Regardless
of the size of your business, or whether it is a sole
proprietorship, partnership, LLC or a corporation, there
are several types of retirement plans to choose from that
can reduce your tax liability and increase the retirement
savings of you and your employees.
Recent studies have confirmed that a retirement plan is
becoming an increasingly important employee benefit. In
fact, more and more job candidates will not consider a job
offer that does not include retirement benefits.
The benefits a business can derive from sponsoring a
retirement plan include:
- Boosting morale and productivity;
- Retaining good employees and thereby saving on
hiring and training costs;
- Attracting experienced employees in today's
competitive environment; and
- Helping employees save for their future since Social
Security retirement benefits alone will be an
inadequate source of income for most retirees.
When choosing the type of plan or plans to establish,
it is first necessary to consider the following questions:
- Do you want to provide similar benefits to all
employees or reward specific employees (i.e., the
owners and key employees) more than others?
- Are the owners and key employees older or younger?
- Will you be able to make a contribution each year,
or do you need the flexibility to skip contributions
in bad years?
- Do you want a plan where no employer contributions
are required?
- What types of plans are being offered by your
competitors?
The answers to these questions will narrow down your
choices. Sometimes a combination of plans will provide the
best arrangement for a company. Multiple plans can be
maintained as long as certain required limitations are not
exceeded.
Following is a brief overview of some of the more
popular types of retirement plans.
Qualified Retirement Plans
In a qualified plan, the contributions are generally
deductible when paid by the employer, but numerous
guidelines must be followed to maintain the qualification
of the plan. These guidelines relate to the coverage of
employees, eligibility to participate, vesting
requirements, distribution rules, contribution and benefit
limitations, special top heavy rules, nondiscrimination
rules, and other miscellaneous provisions.
Some of the primary benefits of maintaining a qualified
retirement plan are:
- Employer contributions to the plan are tax
deductible;
- Earnings on investments accumulate tax-free which
allows contributions and earnings to compound at a
faster rate; and
- Plan assets are protected from creditors.
Defined Contribution Plans
Defined contribution ("DC") plans maintain a
separate account for each participant. The account grows
through employer and/or employee contributions, earnings
and, in some cases, forfeitures from the nonvested portion
of the accounts of terminated participants that are
reallocated to the remaining participants.
Total contributions (employer and employee) plus
forfeitures credited to the participant's account during
the year are limited for 2004 to the lesser of 100% of
compensation or $41,000. In addition, employer
contributions cannot exceed 25% of the total compensation
(capped at $205,000) of all eligible employees.
Since the contributions, investment results and
forfeiture allocations vary year by year, the ultimate
retirement benefit in a DC plan cannot be predicted. The
most common types of DC plans are described below.
Profit Sharing Plans
The profit sharing plan is one of the most flexible
qualified plans available. Company contributions to a
profit sharing plan are usually made on a discretionary
basis. Each year the employer decides the amount, if any,
to be contributed to the plan.
The contribution is usually allocated to employees in
proportion to compensation and may be integrated with
Social Security which results in larger contributions for
higher paid employees.
Profit sharing plans may also use an age-weighted
allocation formula that takes into account each employee's
age and compensation. This formula results in a
significantly larger allocation of the contribution to the
employees who are closer to retirement age. Age-weighted
plans combine the flexibility of a profit sharing plan
with the ability of a pension plan to skew benefits in
favor of older employees.
An Employee Stock Ownership Plan ("ESOP") is
a type of profit sharing plan that is required to invest
primarily in the employer's stock. As owners, employees
may be more motivated to improve corporate performance
because they can benefit directly from company
profitability. Other benefits of these plans are tax
deductions without having to make cash contributions and
establishing a market for closely held stock.
401(k) Plans
A 401(k) plan is a type of profit sharing or stock
bonus plan that allows employees to defer a portion of
their salary into the plan on a pre-tax basis. For 2004,
the deferral limitation is $13,000. The plan may also
permit employees who are age 50 and older to make
additional "catch-up" deferrals ($3,000 for
2004).
The advantage of a 401(k) plan is that the employees
bear the cost of the deferral contributions to the plan.
Although no employer contributions are required, most
companies make matching contributions to the plan to
encourage employee participation.
The disadvantages are the maximum annual deferral
contribution is only $13,000 per participant (for 2004),
and nondiscrimination testing (referred to as "ADP
testing") limits the annual deferral amounts for
owners and highly compensated employees based upon how
much the non-highly compensated employees defer.
