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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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