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Other Articles
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Employee Benefits
Retirement Plans for Small Businesses
By Wayne Michael Lottinville, CFA
Chief Investment Officer, Cascadia Investment Consultants
Small-business retirement plans offer financially
irresistible features for both employers and
employees. Setting up a small-business retirement
plan has never been easier—and the benefits are just
too attractive to pass up.
Employers may possibly obtain tax deductions and
credits—savings that could be reinvested in the
business. For example, an employer in the 25% tax
bracket who makes a $10,000 plan contribution
could reduce federal taxes by $2,500 (refer to the
table below). Moreover, plan contributions invested
in tax-advantaged retirement accounts can grow
untaxed for decades.
Here is a quick review of
the more appropriate
plans for small
businesses, including
partnerships and oneperson
proprietorships.
In small businesses that
do not have employees,
the owners usually
benefit in their dual roles
of employer and
employee. If employees are later brought on, owners
may prefer to modify or change the retirement plan.
Note that what follows are general plan descriptions
that do not cover the many exceptions, caveats, and
limitations imposed by the fine print of tax law.
When evaluating the alphabet soup of plans to
determine which actually makes the most sense for
your particular business, keep several key decision
points in mind:
How can I best structure my contributions?
What are the costs in time and money?
What are the tax benefits for my business?
Are contributions mandatory?
What is my fiduciary responsibility?
What are the deadlines?
Will this plan accommodate business growth?
Payroll Deduction IRA
The Payroll Deduction IRA, the easiest retirement
plan to set up, is not really an employer plan. Yet for
an employer who just can’t do more, it may benefit
some employees.
Employees simply set up either traditional or Roth
IRA accounts at the institution of their choice. Some
employees will already have personal IRA accounts.
Employers may provide help, encouragement, and
assistance for those who don’t.
The employer merely offers to make elective payroll
deductions from the employee’s paycheck to fund
the IRA. Then the employer forwards the deduction
to the appropriate financial institution where it is
invested in the employee’s traditional or Roth IRA
account.
This plan doesn’t really offer much in the way of
benefits to the employer. But it does provide one
major attraction for some employees. Many workers
want to contribute to an IRA but do not. One
reason is that they may wait until the end of the year
to set aside the money and then find that they do
not have sufficient funds to do so. Payroll
deductions help workers save smaller amounts each
pay period. For many people, this is much easier
than making a large IRA contribution all at once.
This Payroll Deduction IRA offers no advantages to
businesses that have no employees. Owners are
hopefully able to establish and fund their own IRA
accounts without payroll deductions.
IRA contribution limits for 2005 are modest,
topping out at $4,000 for workers under age 50 and
$4,500 for workers age 50 and older. For higher
contribution limits and better employer benefits,
choose one of the plans discussed next.
SEP Plan
The SEP (Simplified Employee Pension) plan is
generally very easy to establish and operate.
Contribution limits for 2005 top out at a relatively
high $42,000, and contributions are entirely
discretionary. Thus if the employer can’t or doesn’t
want to make a contribution one year, no problem.
Operating costs are normally low, and contributions
are tax-deductible. Employees may also fund
separate personal IRAs that could allow them to
divert several thousand more into their retirement
accounts.
However, the employer is normally responsible for
making all SEP contributions. Contrast this to the
Payroll Deduction IRA discussed earlier, where
contributions were deducted from the employee’s
paycheck.
Also, the employer cannot discriminate. If a
contribution is made to anyone, it must be made to
all qualified employees according to a formula,
although it is possible that some employees may not
qualify.
SIMPLE IRA
Like the SEP, the SIMPLE (Savings Incentive Match
Plan for Employees of Small Employers) IRA is easy
to set up and operate. SIMPLE plans are usually
funded by both the employer and the employee.
Employer contributions are mandatory, but in some
arrangements, the employer need not make
contributions for those employees who do not elect
to make salary-reduction contributions.
Limits for 2005, including both employer and
employee contributions, are moderately high,
topping out at $20,000 for workers under age 50 and
at $24,000 for those 50 and above.
Contributions are tax-deductible, and employees
may also be able to fund separate personal IRAs and
sock away several thousand more for retirement.
There are a few other restrictions and limitations
that could exclude some small businesses, but the
SIMPLE IRA is a good choice for many employers.