Safe Harbor 401(k) Plans
A 401(k) plan that includes safe harbor provisions will
not need to perform ADP testing if the employer makes
certain safe harbor contributions. To avoid the ADP test,
the employer must make a minimum contribution of either 3%
of compensation or a basic matching contribution of 100%
on the first 3% of salary deferred and 50% of the next 2%
deferred (or an enhanced match at least equal to the basic
match, i.e., 100% up to 4% deferred).
Avoiding the ADP test will allow owners and highly
compensated employees to make the maximum annual deferral
regardless of the deferrals made by the non-highly
compensated employees.
If the plan provides exclusively for safe harbor
contributions, it may be exempt from top heavy testing. If
the plan is subject to top heavy rules, the safe harbor
contributions count toward satisfying the 3% top heavy
minimum contribution requirements.
Disadvantages of the safe harbor plan are that no
allocation requirements may be imposed, such as 1000 hours
of service or employment on the last day of the plan year,
and employer contributions must be fully vested and may
not be withdrawn due to hardship.
Money Purchase Pension Plans
A money purchase pension plan operates like a profit
sharing plan. The major difference is that, unlike profit
sharing plans where employers are permitted to make
discretionary contributions each year, the employer has a
set contribution rate which is stated in the plan
document. These mandatory contributions must be made each
year regardless of the employer's profits.
Prior to recent legislation, profit sharing plans were
limited to 15% of compensation while money purchase plans
were permitted to make contributions as high as 25%. The
increased profit sharing deduction limit to 25% may render
the money purchase pension plan obsolete.
New Comparability Plans
These plans, sometimes referred to as
"cross-tested plans," are DC plans that are
tested for nondiscrimination as though they were providing
monthly benefits from a defined benefit plan. By doing so,
older employees may receive much higher allocations than
would be permitted by DC plan nondiscrimination testing.
New comparability plans are generally utilized by small
businesses that want to maximize contributions to owners
and higher paid employees while minimizing those for all
other employees. Employees are separated into two or more
identifiable groups, such as owners and non-owners. Each
group may receive a different contribution percentage. For
example, a higher contribution may be given to the owner
group than the non-owner group, as long as the plan
satisfies the nondiscrimination requirements.
Simplified Plans
There are two plans available for smaller employers who
want simplified rules and reporting. Contributions are
made directly to the employee's IRA. In a Simplified
Employee Pension ("SEP") plan, the employer
makes discretionary contributions similar to a profit
sharing plan. A Savings Incentive Match Plan for Employees
("SIMPLE") plan permits employees to make
pre-tax elective deferrals, and the employer makes
mandatory matching or non-elective contributions.
The disadvantages of these plans are that many
part-time employees must be covered, contributions are
100% immediately vested and there is little flexibility in
plan design.
Defined Benefit Plans
Defined benefit ("DB") plans are pension
plans that promise the employee a specific monthly benefit
payable at the retirement age specified in the plan.
Benefits are usually based on the employee's compensation
and years of service which rewards long term employees.
The maximum annual benefit for 2004 is $165,000.
Aging business owners who want to shelter more than the
annual DC plan limit (lesser of 100% of compensation or
$41,000 for 2004), may want to consider a DB plan since
contributions can be substantially higher, resulting in
fast accumulation of retirement funds.
The funding for a DB plan is determined actuarially in
accordance with reasonable assumptions for mortality,
interest rates, turnover, etc., and is usually funded
entirely by the employer. The employer is responsible for
contributing enough funds to the plan to pay the promised
benefits even if it lost money during the year.
In addition, a DB plan may be more costly to administer
than a DC plan because of actuarial fees and the expense
of insurance premium payments if the plan is covered by
the Pension Benefit Guaranty Corporation ("PBGC").
The PBGC is a government agency which guarantees certain
pension benefits in DB plans.
Nonqualified Plans
Generally, a nonqualified deferred compensation plan
provides additional benefits for key employees whose
contributions to a qualified plan are restricted by the
plan or legal limits. The advantages of a nonqualified
plan are that there are no coverage restrictions and
benefits can be provided as an added incentive to attract
and retain specific key employees. In addition, there are
no contribution or benefit limitations as there are with
qualified plans.
The disadvantages are that the employer generally does
not receive a tax deduction until the employee takes a
distribution and, if the employer files for bankruptcy,
the employees become general creditors and may lose their
money.
Conclusion
As you can see, there are a number of things to
consider when deciding on the type of retirement plan to
adopt. The selection of the right plan for your business
can both satisfy your business goals and provide you and
your employees with a secure retirement.
Changes can be made to a plan after it has been
established, as long as benefits that have accrued are not
reduced. Periodic evaluation of a company's plan will
ensure that the company is getting the most out of its
retirement plan.
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