribution plans can be judged nondiscriminatory because the benefits provided at retirement are comparable.

Cross-testing is the genesis for age-weighted profit-sharing plans, a type of defined-contribution retirement plan. The reasoning goes that younger employees have more time to accumulate benefits and therefore deserve smaller contributions each year than employees with fewer years until retirement. That way, business owners--assuming they are among the oldest employees--not only get to set aside more pretax money for themselves (which grows tax-deferred) but are required to spend less on contributions for their employees (table).

For an age-weighted plan to make sense, "the demographics have to be right," says Len Carusi, director of retirement plans consulting for Hirschfeld, Stern, Moyer & Ross in New York. Such plan are often used in the private practices of doctors or architects. They also work best for companies so small that staff members don't expect retirement benefits and will be happy with the plan, even if the owner benefits much more than they do. "If you're using the plan to motivate employees, this is hardly the way to go," says Israel Lustig, a New York financial planner.

If this type of plan appeals to you, there's a reason to make the change soon: Plan documents have to be amended by the end of 1994 to conform with recent changes in pension law. The law may change, yet it's unlikely the IRS will be able to take away the extra rewards you have gained while the plan was considered legal.

                                             TRADITIONAL     AGE-WEIGHTED
      OWNER           55      $150,000*       $22,500  (15%)  28,874  (19.2%)
      EMPLOYEE        45      40,000           6,000   (15%)   3,395   (8.5%)
      EMPLOYEE        35      30,000           4,000   (15%)   1,126   (3.7%)
      EMPLOYEE        25      20,000           3,000   (15%)   600     (3%)
      *Maximum that can be used for calculating contributions to a plan.
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