Age-based pension plans approved, delighting small business owners.

Over the past five years, defined-benefit plans--those in which a retiree's benefits are specified--have become less attractive to both employee and employer. The plans have been depressed by federal legislation effectively reducing the size of their tax-deductible contributions and making their administration much more costly. But now, to the delight of many small business owners, what Congress has taken away with one hand the Internal Revenue Servie appearts to be giving back with the other.

PAST SOLUTIONS

As a replacement for the defined-benefit plan, many employers have been turning to the less complicated defined-contribution plan, which specifies the amoung of tax-deductible contributions to each employee's pension account rather than specifying the benefit to be paid. The invested pension funds' performance determines the eventual benefit amount at retirement.

Drawback. These plans, however, lock the employer into a fixed annual contribution. To compensate, many employers added profit-sharing to defined-contribution plans, which allows the employer to determine the amount of the annual contributions. Thus, in good years contributions can be high and in slow years can be adjusted downward.

As good as these combination plans are, some employers, especially small business owners, still were dissatisfied because IRS regulations generally prohibit pension plans from discriminating in favor of highly paid employees, such as business owners or top company officers. In general, all employees--young and old--are allocated almost equal shares.

As a result, many employers were asking if there was a way to discriminate in favor of older employees in a profit-sharing plan. Their argument was that, since older employees have fewer years to build up a pension fund, they should be allowed to contribute faster than the younger employees.

Proposed remedy. In 1990, the IRS issued proposed regulations for Internal Revenue Code section 401(a)(4), which deals with nondiscrimination requirements. Those proposed regulations said, in effect, a profit-sharing plan that allocates contributions based on age does not necessarily discriminate in favor of the highly compensated.

IRS APPROVES

With the release of final regulations last September, the IRS confirmed that age-based allocations satisfying the technical cross-testing requirements, which are described in regulation 1.401(a)(4)-8(b), do not discriminate in favor of highly compensated employees.

Redrafting a pension plan based on employees' age has a dramatic effect on corporate contributions. Consider the comparison between a company's contributions in an age-based plan and a traditional allocation, as shown in the exhibit above. By allocating the contribution on the basis of age, the owner's contribution is increased by 54% while the total outlay remains about $39,000, yet the owner's contribution as a percentage of the total grows to 71% of the total from 46%.

Equally important, if the owner contributes less than $39,000, the amount allocated to his or her share remains at 71%.

While not all profit-sharing plans should have age-based contributions, clearly many small businesses can benefit, as this example shows. And in some cases, even midsized and large companies might benefit, depending on the employees' age spread.

ADDED PLUSES

In addition to allowing the older business owner to shelter more pension contributions, age-based profit-sharing pension plans have these pluses:

* The plan is easier and less costly to administer than a defined-benefit plan, which must meet many federal requirements.

* Unlike under defined-benefit plans, annual premiums don't have to be paid into the government-sponsored Pension Benefit Guarantee Corporation.

* Employers don't have to send annual actuarial certification to the IRS.

CPAs and actuaries, who will make the final determination on which pension plan is best for a business, should be aware that such an option as age-based profit-sharing exists.