Starting a retirement savings plan can be easier than most business owners think. In this article we will discuss the three main types of plans, provide a comparison of the plans, and provide some other information.
The three basic types of plans are, IRA based plans, defined contribution plans, and defined benefit plans. IRA based plans include a payroll deduction IRA, a Simple-IRA, and a Simplified Employee Pension (SEP-IRA). Defined contribution plans include 401(k) plans and profit sharing plans and, in some cases, both of these features can be combined into one plan. Defined benefit plans can provide the largest income deferral for the company and the largest benefit for the employee; however, we are seeing fewer of these plans, due to the cost and administrative requirements.
IRA Base Plans
Payroll Deduction IRAs
Even if an employer does not want to adopt a retirement plan, it can allow its employees to contribute to an IRA through payroll deductions, providing a simple and direct way for employees to save. The employee makes the decision about whether to contribute, when to contribute and how much to contribute to the IRA. The maximum amount the employee can contribute is $5,000 in 2012, $6,000 if age 50 or older. Payroll deduction contributions are tax-deductible by an individual, to the same extent as other IRA contributions. The employer’s cost is minimal, mainly administrative fees. Most employees find this systematic way of retirement savings easier than making an annual IRA contribution.
A Payroll deduction IRA must be established by December 31, 2012 to be effective for the 2012 tax year and employee deferrals must be made by December 31, 2012.
There is no annual IRS filing requirement with this type of plan.
SIMPLE IRA Plans
This savings option is for employers with 100 or fewer employees and involves a type of IRA.
A SIMPLE IRA plan allows employees to contribute a percentage of their salary each paycheck and requires an employer contribution. Under SIMPLE IRA plans, employees can set aside up to $11,500 in 2012, $14,000 if age 50 or older, by payroll deduction.
Employers must either match employee contributions dollar-for-dollar – up to 3 percent of an employee’s compensation – or make a fixed contribution of 2 percent of compensation for all eligible employees. The employer’s contribution requirement is required every year, regardless of the profitability of the company. If not all of the employees participate in the plan, the 3% options can be less costly as it is based only on employees who are making contributions to the plan.
If the plan provides for it, employers can choose to automatically enroll employees in SIMPLE IRA plans as long as the employees are allowed to choose not to have salary reduction contributions made to their SIMPLE IRAs or to have salary reduction contributions made in a different amount.
SIMPLE IRA plans are easy to set up. You fill out a short form to establish a plan and ensure that SIMPLE IRAs (to hold contributions made under the SIMPLE IRA plan) are set up for each employee. A financial institution can do much of the paperwork. Additionally, administrative costs are low.
Employers may either have employees set up their own SIMPLE IRAs at a financial institution of their choice or have all SIMPLE IRAs maintained at one financial institution chosen by the employer.
Employees can decide how and where the money will be invested, and the employee keeps their SIMPLE IRAs even when they change jobs.
A Simple-IRA needs to be established before October 1, 2012 to be effective for the 2012 tax year.
There is no annual IRS filing requirement with this type of plan.
Simplified Employee Pensions (SEP-IRA)
A SEP-IRA allows employers to set up a type of IRA for themselves and each of their employees. Employers must contribute a uniform percentage of pay for each employee, although they do not have to make contributions every year. Employer contributions are limited to the lesser of 25 percent of pay or $50,000 in 2012. The employee cannot make any deferral contributions to this type of plan. Because the full burden of this type of plan is the employer’s, this plan is best for a company with a limited number of non-owner employees.
SEP-IRAs have low start-up and operating costs and can be established using a two-page form. You can decide how much to put into a SEP each year – offering you some flexibility when business conditions vary.
A SEP-IRA can be established by, and, contributions can be made up until the due date of the company’s tax return, including extensions.
There is no annual IRS filing requirement with this type of plan.
Defined Contribution Plans
401(k) Plans
A 401(k) plan is an employee salary deferral plan. The employer has no requirement to make a contribution, unless the plan allows for some type of employer contribution. The cost to the employer is administrative fees including the filing of an information tax return, Form 5500.
With a 401(k) plan, employees can choose to defer a portion of their salary, up to $17,000 in 2012, $22,500 if age 50 or older, by payroll deduction. So instead of receiving that amount in their paycheck today, the employees can contribute the amount into a 401(k) plan sponsored by their employer. These deferrals are accounted separately for each employee. Deferrals are made on a pretax basis but, if the plan allows, they can be made on an after-tax (Roth) basis at the employee’s choosing. Many 401(k) plans provide for employer matching or other contributions. Employer contributions and pretax deferrals (plus earnings) are not taxed by the Federal Government or by most state governments until distributed.
401(k) plans can vary significantly in their complexity. However, many financial institutions and other organizations offer prototype 401(k) plans, which can greatly lessen the administrative burden on individual employers of establishing and maintaining these plans. A Safe Harbor 401 (k) and an Automatic Enrollment 401(k) are variations on the basic 401 (k) plan that can reduce the administrative costs to the employer.
A 401 (k) plan needs to be established by the last day of the tax year to be effective for that year.
Profit Sharing Plans
Employer contributions to a profit sharing plan can be discretionary. Depending on the plan terms, there is often no set amount that an employer needs to contribute each year.
If you do make contributions, you will need to have a set formula for determining how the contributions are allocated among plan participants. The funds are accounted for separately for each employee.
As with 401(k) plans, profit sharing plans can vary greatly in their complexity. Similarly, many financial institutions offer prototype profit sharing plans that can reduce the administrative burden on individual employers.
A profit sharing plan needs to be established by the last day of the tax year to be effective for that year.
An annual filing of Form 5500 is required with this type of plan.
