Tax Tips
Retirement Plans - July 2004
Richard Scrivanich - Partner
What Kind of Retirement Plan Is Right for Your Business?
Many small business owners do not think of retirement plans when thinking about deductions and their yearly tax bill, although retirement plans are often one of the best tax breaks available to small business owners. Retirement plans have a double-pronged benefit–you save taxes now and help build a secure future retirement for participants.
There are a number of retirement plan options for small business owners, each with its own advantages and limitations. The plan you choose depends on the form and size of your business, the amount you wish to contribute, the amount of flexibility you desire, and many other factors. But regardless of your particular circumstances, you will almost certainly find a plan that suits your situation.
In general, there are three basic types of plans: (1) IRA-based plans, (2) defined contribution plans, and (3) defined benefit plans. Each has its own rules for annual contribution limits, filing requirements, and participant rules that are beyond the scope of this article. However, knowing the basics will help you proceed to the next step.
IRA-based plans:
IRA-based plans include payroll deduction IRAs, simplified employee pension (SEP) plans, and savings incentive match plan for employees IRAs (SIMPLE-IRAs).
Payroll deduction IRA: The payroll deduction IRA is probably the simplest retirement arrangement for a business, although it does not provide a deduction for your business. Under a payroll deduction IRA, an employee establishes an IRA (either a traditional IRA or a Roth IRA) with a financial institution. The employee then authorizes a payroll deduction for the IRA. Your responsibility as an employer is simply to transmit the employee’s authorized deduction to the financial institution.
SEP: A SEP is basically an IRA you set up for yourself and your employees. SEP administrative costs should be lower than for some other plans. By establishing a SEP, you the employer have adopted a plan that has a trust for the plan assets, and each of your employees (including yourself) has a separate account within the trust. A SEP is funded only by employer contributions. Each employee is always 100% vested in (or has total ownership of) the contributions to his or her SEP. If you set up a SEP for yourself, you generally must cover all employees who meet an age and service test.
SIMPLE-IRA: SIMPLE-IRAs are available only for a small business with 100 or fewer employees. If you opt for a SIMPLE-IRA plan, your employees can elect to defer part of their salary. Each employee is always 100% vested in all contributions to their SIMPLE.
Defined contribution plans:
With a defined contribution plan, you as the employer make a stated (“defined”) contribution to the plan. Each participating employee has a separate account and his or her retirement benefit results from the contributions made to his or her account and the earnings on those amounts. Examples of defined contribution plans include 401(k) plans, including SIMPLE 401(k)s, profit-sharing plans, and money purchase plans.
401(k) plans: With a 401(k) plan, employees can choose to defer some of their salary. So instead of receiving that amount in their paycheck, the employee defers, or delays, getting that money. In this case, their deferred money is going into a 401(k) plan sponsored by their employer. This deferred money generally does not get taxed by the federal government or by most state governments until it is distributed.
You can make a 401(k) plan as simple or as complex as you want. A preapproved 401(k) plan cuts down on administrative headaches and expenses. While 401(k) plans provide some popular advantages, the administrative costs often make them too expensive for small businesses.
SIMPLE 401(K) Plans: A new subset of the 401(k) plan is the SIMPLE 401(k) plan. Like the SIMPLE-IRA, this plan is for the small business with 100 or fewer employees. Under a SIMPLE 401(k) plan, an employee can elect to defer some compensation. But unlike a regular 401(k) plan, the employer must make either:
- 1. A matching contribution up to 3% of each employee’s pay depending on the amount each employee contributes; or
- 2. A nonelective contribution of 2% of each eligible employee’s pay, regardless of whether the employees make contributions.
The employees are totally vested in any and all contributions.
Profit-sharing plans: Contributions to a profit-sharing plan are discretionary. If you do make contributions, you will need to have a set formula for determining how the contributions are divided. This money goes into a separate account for each employee. As with 401(k) plans, you can make a profit-sharing plan as simple or as complex as you want. Preapproved profit-sharing plans are available to cut down on administrative headaches. However, you will still need to test the plan to assure that benefits do not discriminate in favor of the highly compensated employees.
Money purchase plans: Money purchase plans have required contributions percentages, which are stated upfront in the plan. Preapproved money purchase plans are available to cut down on administrative requirements. Money purchase plans are subject to more generous limits; therefore it is possible to grow larger account balances than under some other arrangements. However, administrative costs may be higher, and an excise tax applies if the minimum contribution requirement is not satisfied each and every year.
Defined benefit plans:
With a defined benefit plan, the participant is promised a stated “defined” benefit. There are no separate accounts, only one general trust. Usually the benefit is stated as a percentage of pay or a specific dollar amount multiplied by the participant’s years of service. Trust earnings have no impact on the participant’s promised benefit.
Sometimes, you might hear defined benefit plans described as:
- Career Average Earnings Plans
- Final Average Earnings Plans
While there are often higher costs and more complexity with these plans, defined benefit plans can provide significant benefits in a relatively short period of time, and, often, employers can contribute (and deduct) more than under other retirement plans. Another advantage is that the plan provides a predictable benefit. However, such plans are the most costly and most administratively complex.
Many choices to make
Is one of these plans for you? Please call us if you would like to consider the many possibilities for establishing a retirement plan for your business or to discuss whether your current plan still fits your needs and expectations. Because of the significant tax advantages available now, and the important future benefits a retirement plan can provide, establishing a retirement plan is one of the most important steps you can take for both yourself and your business.
If you would like to discuss establishing a retirement plan for your business or any other tax matters, please call me at (562) 698-9891.
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