For businesses, retirement plans can provide tax advantages to owners and give employees a good reason to save for their futures. Each retirement plan comes with its own advantages and disadvantages. The same type of plan can be a disaster for one company while being effective for another. Below is a summary of the types of plans to help you decide what retirement plan is right for your business, if any.
- Simplified employee pension (SEP) plans – SEP’s can be used by any business, no matter how small or large. There are no employee contributions in this plan. Contributions made by the employer (up to the lesser of 25% of each qualified employee’s compensation or $55,000 for 2018) are tax deductible to the business. After adoption, there are no annual IRS filings and administrative expenses are minor. Other factors to consider are that employees are always 100% vested in employer contributions to their SEPs and that the employer is required to make contributions at equal percentages to all eligible employees.
- Savings Incentive Match Plan for Employees (SIMPLE) IRA plans – these plans are typically available to businesses with 100 or less employees who received $5,000 or more in compensation in the prior year. There are pretax employee contributions in this plan. Like a SEP, contributions made by the employer are tax deductible to the business and employees are always 100% vested in employer contributions. The employer must either match all employee contributions up to 3% of the employee’s compensation or make a contribution of 2% of an eligible employee’s compensation (whether or not the employee makes a contribution).
- Qualified plans – there are two types of qualified plans: defined benefit and defined contribution plans. These plans can be more complicated and as a result have strict reporting requirements. These plans are generally more suited for larger or growing businesses, which have the staff and resources to handle the reporting requirements. Loan provisions and in-service withdrawals are allowed in qualified plans, but not SEP or SIMPLE IRA plans.
- In a defined benefit plan, or “pension plan” as some might say, the employee is guaranteed a consistent flow of income in the future, hence the name. The benefit payments in the future are defined by the plan document. The amount of these payments is typically dependent on the employee’s compensation history as well as their years of employment. On an annual basis, the employer must contribute enough to satisfy the minimum funding requirement, which is a complex calculation generally made by an actuary. Defined benefit plans are those that are typically earned by municipal workers – teachers, police, firefighters, etc.
- Defined contribution plans are the more common of qualified plans. Think of 401(k) and 403(b) plans (among others) for the most common examples of defined contribution plans. Employers contribute into individual accounts for each employee, again, hence the name. The amount of contribution is defined by the plan participant. Employees can then invest that money as they choose using the investment options available in the plan. Immediate vesting of contributions is not required and the plan may allow for employee loans. Two types of defined contribution plans are profit-sharing plans and money purchase plans.
- With a profit-sharing plan, employer’s contributions are discretionary, therefore, the employer does not have to make contributions to the plan annually. This plan can include a 401(k) feature, which is described below.
- With a money purchase plan, annual employer contributions are required and the contribution percentage used to calculate the contribution amount for each year cannot change.
- 401(k) plans – Employees participating in this type of plan can elect to defer a portion of their compensation (pretax) to their retirement accounts. For 2018, employees in a 401(k) plan may contribute as much as $18,500 ($24,500 for those age 50 or older at the end of the calendar year). The employer can also contribute a percentage of each eligible employee’s compensation and/or match the amount of employee’s elective deferral. For 2018, the maximum amount of total employer and employee contributions are the lesser of the employee’s total compensation or $55,000. Employees can be 100% vested immediately in the employer contributions or can become vested over time using a vesting schedule. Two types of vesting are graded and cliff. Under graded, an employee becomes vested gradually over time such as 20% vested in year one, 40% in year two and eventually 100% in year five. Under cliff vesting, the employee becomes 100% vested at a certain point such as five years of service. As a 401(k) plan is more complicated than a SEP or SIMPLE IRA, a third party administrator, or TPA, is recommended to assist with compliance and testing of the plan. An annual filing with the IRS is required.
- Solo 401(k) or solo Roth 401(k) plans – If the business owner and his/her spouse are the only employees, they may qualify for this plan. They come with the same benefits offered by larger businesses, but at a cheaper cost.
If you’re a business owner looking for ways to save for retirement and lower your current income tax burden, then you should be actively seeking guidance on which retirement plan offering best suits your needs. All factors should be considered when choosing a retirement plan: cost-effectiveness, who you want contributing, employee turnover, administration, and complexity. Contact the tax and retirement plan experts at Cerini & Associates is you need any assistance in making the right choice.