By Scott R. Rain, J.D.
In order to maintain their current standard of living, many studies estimate that individuals will need anywhere between 70% and 80 % of their pre-retirement income. While we can discuss the pros and cons of the Social Security system and what type of benefit individuals can expect to receive, it is more important to examine retirement savings programs for small business owners that can be controlled.
Many companies and organizations have already established a wide range of retirement plan options, from defined pension programs to employee 401(k) savings plans. However, a number of newer, growing small businesses have yet to create a retirement savings plan. With this in mind, it's important for them to know how to establish or sponsor a retirement plan. The following is a review of some of the various retirement plan options for employers.
Three basic retirement plans
There are three basic types of retirement plans that employers can establish for the benefit of their employees and themselves. Those plans include individual retirement arrangements (IRAs), defined contribution plans and defined benefit plans. Any retirement plan chosen by an employer will typically have the same tax advantages, including deductible employer contributions, employee contributions that are not taxed until distribution to the employee, and investment earnings in the accounts that grow tax deferred.
The differences in the accounts are related to the amounts that the employer and employee can contribute to the plans in order to comply with the rules and regulations of the Internal Revenue Code. This article will focus on IRAs and defined contribution plans.
Types of IRAs
In general, IRAs are individually owned accounts that allow contributions to grow tax deferred and sometimes tax free. Employers have the ability to help its employees set up and fund their accounts depending on the type of IRA established. Types of IRAs that will be discussed in more detail below include a Simplified Employee Pension (SEP) IRA and a SIMPLE IRA.
A SEP IRA is an arrangement under which an IRA is established for each eligible participant and the employer contributes to the SEP IRA. Contributions under a SEP IRA are deductible by the employer and are excluded from the participant’s income until the year in which they are distributed. The employer has discretion to decide what the annual contribution will be to the plan. The contribution can range from 0% to 25% of compensation up to a maximum of $51,000 for 2013; however, the contribution must be the same percentage for both the employer and the employees.
Advantages of a SEP IRA include the following:
- Minimal plan setup and plan administration due to the limited IRS oversight;
- Responsibility for investment selection may be shifted to participants; and
- Making SEP contributions is completely discretionary, and the contribution amounts may be varied within statutory limits.
The disadvantages of using a SEP may include the following:
- Full and immediate vesting and withdrawal rights for employees.
- There are no employee deferrals.
- Limited ability to exclude classes of employees from participation. Under IRS rules, if an employee has worked for the employer during 3 of the past 5 years, a SEP IRA must be offered to those employees over the age of 21 and who earned $550 or more during the current year.
- Individual and overall contribution limits may be lower than those for other qualified plans.
A SEP IRA must be established and funded by the employer’s tax filing deadline, including extensions.
A SIMPLE IRA is a retirement plan for businesses with no more than 100 employees with $5,000 or more in compensation during the preceding year. The employer establishes a SIMPLE IRA for each eligible employee and makes mandatory annual contributions. The employee may also elect to defer a portion of his or her salary to the SIMPLE IRA.
The employer must choose before each plan year whether to make a matching contribution or a non-elective contribution for every participant. The matching contribution is generally the lesser of 3% of a participant’s compensation or the amount of the participant’s salary deferral. The non-elective contribution is 2% of the participant’s compensation, subject to a compensation limit for 2013 of $255,000.
SIMPLE plans are also subject to various requirements concerning establishment, vesting rights, participation, notice, administration, distributions, and taxation.
Advantages of a SIMPLE IRA
- The administrative cost of establishing and maintaining a SIMPLE IRA plan are very low relative to the other alternatives.
- In addition to employer contributions, employees covered by a SIMPLE IRA can contribute to their individual account through regular payroll deductions.
One disadvantage of the SIMPLE IRA is that the allowable employee deferrals are less than that of a 401(k) plan. For 2013, the salary deferral limit for a SIMPLE IRA is $12,000 plus an additional $2,500 if the employee is age 50 or older, while the deferral limits for 401(k) plans are $17,500 plus an additional $5,500 if the employee is over the age of 50.
