Retirement plans for small business owners
By Jason Lampa MBA
College Savings Bank
Establishing a retirement plan is an effective way to attract talent to an organization. The best type of plan depends on a number of factors that each small business owner needs to review.
The obvious question is: Why should you, as a small business owner, set up a retirement plan for you and your employees? Actually, the benefits are many, and it is a win-win situation for you, your business, and your employees.
Retirement can last for 30 years or more. Studies have shown that a retiree will need up to 80 percent of his/her annual income to retire comfortably. Also, the average monthly payment from Social Security Administration as a retirement benefit is only $1,153 -- and that is not a lot to enable comfortable retirement living. Therefore, some form of retirement plan outside of the government Social Security plan is necessary.
Setting up a small business retirement plan allows for investing now to gain financial security for when you and your employees retire in the future. In addition, both you and your employees get significant tax advantages, plus other incentives.
As a business benefit, employer contributions are tax deductible, and assets in the plan grow tax-free with compounding interest. Your business may also be eligible for certain tax breaks, tax credits and other incentives for starting a retirement plan. Businesses who offer retirement plans tend to attract and retain better employees, as well. Along with that goes the savings involved in hiring and training new employees.
For employees, there are also benefits, aside from the obvious one that they will have a better retirement in terms of financial security. The employee benefits because the tax on employee contributions and investment gains in the plan are deferred until the monies are distributed. Contributions can be made through payroll deductions so the employee does not even miss the money being contributed into the plan. Typically, there are also flexible plan options available.
Now that you know that setting up a small business retirement plan is beneficial for you, your business, and your employees, let us look at some of the types of plans available.
Especially with a small business, a Single (k) retirement plan is a flexible, easy and cost-efficient way to maximize retirement savings. This type of plan is for businesses that are operated and run by a single owner who also may have part-time employees. Typically, it is for sole proprietorships, closely-held family businesses, and corporations.
A Single (k) retirement plan offers the benefits of a 401(k) plan with the flexibility offered in profit sharing plans. With this type of plan, annual contributions of both salary deferral and profit-sharing contributions are allowed. Taxes are deferred until distribution. As a bit of further information, the Single (k) plan is not protected against creditors and/or lawsuits unless the plan covers at least one other employee besides the owner.
Single defined benefit plan
The single defined benefit plan is for those single employers (as opposed to the multi-employer defined benefit plan) wishing to set up a retirement plan. Any business owner or self-employed individual is eligible for this type of plan, as well as employees who have worked at least 1,000 hours during the past year (or 2 years if there is no vesting period). There are no set limits to the contributions, but the contributions are based on actuarial assumption. The maximum retirement payout is $185,000 or 100 percent of the average of the three highest consecutive earning years. The vesting period is determined by the employer and employees cannot contribute to the plan.
This type of plan works best for older employers who are looking to save a lot of retirement monies over a short period of time. This type of plan also may be expensive and not very flexible because contributions are not optional and the actuary determines the contribution/deduction limit.
Simplified employee pension plan (SEP)
The SEP is a simplified plan that allows employers to contribute toward their own retirement as well as that of their employees. The administrative costs for setting up a SEP plan are typically lower than plans that are more complex. In this type of plan, employers contribute to a conventional IRA for themselves and each of their employees, subject to certain restrictions.
SEPs can be set up with businesses of any size, even if the owner is self-employed. The employer must adopt the SEP plan document and typically cannot have any other retirement plan in place. The financial institution that holds the SEP can have several investment funds for employees to choose from. There are no filing requirements for this plan because the financial institution that holds the SEP-IRAs handles most of the paperwork.
The SEP plan also may have a flexible contribution obligation, which makes it a good plan if cash flow may be an issue. For example, contributions for employees may be larger in good cash flow times or contributions may be reduced when business is down, but the contribution rate must be the same for all employees. With this type of plan, only employer contributions are accepted. Employees cannot contribute to the plan.
Individual Retirement Account (IRA)
Although it is often thought that IRAs are generally for individuals, employers can also set up and fund IRAs for their employees. An employer can set up a Traditional IRA (or a Roth IRA) with a payroll deduction plan. The employee authorizes a set amount to be deducted from their pay, with the remainder of the pay going back to them. At retirement, what the employee receives depends on the funding of the IRA and what the earnings or income is on those funds.
A Traditional IRA offers tax advantages to the employee, in that the earnings may not be taxed until the funds are distributed. A Roth IRA operates a little differently from a Traditional IRA in that the contributions to a Roth IRA are not tax deductible whereas they may be in a Traditional IRA. In addition, the distributions and earnings are not included as income in a Roth IRA. For both, however, earnings remaining in the account are not taxed. It is only distribution of funds that affects the taxing.
Both types of IRAs can be set up as a payroll deduction plan, and are available at different financial institutions, banks, insurance companies and brokerage firms.
The Simple IRA plan gives small business owners a simplified method of making contributions towards their own and their employees' retirement funds. It is a savings incentive match where the employees can choose to make salary reduction contributions towards their retirement savings and the employer matches the amount of the contribution. The employer can match the contribution amount dollar-for-dollar or can make a percent contribution as a non-elective contribution. That means the employee does not necessarily have to contribute anything towards their IRA, but they will still receive the employer contribution into their IRA.
The basic rules for a Simple IRA plan are as follows: This plan is available for small business owners with 100 employees or less, who do not have any other retirement plans. The employer must match dollar-for-dollar up to 3 percent of the employee's salary (some years may be as low as 1 percent) or the employer must contribute an amount equal of up to 2 percent of the employee's salary (to a maximum of $4,600), whether or not the employee makes any contributions to the plan.
Vesting (the time when the employer contribution is owned fully by the employee) for this plan is immediate. The contributions are all made directly into an IRA that is set up for each individual. The employee typically has several investment choices and investment options, according to the financial institution the employer has partnered with.
Profit sharing plans
Any business owner or self-employed individual is eligible for a profit sharing plan, and employees who have worked at least 1,000 hours during the past year (or two years if there is no vesting period) are also eligible. Profit sharing plans allow the business owner or employee a chance to share in the company's profits. The amount of the annual contribution will vary from year to year, based on the company's performance and is determined by the plan's benefit formula set up by the employer. The vesting period is also determined by the employer.
Employees may be allowed to take out loans with this type of plan and it has greater design flexibility. However, because minimum coverage tests must be met, it can exclude some employees. The minimum coverage rule for the 401(k) requires that employers make the plan available to a cross-section of employees and must satisfy the ratio-percentage test or the average benefits test.
Since this type of plan is usually more complex to set up and operate, administration of a profit sharing plan is typically handled by a professional.
Therefore, as a small business owner, you now have a number of options to set up a retirement plan that would suit you, your business and your employee's needs. Setting up a retirement plan is an excellent way to allow your small business to offer the best opportunities for retirement savings -- and with the tax advantages, incentives and other benefits, setting up a retirement plan for you and your employees just makes good business sense.
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