Retirement Plans for Businesses
Retirement Plans for Businesses
Defined Benefit plans and Defined Contribution Plans
- 401(k) and ROTH 401(K)
- SIMPLE 401(K)
- SIMPLE IRA's
- SEP IRA's
- Cash Balance Plans
The creation of the Simplified Employee Pension (SEP) and the Savings Incentive Match Plan for Employees (SIMPLE) affords smaller businesses with a way to offer their employees a retirement plan. The SEP and SIMPLE were designed for businesses with less than 100 employees and are less costly to administer than a 401(k). For the employees, they are both easy to understand and provide a convenient way to save for retirement.
As qualified retirement plans, SEPs and SIMPLEs enjoy the same tax treatment as other plans. Contributions by employees and employers are tax deductible or made on a pre-tax basis. The accumulation inside the accounts grows tax deferred. The many of the same restrictions apply as well. Withdrawals made prior to age 59 ½ may be subject to a penalty.
As with all defined contribution plans, the future retirement benefit is uncertain as it depends on the amount of contributions, how long they accumulate, and the rate of return on the account over that period of time. At the time of distribution, withdrawals are taxed as ordinary income with no allowance for 10-year averaging as is available through a 401(k).
Understanding Defined Benefit and Defined Contribution Plans
Defined Benefit Plans: These plans provide a guaranteed retirement benefit based on a formula that typically factors in salary and years of service. The employer takes on the responsibility for investment decisions and ensuring that sufficient funds are available to meet future retirement obligations.
Defined Contribution Plans: In contrast, defined contribution plans allow for contributions from the employee, employer, or both into individual retirement accounts. The retirement benefit depends on the account’s investment performance, transferring the investment risk to the employee. Popular examples include 401(k) plans, SIMPLE IRAs, and SEP IRAs.
401(k) and Roth 401(k)
A traditional 401(k) plan allows employees to save for retirement by making pre-tax contributions. These contributions lower taxable income in the year they are made, but withdrawals in retirement are taxed as ordinary income.
With a Roth 401(k), contributions are made with after-tax dollars, meaning there is no immediate tax benefit. However, qualified withdrawals in retirement are tax-free, providing potential long-term tax advantages for certain individuals.
SIMPLE 401(k)
Designed for small businesses with fewer than 100 employees, a SIMPLE 401(k) offers an accessible, cost-effective way to help employees save for retirement. Employees can contribute a portion of their salary on a pre-tax basis, while employers are required to make matching or non-elective contributions. The plan offers straightforward administration while allowing employees to build retirement savings.
SIMPLE Plan
In a SIMPLE Plan, employees establish their own IRA to which they can electively make tax deductible contributions. Employees who earn at least $5,000 during any two prior years as well as the current year are eligible to participate on a voluntary basis. The maximum amount that can be contributed is $11,500 or 100% of their compensation whichever is less. 2
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. 3
There is another version of a SIMPLE called the 401(k) version which is structured much like the IRA version. The advantage of the 401(k) version to the employer is that it can establish stricter requirements for plan eligibility which could reduce the amount of matching contributions. The disadvantage is that the same ERISA reporting rules apply to a SIMPLE 401(k) as they do the regular 401(k), so it can be more costly to administer.
Simplified Employee Pension (SEP)
A SEP is easy to setup even easier to administer. Each employee established 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. 1
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.
Cash Balance Plans
Cash Balance Plans combine features of traditional pensions and defined contribution plans. Each participant has an account that grows with annual employer contributions and a guaranteed rate of return. At retirement, participants can take the accumulated balance as a lump sum or an annuity, offering both security and flexibility. This plan is particularly beneficial for businesses seeking to provide more predictable retirement outcomes for employees.
For additional information on small business retirement plans, contact us today.
1 Contributions are limited to 25% of a maximum of $245,000 in 2010 or $49,000.
2 $11,500 is the current maximum and the amount is indexed for inflation.
3 An employer may make less than the 3% contribution for two years out of five year period but it cannot be less than 1%