401(k) Plan
The plans discussed so far are all IRA-based. With
the 401(k), however, the small business may take a
big step into the major leagues of retirement plans.
The 401(k) plan has experienced broad popularity
and wide adoption for good reasons. First, with a
401(k), a lot of money can quickly be diverted into
tax-advantaged retirement accounts. Limits for 2005
are $42,000 for workers under age 50 and at $46,000
for those 50 and above.
Second, the 401(k) is generally funded by both the
employer and employees. But employer
contributions may be discretionary, even when the
employee contributes. This provides employers
needed leeway in cash-strapped years.
Contributions are tax-deductible, and employees
may be able to fund separate personal IRAs. A wide
variety of bells and whistles can help small
businesses customize 401(k) plans for special needs.
This added flexibility comes at a price, however. The
401(k) plan can be more expensive to set up and
operate than IRA-based plans. Paperwork
requirements are generally higher, and regulators are
more likely to scrutinize these plans.
But just because 401(k) plans can be complicated
and expensive doesn’t mean that they must be.
Several simplified versions are now available from
plan providers. These have names like Solo 401(k)
and Safe Harbor 401(k). [There is even a SIMPLE
401(k), but for many employers, a regular 401(k)
offers a much better deal.]
Stripped down, these simplified 401(k)s are still not
as easy to set up and operate as IRA-based plans, but
their level of complexity is much more manageable.
For small-business owners who want to ramp into a
high-octane plan, they are certainly worth exploring.
In the chart on the next page we can see how, in the
four options discussed so far, contributions might
ramp up at various levels of income for a worker
under age 50. Those over 50 might do a bit better.
As this chart shows, a faster contribution ramp and
higher limits generally require more complex plans.
Defined Benefit Plan
But suppose that even the rapid potential rise and
relatively high limits of the 401(k) plan are
insufficient for your needs. Perhaps instead of wisely
building your retirement accounts, you wildly
misspent your youth as well as every dollar you ever
got your hands on.
Now, in your 50s, through an amazing stroke of
good luck, you find yourself raking it in, making
much more than you ever thought possible. All your
friends are bragging about the size of their 401(k)s—
that is, when they are not bragging about the five
properties they’ve just flipped on their way to
becoming the next Donald Trumps—and you realize
that you are behind the curve.
Now that you finally made the Big Time, is there a
way that you could put much more of your earnings
into a retirement account and save a bunch on taxes
to boot?
The answer may be “yes”—
through a defined benefit
plan.
The defined benefit plan is
that well-worn pension plan
of old, more commonly
found in businesses like steel
companies and airlines. It
normally pays out a benefit
to company retirees based on
a formula—for example,
$100 a month for each year
of employment with the
company. The company is
on the hook for these
benefits far into the future,
unless it goes bankrupt.
(This has happened to steelworkers and airline
pilots, whose pension benefits took a haircut when
companies declared bankruptcy and turned their
defined benefit plans over to the Pension Benefit
Guarantee Corporation, which is supposed to back
up failed pension plans. The PBGC doesn’t pay the
full value of the company pension to workers. The
PBGC may itself be on the verge of insolvency due
to chronic underfunding, and politicians are now
talking about a taxpayer bailout that could reach a
half trillion dollars.)
Thus, this option is not for the faint of heart, and it
may not work for you at all if you have employees or
irregular cash flows from your business.
Setting up and operating a defined benefit plan is
generally costly and labor-intensive. Experts will
need to be consulted. Finally, employer
contributions to the plan are mandatory, even in lean
years or when the business suffers a loss. But for
those who might fit the above “profile” of the older
sole proprietor with significant and steady earnings,
the defined benefit plan just might help you quickly
stuff a lot of your earnings into a tax-advantaged
retirement plan.
How much? It’s difficult to say. It will be whatever
your actuary says is required to fund the projected
benefits, which currently are limited to $170,000 a
year. An actuary will make the determination as to
the maximum annual contribution—which is
identical to the mandatory minimum contribution.
Deciding Among the Options
In summary, we’ve looked at five options:
Payroll Deduction IRA
SEP
SIMPLE IRA
401(k) Plan
Defined Benefit Plan
These generally provide sufficient flexibility for most
small businesses. Determining which is best for you
will require an analysis of your situation, needs, and
expected business growth.
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