Ask an Expert: Retirement Plans for Small Businesses and Professional Practices
There are several types of retirement plans to choose from, and each type of plan has advantages and disadvantages. This article 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’ needs.
Traditional qualified retirement plans
Retirement plans can be broken down into two broad categories: traditional qualified employer plans and IRA-based plans. Qualified employer plans can be adopted by most employers. These plans generally must adhere to strict IRC (Internal Revenue Code) and ERISA (Employee Retirement Income Act of 1974) guidelines regarding participation in the plan, vesting, funding, nondiscrimination, disclosure and fiduciary matters. In addition, they allow for vesting schedules, except Safe Harbor 401(k)s, and eligibility requirements that can be instrumental in attracting and retaining highly qualified employees.
Defined contribution plans: 401(k) and profit sharing
Within the category of qualified employer plans there are two types: the defined contribution and the defined benefit plans. As for the defined contribution plans, by far the most popular is the profit sharing plan with a cash deferral feature, also known as the traditional 401(k). The 401(k) allows participating employees to save a certain amount of their pay-within their own individual 401(k) account-without paying current income tax on the amount they save. In addition, the amount they save and all earnings on the savings grow tax deferred. Monies in the employee’s 401(k) account are only taxed when they are withdrawn. (Withdrawing money from a 401(k) can be complicated and is too in-depth for this article. Be aware of this and contact your fee-only adviser, not merely fee-based adviser or broker, preferably with substantial accounting experience, when the time comes.) In addition to the deferral portion of the 401(k) there is the profit sharing portion. This allows the employer to make a contribution to the employee’s 401(k) account. This contribution is tax deductible to the employer and tax deferred for the employee (taxed similarly to the employee deferral mentioned previously). The profit sharing contribution can be calculated in many ways, from a simple percentage of the employee’s wage to special allocations based on classes of employees or ages of employees. Because of this flexibility the profit sharing match can be designed in a way that is most advantageous to an owner/employee if desired. There is typically no requirement to make the profit sharing contribution every year. In 2008, the maximum contribution for any employee can not exceed $46,000 (plus catch-up contribution of $5,000 if the employee is age 50 or older).
Roth 401(k) and Safe Harbor 401(k)
There are many other types of defined contribution plans. They are typically all just a variation of the traditional 401(k). The Roth 401(k)—new in 2006—works similarly to the 401(k) except the employee pays tax on his or her portion saved from current pay. The savings and the earnings then grow tax free, even upon withdrawal. The profit sharing plan can be implemented without the cash deferral feature. A Safe Harbor 401(k) works similarly to the 401(k) except the profit sharing contribution must be paid to all eligible employees each year based on a simple percentage.
The primary advantage for defined contribution plans is flexibility. Depending on what the employer wants to accomplish with the plan-accumulate wealth for the owner, was a tool to recruit and retain employees, or both-it most likely can be done with one of these plans. The disadvantage to these plans is they are typically costly to set up and administer. Many times these costs are more than offset by the tax and economic advantages the plans create.
Defined benefit plan
The second type of qualified employer plan is the defined benefit plan. This is by far the most complex and sophisticated type of retirement plan. A defined benefit plan sets out a formula that defines how much each participant will receive annually after retirement, if the person works until retirement age. The maximum annual retirement benefit an individual may receive is $185,000 or 100 percent of the final average pay at retirement. An actuary certifies how much will be required each year to fund the projected retirement benefit. Unlike the defined contribution plan, there is no relatively low limit to the contribution each year. Therefore, these plans potentially offer the largest contribution deduction on the employer’s tax return and the highest retirement benefits to business owners. This type of plan is often used with a sole practitioner or small professional group that has few, if any, employees. As you may have guessed, this plan can also be expensive to administer.
IRA-based plans: simplified savings
The SIMPLE IRA plan
The second broad category of retirement plans is IRA-based plans. These plans are generally much less costly and burdensome to set up and administer. This is primarily because they only require limited ERISA compliance, unlike qualified employer plans. It is important to note that IRA-based plans require immediate vesting. This means that the IRA-based plans, unlike other plans mentioned above, have limited efficacy when it comes to retaining high-quality employees. Lastly, with some IRA-based plans the amount that can be contributed/deferred to each employee is significantly less than the qualified employer plans allow.
The most popular IRA-based plan is the SIMPLE IRA. As the name suggests, it’s simple to set up and simple to administer. More importantly, it is inexpensive to set up and inexpensive to administer. The SIMPLE IRA works similarly to the 401(k) in that each employee is allowed to defer a portion of his or her current pay. In addition, the employer is required to make a matching contribution. This amount is either 2 percent of each eligible employee’s compensation or up to 3 percent of each eligible employee’s compensation for employees who defer a percentage of their compensation. With the up to 3 percent option, the employer only matches what the employee defers, never to exceed 3 percent of the employee’s compensation.
The SEP IRA plan
Another IRA-based plan option is the SEP IRA. This works similarly to the profit sharing plan. The SEP IRA allows the employer to match a uniform percentage of pay for each employee each year. The employer is not required to contribute every year.
Finding the right plan is a mix of legal, accounting and financial considerations
Determining the correct retirement plan for your business can be difficult-and costly if the wrong one is implemented. Each has unique advantages and disadvantages. If you are considering a retirement plan, ask a fee-only plan professional with substantial legal, accounting and financial education, training and experience to help you determine what plan works best for you and your business needs. The rules regarding employer-sponsored retirement plans are very complex and easy to misinterpret. In addition, even after you have 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.
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Stephen L. Hicks, JD, MS and Roger L. Millbrook, JD, CPA/PFS both hold law degrees and other advanced degrees and designations in the area of financial services, and are principals of Siena Capital Management, LLC and Siena Accounting Services, Inc.