Headline reads: "Unemployment Near All Time Low." Translation: competition for quality employees hits all time high. Employers must offer competitive benefits to attract and maintain employees. Read the "help wanted" ads, and you will quickly conclude that demand is great for employees. The ads emphasize employee benefits, such as retirement plans, in hopes of attracting better candidates. A well-designed retirement plan is an essential benefit employers must offer to attract and maintain a quality work force.
Regular review of your retirement plan is imperative in today's rapidly changing business environment. A successful retirement plan should meet the needs and circumstances of the company, its owners and its employees. With the right approach, the designer can create a plan that will be successful for today and into the future. Spending the time and resources will benefit the company, owners and employees in the long run.
When reviewing or establishing a retirement plan, understanding the basic differences and advantages of your options is important for success. There are primarily two types of retirement plans offered by employers: "defined benefit" and "defined contribution" plans.
Defined Benefit Plans
Think of the defined benefit plan as one that offers a specific dollar amount to be paid in the future at retirement. It may be paid out in a lump sum, which can be rolled over to an IRA, or as an annuity payment for a specific period. The benefit one receives is based on a formula that includes years of service and compensation. This type of plan requires an actuarial calculation to determine the amount of benefit one will receive and the amount of contribution a company makes to the plan.
For a business owner who is close to retirement but with no retirement plan, this is an excellent option to consider. It will, in all likelihood, offer the greatest benefit to the owner because the actuarial calculation will be weighted in favor of age and compensation. As with all things, one must weigh the pros against the cons, considering company specific needs and circumstances.
Defined Contribution Plans
The other type of plan is a defined contribution plan. This type of plan bases the benefit one receives at retirement on the accumulated growth of the contributions. The future benefit is not certain in amount and is based on the performance of the investment. Its value may be better or worse than that offered by the defined benefit plan.
The advantage to a defined contribution plan is that the company is not locked into a future dollar commitment, only the current contribution. It also may allow the participants to defer a portion of their salary on a tax-deferred basis for retirement. The deferral amount is significantly greater than the amount an individual can set aside for retirement on a tax-deferred basis. Currently the maximum is $10,000 versus $2,000 for an IRA. A company wanting to avoid a future liability or commitment for retirement benefits would use a defined contribution plan. There are several different types of defined contribution plans, so let's review them.
Money Purchase Plans
An employer is allowed to make a tax deductible contribution of up to 25 percent of compensation, with a maximum of $30,000 annually. The contribution percentage is established in the plan adoption agreement and is inflexible. The agreement must be amended to change the contribution percentage. The plan must be established by the last day of the year. The plan will be required to meet certain regulatory filing requirements. The company can establish eligibility requirements for age (no older than age 21) and years of service (no longer than 2 years). One year is preferred, because it allows the employer to establish a vesting schedule for the employer's contribution. Vesting means the employee must work for a certain time period in order to receive the full benefit of the employer's contribution.
Profit Sharing Plans
A profit sharing plan allows for a discretionary tax-deductible contribution paid by the employer. The maximum amount is 15 percent of total compensation paid to all eligible employees. The company contribution is determined annually and can be suspended if so desired. This plan has similar eligibility, vesting and annual regulatory filing requirements as the above mentioned. It must be established by the last day of the company year end. The contributions can be structured in such a way as to favor one employee group over another, thus allowing for "permitted disparity" between contribution percentages of different employees.
Many companies combine a money purchase and a profit sharing plan. This combination allows the company to fluctuate the total annual contributions, though the money purchase percentage is locked. In good years, the company contributes the required money purchase percentage and also makes a contribution to the profit sharing plan. In lackluster years, its only commitment is to the money purchase plan.
This plan offers both an employee and employer contribution to the plan. The employee makes an elective contribution to defer up to 15 percent of annual compensation with a $10,000 maximum (adjusted annually). The employer may also make a matching contribution and/or an annual discretionary profit sharing contribution. The maximum of all contributions is limited to 25 percent of compensation up to a maximum of $30,000. The plan must be established on or before the last day of the employer's taxable year. The plan can also be structured to favor one employee group over another, creating "permitted disparity" of contribution percentages of different employees. The employer's contribution is tax deductible. This plan has similar requirements as the above mentioned plans. This plan also offers the employee investment direction over the money.
Simplified Employee Pension: SEP IRA
This plan, popular in the small business community, is simple to establish and administer with no government reporting requirements. The contribution is fully discretionary each year and is made on behalf of the eligible employee to an IRA account. The funds are immediately vested—the property of the employee. The plan must be established by the company's tax-filing deadline plus any extensions. An employer must include all employees who have reached age 21 and have been employed in any 3 of the preceding 5 calendar years, including part-time employees who have earned $400 or more. The maximum contribution is 15 percent of compensation up to the established compensation cap of $160,000. The contribution is tax deductible for the employer.
Savings Incentive Match Plan For Employees:
The newest of the plans available, SIMPLE IRA, has the salary deferral features of a 401(k) without the administrative requirements. The amount of salary deferral is limited to $6,000 a year. The employer is also required to make either a non-elective 2-percent contribution on behalf of the eligible individuals or a dollar-for-dollar match, up to 3 percent of compensation, of the participating employees deferral amount. The 3-percent match can be reduced during two years out of a 5-year period, but no lower than 1 percent for a given year. The total contribution for both the deferral and the match can not exceed $12,000 annually. All contributions are 100 percent vested immediately. All employees who have earned $5,000 during any preceding 2 years and are expected to earn $5,000 in the present year must be eligible to participate. This plan is for companies with 100 employees or less. If the company has an established SIMPLE IRA and staff exceeds 100, the company can continue the plan for 2 years. A company cannot have any other retirement plan in place while using a SIMPLE IRA plan. The regulatory filing requirements have been eliminated, but for the 60 days preceding any new tax year the company must notify all eligible employees and allow them the opportunity to make or change the elective deferral percentage or amount. The plan must comply with the 60-day election period; therefore, before November 1.
Reprinted with permission from The Family Business Report sponsored by the Goering Center at the University of Cincinnati College of Business Administration.