The Retirement Plan Exemption

April 13, 2006

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Retirement plans represent a significant asset exemption planning opportunity for the small business owner. In states with a small or nonexistent homestead exemption, this category may provide the best protection available for assets. Even in states with a significant or unlimited homestead exemption, the amount that can be accumulated and protected inside a retirement plan will often exceed the value of the homestead exemption.

As of October 17, 2005, new federal bankruptcy laws state that all retirement funds held in a qualified plan are exempt from attachment by creditors. This makes these types of plans one of the surest ways to protect wealth.

Every small business owner should be aware of some basic retirement plan concepts. Today, self-employed individuals operating limited liability companies (LLCs), sole proprietorships, general partnerships, and S corporations can form retirement plans on virtually the same terms as large C corporations.

A popular retirement plan among small business owners is the SIMPLE (Savings Incentive Match Plan for Employees). The SIMPLE can be formed as an amendment to an existing standard 401(k) plan or as an IRA (Individual Retirement Account).

Each year you may contribute net earnings (up to $10,000 in 2006, $10,500 in 2007) to your own account in a SIMPLE plan, and you must permit your employees to make similar salary-reduction contributions as well. All these contributions must be matched by the business, up to 3 percent of an employee's pay.

The IRA version is easier to set up. However, as discussed below, the 401(k) version may be a better choice, because it may offer better protection from the claims of creditors because of its ERISA-qualified status.

The SIMPLE plan is exempt from the usual pension anti-discrimination and top-heavy rules that govern pensions. This makes administration of the plan much simpler (hence the name).

Warning

If you use a SIMPLE plan, it must be the only retirement plan the business offers.

As an alternative, you may choose to form a SEP (Simplified Employee Pension), under which up to the lesser of 25 percent of your salary up to $220,000 or $44,000 in 2006 ($225,000 and $45,000 in 2007) may be contributed to an IRA. You must also contribute the same percentage of each employee's pay to individual IRAs established for each employee, but the plan is flexible: The contribution percentages can vary from year to year and you can even skip years if you wish.

Finally, small business owners may establish "regular" pension plans, including defined-benefit, defined-contribution, and conventional 401(k) salary-reduction plans. An advantage of the conventional plan is the high contribution limit of $44,000 per year in 2006 ($45,000 in 2007) for your own account for defined-contribution plans (or even more, if you use a defined-benefit pension plan), and the fact that you can contribute less for lower-paid or younger employees. You may also combine types of plans to get the best features of each.

Work Smart

While using conventional types of pension plans allows you to combine different plans to get the maximum advantage from each of them, don't forget about the complexity that can be involved for these retirement plans. The administrative costs for a conventional plan may be cost-prohibitive for the small business owner.