As with any retirement plan, SIMPLE IRAs have specific distribution rules that must be followed. Any distribution is included in the employee’s income and is subject to regular income taxes. In addition, there is a 10% early withdrawal penalty on all distributions taken before the age of 59.5. More significantly, if the distribution is made within the first 2 years of participation in the plan, the 10% penalty tax is increased to 25%.
A SIMPLE IRA must be established by October 1 of the first plan year. There is an exception for businesses that are established after October 1; those businesses must establish a plan as soon as administratively feasible.
Defined contribution plans/401(k) plans
Defined contribution plans are plans in which the employer agrees to contribute an amount to the employee's account each year in which the employee is employed. The income that the employee receives during retirement depends upon how much money the plan accumulated and how much income that amount can generate. Typical examples of defined contribution plans include 401(k) and 403(b) plans. Under both types of plans, funding of the plan can be in the form of contributions made only by the employer or contributions from both the employer and employee.
A 401(k) plan is retirement plan that must meet certain qualifications established by the Internal Revenue Code (the “Code”). There are different types of 401(k) plans, including traditional 401(k) plans and safe harbor 401(k) plans.
While there are different types of 401(k) plans, they all share some common characteristics. First, an employee can contribute part of his wages either pre-tax or post tax (Roth) depending on the options offered in the plan. The amount of salary deferrals is limited by the Code.
As mentioned above, for 2013, an employee can contribute up to a maximum of $17,500, with an additional contribution of $5,500 if the employee is over the age of 50. Furthermore, in some plans, the employer also makes contributions commonly referred to “matching” contributions. The match is usually based as a percentage of the employee’s salary deferral. Employers also may have the discretion to make profit sharing contributions to the plan.
Employer contributions are deductible on the employer’s federal income tax return to the extent that the contributions do not exceed the limitations described in the Code.
Unlike SEP IRAs and SIMPLE IRAs where contributions to the plans are always 100% vested, meaning they belong to the employee, traditional 401(k) plans often have a vesting schedule for employer contributions, meaning the employee is not entitled to take a distribution until they have met certain service requirements that are identified in the plan document.
Safe harbor 401(k) plans differ from traditional 401(k) plans in that the employer is required to make certain contributions to the plan, thereby encouraging employee participation and reducing some of the administrative burden. By requiring certain employer contributions, highly compensated employees are typically able to defer more into the plan than with a traditional 401(k) plan.
Under the safe harbor rules, employers can elect to match each eligible employee’s contribution, dollar for dollar, up to 3% of the employee’s compensation plus 50% of the contribution that the employee makes in excess of 3% of his compensation, but less than 5% of the employee’s compensation. Alternatively, the plan can be designed so that the employer can make a non-elective contribution equal to 3% of compensation to each eligible employee’s account.
Unlike a traditional 401(k) plan, in a safe harbor 401(k) plan employer contributions are fully vested when made.
A 401(k) plan must be established by the last day of the employer’s taxable year with respect to which a contribution is going to be made. If the plan is going to allow for salary deferrals, then it is recommended that the employer establish the plan as soon as possible during the year.
There are many different variations of a 401(k) plan that can be established and an employer has significant flexibility in the design of the plan; however, with that flexibility comes an increase in the administrative complexity for the plan. When looking to establish a 401(k) plan it is important to discuss what you, as an employer, hope to accomplish with the plan.
There are a lot of options for small employers to consider when looking to implement an employer-sponsored retirement plan. Therefore, it is important to discuss your situation with a qualified consultant who can help you design a solution to assist you and your employees in attaining a secure and comfortable retirement.
Scott R. Rain, J.D., is a Tax Senior at Schneider Downs & Co.’s SD Retirement Plan Solutions. The focus of his work is client relations, technical research, participant education and problem resolution. His background also includes providing financial consulting and tax planning services to clients. He can be reached at 412.697.5315 or firstname.lastname@example.org.