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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