By Ken Bloom
April 15, 2010
In today’s tough economy, businesses are trying to find ways to offer employees benefits that are both cost effective and help to retract and retain employees. One of the most important benefits you can offer employees is a retirement plan. However, understanding which retirement plan fits your business can be confusing.
Most small businesses offer employees a defined contribution retirement plan, which provides benefits solely on the amount contributed to the participants account plus any investment income, gains and losses that may be allocated to the participants’ account.
There are four types of defined contribution plans to consider: 401(k) plan; Savings Incentive Match Plan for Employees (SIMPLE); Simplified Employee Pension (SEP); and Profit Sharing. These plans can be broken down into two categories: employer paid (SEP and Profit Sharing), where the employer must make contributions for each eligible employee and employee paid (401(k) and SIMPLE), where the employee must elect to contribute a portion of their salary to the plan.
All of these plans provide the employer with tax deductions for contributions to the plan, and employees are not taxed on the contributions or earnings until they receive a distribution.
Small business owners need to factor in the size of their business, the cost and specifics of each plan, and the differences in administration time and costs to determine which plan makes the most sense for their business.
Employee Paid Plans
The 401(k) plan is one of the more popular plans. Each eligible employee has the option to have a certain amount of their compensation deferred and contributed to the plan. Contributions by employees are limited to a specific dollar amount ($16,500 in 2010 plus an additional $5,500 for employees 50 and older). Withdrawals are generally not allowed until termination of employment, retirement, disability, or hardship.
A disadvantage of a 401(k) plan for employers is that the plan must satisfy a special non-discrimination test every year. The test is designed to ensure that a company can’t discriminate in favor of highly compensated employees (HCEs) who participate in the plan. The amount the HCEs can contribute must be determined every year by complex testing. Basically, the HCEs are limited to the percentage of compensation deferred by all eligible employees. As a result, business owners often find that they are either unable to make significant contributions for themselves, leaving them with incurring the cost of maintaining the plan without receiving much in the way of benefits. Therefore, it may be necessary for the employer to offer an employee matching contribution feature so as to increase the percentage of participation by the employees. Although the matching contribution may increase the amount of employee participation, the plan still must undergo annual testing before the HCE can make any contribution. Another alternative is the “safe harbor plan” which does not require extensive discrimination testing. This option allows all eligible employees (including HCE) to participate in the plan, provided the employer makes a limited matching contribution for all employees who participate. Employers who establish a safe harbor plan are not subject to annual testing and HCE can contribute the maximum ($16,500 plus $5,500 catch up) regardless of the participation level of the employees.
A SIMPLE plan is designed for businesses with 100 or fewer employees. With a SIMPLE, an IRA is established for each participating employee and all employees who received at least $5,000 of compensation from the employer for the preceding year are eligible to participate. Contribution limits in 2010 are $11,500 plus an additional $2,500 for employees 50 and older.
The employer must make matching contributions of either 3 percent of compensation for those employees that elect to contribute or a contribution of a flat 2 percent of compensation for every employee eligible to participate in the plan. The employer can also elect to reduce the matching contribution to 1 percent for no more than two out of five years.
The advantages of a SIMPLE plan includes simplified reporting requirements and the absence of the qualification rules prohibiting the plan from discriminating in favor of highly compensated employees. This means owners are able to make contributions even if their employees do not elect to participate.
Employer Paid Plans
A SEP is an individual retirement arrangement to which an employer or a self-employed individual can contribute beyond the IRA limits. The rules governing SEPs are meant for small employers that want to avoid the administrative costs and other burdens of a 401(k).
Employers can make contributions to SEPs for a particular tax year until the due date of the return for that year. The downside of a SEP is that the employer must make contributions for each employee age 21 or over who has worked for the employer for at least three of the last five years and received compensation of at least $500. These contributions must be an equal percentage to the percent the employer contributes to the SEP for themselves.
SEP contributions by the employer cannot discriminate in favor of highly compensated employees. The employer also cannot prohibit withdrawals from the SEP and employer contributions can’t be conditioned on retention in the SEP of any portion of the amount contributed.
Profit Sharing Plan
With a profit sharing plan, an employer agrees to make discretionary contributions that are invested and accumulate tax deferred until distribution. Contributions are generally made to one account for the benefit of all employees. A participant’s benefits are based solely on the amount in their account at the time of the distribution event, such as retirement or death. Although not required, some plans also permit an employee to receive distributions prior to termination of employment if they have worked for a certain number of years.
In general, most full-time employees with a year or more of service must be eligible to participate in the plan. The employer is responsible for all contributions, and employer contributions are deductible to the extent of 25 percent of compensation. The contributions are also usually subject to a vesting schedule, where an employee has to remain with the company for a pre-determined amount of years before being able to receive contributions to the plan upon retirement or job termination.
As you can see, there’s a lot to think about before deciding which retirement plan to offer employees, such as administrative costs, whether you need to match employee contributions and the contribution limits. But one of the most important things to consider that often gets overlooked is which plan enables you to maximize retirement savings options for all levels of employees and the business’ owners. So I advise you to take your time when picking a plan to make sure it works for both you and your employees.
Ken Bloom is an attorney, financial advisor and tax expert and a partner with Rick Bloom in Bloom Asset Management and in the law firm of Bloom, Bloom & Associates, specializing in business, taxation and estate planning. He has been a featured speaker on investing, estate planning and taxes.