Retirement Planning For Small Businesses
As a business owner, you should carefully consider the advantages of establishing an employer-sponsored retirement plan. Generally, you’re allowed a deduction for contributions you make to an employer-sponsored retirement plan. In return, however, you’re required to include certain employees in the plan, and to give a portion of the contributions you make to those participating employees. Nevertheless, a retirement plan can provide you with a tax-advantaged method to save funds for your own retirement, while providing your employees with a powerful and appreciated benefit.
Types of Plans
Let’s explore the different types of retirement plans available for your business. Each plan has its unique advantages and disadvantages, and depending on your needs, you might even consider combining different plans for maximum benefit.
Profit-sharing plans are a common type of employer-sponsored retirement plan. These straightforward plans allow you, as an employer, to make a contribution that is spread among the plan participants. You are not required to make an annual contribution in any given year. However, contributions must be made on a regular basis.
With a profit-sharing plan, a separate account is established for each plan participant, and contributions are allocated to each participant based on the plan’s formula (this formula can be amended from time to time). As with all retirement plans, the contributions must be prudently invested. Each participant’s account must also be credited with his or her share of investment income (or loss).
A type of deferred compensation plan, and now the most popular type of plan by far, the 401(k) plan allows contributions to be funded by the participants themselves, rather than by the employer. Employees elect to forgo a portion of their salary and have it put in the plan instead. These plans can be expensive to administer, but the employer’s contribution cost is generally very small (employers often offer to match employee deferrals as an incentive for employees to participate). Thus, in the long run, 401(k) plans tend to be relatively inexpensive for the employer.
The requirements for 401(k) plans are complicated, and several tests must be met for the plan to remain in force. For example, the higher paid employees’ deferral percentage cannot be disproportionate to the rank-and-file’s percentage of compensation deferred.
Note: A 401(k) plan can let employees designate all or part of their elective deferrals as Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pretax contributions to a 401(k) plan, there’s no up-front tax benefit–contributions are deducted from pay and transferred to the plan after taxes are calculated. Because taxes have already been paid on these amounts, a distribution of Roth 401(k) contributions is always free from federal income tax. And all earnings on Roth 401(k) contributions are free from federal income tax if received in a “qualified distribution.”
Note: 401(k) plans are generally established as part of a profit-sharing plan.
Simplified Employee Pension (SEP)
A SEP is easy to setup and even easier to administer. Each employee establishes their own SEP-IRA to which the employer contributions are made. Although the employer is not required to make a contribution each year, when one is made it must be contributed to all employees over the age of 21, part-time included, based on 25% of covered compensation.
The employees manage their own SEP-IRAs which can be invested in mutual funds, money market funds, or fixed investments. The funds are always 100% vested so they can be accessed immediately by the employee (subject to an early withdrawal penalty). Employees with SEP-IRAs can also invest in their own traditional or Roth IRA subject to some income limitations.
For employers, their only responsibility is to make the contribution by their tax filing deadline. There is no administration of the accounts and there is no forfeiture provision to manage.
Savings Incentive Match Plan for Employees (SIMPLE)
In a SIMPLE Plan, employees establish their own IRA to which they can electively make tax deductible contributions. Employee funds are 100% vested, however, in addition to the normal early withdrawal penalty of 10%, if a withdrawal is made within the first two years of participation, the penalty is 25% unless any exceptions apply.
The employer must match the employee’s contributions up to 3% of their elective deferral, or 2% of all compensation for all employees whether they defer or not.
Win-Win for Both Your Business and Employees
Offering an employer-sponsored retirement plan can be a win-win for both your business and employees. It’s a valuable benefit that can help you attract and retain top talent while providing a tax-advantaged method for you and your employees to save for retirement.