Defined Benefit Plans
Some employers find that defined benefit (DB) plans offer business advantages. For instance, employees often value the fixed benefit provided by this type of plan. In addition, employees in DB plans can often receive a greater benefit at retirement than under any other type of retirement plan. On the employer side, businesses can generally contribute (and therefore deduct) more each year than in defined contribution plans. However, DB plans are often more complex and likely more expensive to establish and maintain than other types of retirement plans. They also require a contribution every year based on the benefits to be paid to each employee. This requirement can be burdensome in years when the company has no profits.
A defined benefit plan needs to be established by the last day of the tax year to be effective for that year.
An annual filing of Form 5500 is required with this type of plan.
Tax Advantages
A retirement plan has significant tax advantages:
- • Employer contributions are deductible from the employer’s income,
- • Employee contributions (other than Roth contributions) are not taxed until distributed to the employee, and
- • Money in the plan grows tax-free.
Other Incentives
Following are some other advantages for establishing a retirement plan.
- • There is a tax credit for small employers that would enable them to claim a credit for part of the ordinary and necessary costs of starting a SEP, SIMPLE, or certain other types of plans. The credit equals 50 percent of the cost to set up and administer the plan, up to a maximum of $500 per year for each of the first 3 years of the plan;
- • Tax credit for certain low- and moderate-income individuals (including self-employed) who make contributions to their plans (“Saver’s Credit”).
- • The amount of the credit is based on the contributions participants make and their credit rate. The maximum contribution eligible for the credit is $2,000. The credit rate can be as low as 10 percent or as high as 50 percent, depending on the participant’s adjusted gross income; and
- • A Roth 401(k) program can be added to a 401(k) plan to allow participants to make after-tax contributions into separate accounts, providing an additional way to save for retirement. Distributions upon death or disability or after age 591/2 from Roth accounts held for 5 years, including earnings, are generally tax-free.
Here is a chart comparing various components of each of the plans. Please contact us if you would like to discuss what type of retirement plan would work best for your situation.
| DEFINED CONTRIBUTION PLANS | ||||||
| Traditional 401(k) | Profit Sharing | Defined Benefit | ||||
| Key Advantage | Permits employer to make large contributions for employees. | Permits employer to make large contributions for employees. | Provides a fixed, pre-established benefit for employees. | |||
| Employer Eligibility | Any employer with one or more employees. | Any employer with one or more employees. | Any employer with one or more employees. | |||
| Employer’s Role | No model form to establish this plan. Advice from a financial institution or employee benefit adviser may be necessary. Annual filing of Form 5500 is required. Requires annual non-discrimination testing to ensure plan does not discriminate in favor of highly compensated employees. | No model form to establish this plan. Advice from a financial institution or employee benefit adviser may be necessary. Annual filing of Form 5500 is required. | No model form to establish this plan. Advice from a financial institution or employee benefit adviser would be necessary. Annual filing of Form 5500 is required. An actuary must determine annual contributions | |||
| Contributors To The Plan | Employee salary reduction contributions and maybe employer contributions | Annual employer contribution is discretionary | Primarily funded by employer | |||
| Maximum Annual Contribution (per participant) | Employee: $17,000 in 2012. Additional contributions can be made by participants age 50 or over up to $5,500. Employer/Employee Combined: Up to the lesser of 100% of compensation1 or $50,000 for 2012. Employer can deduct (1) amounts that do not exceed 25% of aggregate compensation for all participants and (2) all salary reduction contributions | Up to the lesser of 100% of compensation1 or $50,000 for 2012. Employer can deduct amounts that do not exceed 25% of aggregate compensation for all participants | Annually determined contribution. | |||
| Contributor’s Options | Employee can decide how much to contribute pursuant to a salary reduction agreement. The employer can make additional contributions, including matching contributions as set by plan terms. | Employer makes contribution as set by plan terms. | Employer generally required to make contribution as set by plan terms. | |||
| Minimum Employee Coverage Requirements | Generally, must be offered to all employees at least 21 years of age who worked at least 1,000 hours in a previous year | Generally, must be offered to all employees at least 21 years of age who worked at least 1,000 hours in a previous year | Generally, must be offered to all employees at least 21 years of age who worked at least 1,000 hours in a previous year | |||
| Withdrawals, Loans & Payments | Withdrawals permitted after a specified event occurs (e.g., retirement, plan termination, etc.) subject to federal income taxes. Plan may permit loans and hardship withdrawals; early withdrawals subject to an additional tax. | Withdrawals permitted after a specified event occurs (e.g., retirement, plan termination, etc.) subject to federal income taxes. Plan may permit loans and hardship withdrawals; early withdrawals subject to an additional tax. | Payment of benefits after a specified event occurs (e.g. retirement, plan termination, etc.). Plan may permit loans; early withdrawals subject to an additional tax. | |||
| Vesting | Employee salary reduction contributions are immediately 100% vested. Employer contributions may vest over time according to plan terms. | May vest over time according to plan terms. | May vest over time according to plan terms. | |||
If you are a small business with no employees our prior article ‘Retirement Plans for Businesses with No Employees‘ will be of interest to you.
About Blackman & Sloop CPAs, P.A.:
Blackman & Sloop is a full-service CPA firm headquartered in Chapel Hill, North Carolina and is actively involved in auditing, taxation, management consulting, financial planning, and related services. The firm directs a large part of its services toward providing management with advice on budgeting, forecasts, projections, financing decisions, financial analysis, and tax developments. The firm also performs review and compilation services and prepares not-for-profit, corporate, individual, estate, retirement plan, and trust tax returns as well as technology consulting services regarding installation and training on QuickBooks. Blackman & Sloop provides services in Raleigh, Durham, Chapel Hill, RTP, Hillsborough, Pittsboro, Charlotte, and the rest of North Carolina. To find out more please visit http://www.blackmansloop.com
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