As a business owner, you should carefully consider the advantages of establishing an employer-sponsored retirement plan. Generally, you’re allowed a deduction for contributions you make to an employer- sponsored retirement plan. In return, however, you’re required to include certain employees in the plan, and to give a portion of the contributions you make to those participating employees. Nevertheless, a retirement plan can provide you with a tax-advantaged method to save funds for your own retirement, while providing your employees with a powerful and appreciated benefit.
TYPES OF PLANS
There are several types of retirement plans to choose from, and each type of plan has advantages and disadvantages. This discussion covers the most popular plans. You should also know that the law may permit you to have more than one retirement plan, and with sophisticated planning, a combination of plans might best suit your business’s needs.
Profit-sharing plans are among the most popular employer-sponsored retirement plans. These straightforward plans allow you, as an employer, to make a contribution that is spread among the plan participants. You are not required to make an annual contribution in any given year. However, contributions must be made on a regular basis.
With a profit-sharing plan, a separate account is established for each plan participant, and contributions are allocated to each participant based on the plan’s formula (this formula can be amended from time to time). As with all retirement plans, the contributions must be prudently invested. Each participant’s account must also be credited with his or her share of investment income (or loss).
A type of deferred compensation plan, 401(k) plans are generally established as part of a profit-sharing plan. Now the most popular type of plan by far, the 401(k) plan allows contributions to be funded by the participants themselves, rather than by the employer. Employees elect to forgo a portion of their salary and have it put in the plan instead. These plans can be expensive to administer, but the employer’s contribution cost is generally very small (employers often offer to match employee deferrals as an incentive for employees to participate). Thus, in the long run, 401(k) plans tend to be relatively inexpensive for the employer.
The requirements for 401(k) plans are complicated, and several tests must
be met for the plan to remain in force. For example, the higher-paid employees’ deferral percentage cannot be disproportionate to the rank-and-file’s percentage of compensation deferred.
There are several ways to avoid discrimination, including adopting a “safe harbor” 401(k), a qualified automatic contribution arrangement (QACA), or a SIMPLE 401(k) plan. If you don’t have any employees (or your spouse is your only employee) an “individual” or “solo” 401(k) plan is another way to avoid performing discrimination testing. With so many options available, make sure to consult with an experienced plan administrator to determine which 401(k) plan is best for you and your business.
MONEY PURCHASE PENSION PLANS
Money purchase pension plans are similar to profit-sharing plans, but employers are required to make an annual contribution. Participants receive their respective share according to the plan document’s formula.
Like profit-sharing plans, money purchase pension plans are relatively straightforward and inexpensive to maintain. However, they are less popular than profit-sharing or 401(k) plans because of the annual contribution requirement.
DEFINED BENEFIT PLANS
By far the most sophisticated type of retirement plan, a defined benefit program sets out a formula that defines how much each participant will receive annually after retirement if he or she works until retirement age. This is generally stated as a percentage of pay, and can be as much as 100% of final average pay at retirement.
An actuary certifies how much will be required each year to fund the projected retirement payments for all employees. The employer then must make the contribution based on the actuarial determination.
Unlike defined contribution plans, there is no limit on the contribution. The employer’s total contribution is based on the projected benefits. Therefore, defined benefit plans potentially offer the largest contribution deduction and the highest retirement benefits to business owners.
SIMPLE IRA RETIREMENT PLANS
Actually a sophisticated type of individual retirement account (IRA), the SIMPLE (Savings Incentive Match Plan for Employees) IRA plan allows employees
to defer a portion of annual compensation by contributing it to an IRA. In addition, employees age 50 and over may make an extra “catch-up” contribution. Employers are required to match deferrals, up to 3% of the contributing employee’s wages (or make a fixed contribution
of 2% to the accounts of all participating employees whether or not they defer to the SIMPLE plan).
SIMPLE plans work much like 401(k) plans, but do not have all the testing requirements. So, they’re cheaper to maintain. There are several drawbacks, however. First, all contributions are immediately vested, meaning any money contributed by the employer immediately belongs to the employee (employer contributions are usually “earned” over a period of years in other retirement plans). Second, the amount of contributions the highly paid employees (usually the owners) can receive is severely limited compared to other plans. Finally, the employer cannot maintain any other retirement plans. SIMPLE plans cannot be utilized by employers with more than 100 employees.
The above sections are not exhaustive, but represent the most popular plans in use today. Current tax laws give retirement plan professionals new and creative ways to write plan formulas and combine different types of plans, in order to maximize contributions and benefits
for higher paid employees.
FINDING A PLAN THAT’S RIGHT FOR YOU
If you are considering a retirement plan for your business, ask a plan professional to help you determine what works best for you and your business needs. The rules regarding employer-sponsored retire- ment plans are very complex and easy to misinterpret. In addition, even after you’ve decided on a specific type of plan, you will often have a number of options in terms of how the plan is designed and operated. These options can have a significant and direct impact on the number of employees that have to be covered, the amount of contributions that have to be made, and the way those contributions are allocated (for example, the amount that is allocated to you, as an owner).