Retirement plans, aside from offering retirement and tax benefits, are an important way to attract and retain qualified employees. Under these plans, employer contributions are deductible even though employees are not taxed until the funds are actually distributed to them. There are a variety of retirement plan options available to business owners and their employees; each should be evaluated in the context of the business owner’s needs and resources. Vesting rights (the participants’ right to company contributions that have accrued in their individual accounts) vary according to the type of plan utilized. Whichever plan you use, it must receive the approval of the IRS.
Simplified Employee Pension Plan (SEP IRA)
SEP IRAs are low cost and low maintenance retirement plans that are best suited for businesses with a small number of employees- all business owners or self-employed individual are eligible. A SEP plan is comparable to an employer establishing and funding a “company provided IRA” for the benefit of each employee. There are no requirements for a separate employer trust document. Vesting in a SEP IRA is immediate.
Eligibility
A SEP IRA is available to employers who have 25 or fewer employees eligible to participate and 50% of the employees make the election to participate.
Funding
Employer tax-deductible contributions are used to fund the plan; employee contributions are not allowed and all eligible employees (who have been employed for 3 out of the past 5 years) must be covered. Under a SEP IRA up to 15% of income ($25,500/year maximum) may generally be contributed on behalf of employees; whatever percentage is used, it must be uniform for the employer and employees.
Administration
Administration of a SEP is relatively simple; there is no requirement to file annual reports with the IRS. The business can make an election each year as to whether to make a contribution or not, and if so, in what amount- this provides flexibility to the business. Vesting in a SEP IRA is immediate.
Simple IRAs
Simple IRAs allow employees to contribute to the plan and require the employer to match the contribution. Only $6,000 plus up to 3% of salary is the maximum that can be contributed for each employee annually. Since the amount that can be contributed to a Simple IRA is limited and the employer match is mandatory there is less flexibility than with a SEP IRA. Vesting in a Simple IRA is immediate.
Eligibility
In order for a business to establish a Simple IRA, it must have fewer than 100 eligible employees- employees who earn more than $5000 year and do not have another retirement plan. Distributions cannot be made without a penalty before age 59 1/2, and distributions must begin before age 70 1/2.
ROTH IRAs
A ROTH IRA is a retirement account whereby individuals can put up to $2000 per year of earned income into the plan. While in the plan, asset growth, dividends and interest are not taxable, and monies withdrawn from the plan are tax-free under certain conditions. The Roth IRA provides no deduction for contributions, but instead provides a benefit that isn’t available for any other form of retirement savings: if you meet certain requirements, all earnings are tax-free when you or your beneficiary withdraws them. Since you don’t get a deduction when you contribute to the Roth IRA, a decision must be made whether a deduction for contributions is more important to you than the ability to draw earnings tax-free. Dividends, interest and capital gains accumulated within a ROTH IRA are tax-free if the account is owned at least 5 years and owner is over 59 1/2. Vesting in a Simple IRA is immediate.
Eligibility
Individuals who participate in various other company retirement plans can also establish a Roth IRA. If family annual gross income reaches $160,000 or more per year for married couples and $110,000 or more for single filers no contributions can be made.
Money Purchase Plan
Contributions to a Money Purchase Plan are fixed and are limited to 25% of salary, up to $30,000 each year with the employer making all contributions. While the contribution limit for a money purchase pension plan is higher than for a profit sharing plan (see below), a money purchase pension plan is less flexible; once the percentage is determined, contributions are mandatory even if the company has a bad year. The vesting requirements and contributions are determined by the plan.
Eligibility
Money Purchase Plans are available to any business owner or self-employed individual and participation is limited to employees who have worked at least 1000 hours during the past year.
Profit Sharing Plan
Profit Sharing Plans and Money Purchase Plans are quite similar- the primary difference is that for Profit Sharing Plans, the contribution limits are somewhat lower and can vary from year to year. The employer can contribute 15% of salary or $25,500 for each employee annually. Vesting is determined by the plan.
Eligibility
Profit Sharing Plans are available to any business owner or self-employed individual and participation is limited to employees who have worked at least 1000 hours during the past year.
Funding
The employer can contribute 15% of salary or $25,500 for each employee annually. The amounts of any contributions can be decided and funded after year-end; this gives Profit Sharing Plans greater flexibility and offers protection if business income decreases. The vesting requirements and contributions are determined by the plan.
401(k)
401(k) plans are most suitable for employers with 25 or more employees. Usually, there is a flat fee ($1,500+) to set up the plan, and a per employee maintenance charge. The plan may be somewhat pricey to create and maintain, although competition among 401(k) providers has driven the cost down.
Eligibility
401(k) plans are available to any business owner or self-employed individual and participation is limited to employees who have worked at least 1000 hours during the past year.
Funding
Employees and employers both contribute to the plan- the funds need not match. The maximum contribution is $30,000 or 25% of salary. A 401(k) plan permits employees to contribute to their own retirement account and thereby supplement Social Security. Employees who choose to do so can generally contribute up to the limits set by the plan and up to the annual indexed dollar limit set by the Internal Revenue Service (currently $10,500)- substantially more than is permitted for an IRA. All employee contributions are made with pre-tax dollars, thereby reducing an employee’s taxable income. Employers can elect to match employee contributions and make profit sharing contributions. Typically, deductions are made from payroll for contributions.
Keogh Plan
A Keogh plan is a tax-deferred retirement savings plan for people who are self-employed, and is much like an IRA. Keogh plans require more paperwork than IRA-type plans, including an annual report to the IRS, for which your accountant might charge you several hundred dollars to prepare. Generally, employer contributions are 100% vested at the time of contribution.
Eligibility
Keogh plans are available to any business owner or self-employed individual and participation is limited to employees who have worked at least 1000 hours during the past year.
Funding
The main difference between a Keogh and an IRA is the contribution limit. Employer’s contributions are discretionary or fixed, depending on whether the plan is established as a profit sharing or money purchase plan. The maximum amount of tax-deductible contributions is 15% of eligible compensation of all participants (25% if the plan is a money purchase plan). Participants in Keogh plans are subject to the same restrictions on distribution as IRAs, namely distributions cannot be made without a penalty before age 59 1/2, and distributions must begin before age 70 1/2. The plan may permit employees to take loans and/or withdrawals according to plan provisions.
Defined Benefit Plan
Defined benefit pension plans are traditional plans that promise workers a specific monthly benefit at retirement. The amount of the benefit is known in advance, usually based on factors such as age, earnings, and years of service- the benefits are first “defined” and the annual employer contributions needed to provide these benefits are then determined. Defined Benefit Plans are a retirement plan of choice for employers who want to offer a fixed benefit or to favor older employees. These plans can be administered through a Keogh. The employer/plan determines vesting.
Contributions
Employers contribute as much as is needed to provide an annual retirement payout of $135,000 (as determined by an actuary) or 100% of the average of your three highest consecutive pay years. Employees cannot contribute to the plan. A Defined Benefit Plan can be expensive and it’s not very flexible; contributions are not optional.
Administration
The assets of the plan are held in a pool, rather than individual accounts for each employee, and as a result, there is no employee control over investments. With a defined benefit plan the employer is legally required to make sure there is enough money in the plan to pay the guaranteed benefits. If the company fails to meet its obligation, the federal government will become intercede. Defined-benefit plans are the only type of pension insured by the Pension Benefit Guarantee Corporation (PBGC).