What to Offer?
Do I want to offer a retirement plan to my employees? If so, what type of plan should I offer? How much, if any, do I want to contribute toward my employees’ retirement? How much do I want to contribute for myself? These are all questions you should ask when deciding whether or not to offer a retirement plan to your employees. These are also the same questions you should ask if you’re evaluating your current retirement plan design to see if it’s still the best fit for you and your company’s objectives.
While not all-inclusive, the three most common retirement plan designs for small businesses are the Simplified Employee Pension (“SEP”), the Savings Incentive Match Plan for Employees (“SIMPLE”), and the 401(k) Plan. Some advantages and disadvantages of each are listed below.
Simplified Employee Pension (“SEP”)
A SEP is an individual retirement account (“IRA”) set up to receive discretionary employer contributions. A SEP is often used by sole proprietors as they are able to contribute 20% of earned income to the plan (computed after the self-employment tax deduction but before the SEP contribution). A SEP contribution of up to $46,000 may be made for 2008. The SEP contribution percentage is discretionary; therefore, you may provide a SEP contribution one year and decide to either reduce the contribution the following year or not provide one at all.
Two additional advantages to a SEP are: (1) there is very little bookkeeping and paperwork required, and costs for consultants (i.e., attorney, accountants) are very minimal, if any; and (2) a SEP can be established after the end of the employer’s taxable year.
The main disadvantages to a SEP are: (1) the eligibility rules to determine which employees should be covered are not very restrictive, thereby allowing seasonal and part-time employees to be covered; (2) if a SEP is established for a company with employees, a similar contribution percentage must be contributed for all employees (including the business owner); and (3) employees are always 100% vested in the SEP contributions.
Savings Incentive Match Plan for Employees (“SIMPLE”)
A SIMPLE is a retirement plan that allows employee contributions and requires employer contributions. A SIMPLE is often used by employers who want to provide their employees the opportunity to defer current income taxes through pre-tax salary reduction contributions, while also providing them an employer contribution.
A SIMPLE requires either a 3% employer match (dollar for dollar) or 2% employer non-elective contribution. The employer can elect to reduce the matching contribution to 1% as long as it is not reduced for more than 2 years out of the 5 preceding years; however, the employer must give employees a notice explaining the match reduction. If the 2% non-elective contribution is provided, employees must also be given a notice explaining the non-elective contribution. Employees are always 100% vested in the employer contributions to the SIMPLE.
Even though the contribution limits are lower than that of a SEP and a 401(k) plan (described below), it is often the preferable plan design for small employers because there is very little bookkeeping and paperwork, and costs are much lower than that charged to administer a 401(k) plan. A SIMPLE may only be implemented if the employer has less than 100 employees who earned $5,000 or more during the preceding calendar year. A SIMPLE can only be established between January 1st and October 1st for the calendar year in which the SIMPLE will be effective.
401(k) Plan
The greatest advantage to designing a 401(k) plan is business owners can maximize their retirement contributions (up to $46,000 for 2008 and up to $51,000 for those age 50 or older), while minimizing what they must contribute to their employees through the use of employee contributions, employer match, and profit sharing contributions.
There are also additional features with a 401(k) plan that are not available through a SEP or a SIMPLE, two of which are participant loans and the application of vesting schedules to employer contributions. While participant loans may cause an additional administrative burden, this feature usually encourages employees to participate in the 401(k) plan because they know they can get to their money if they really need it. With a 401(k) plan, employee participation is crucial to passing certain nondiscrimination tests that are required. Also, attaching vesting schedules to employer contributions encourages low employee turnover. A common vesting schedule is the 6-year graded. An employee must work 1,000 hours each year for 6 years to become 100% vested in the employer contributions. The employee becomes 20% vested after 2 years of service, 40% after 3 years, 60% after 4 years, 80% after 5 years and then 100% after the 6th year of service.
Employer contributions under a 401(k) plan can be designed differently for different employers. Because there is great flexibility with the design of employer contributions, 401(k) plans are subject to several nondiscrimination tests. Some of the nondiscrimination tests can be avoided with more advanced 401(k) plan designing (i.e., safe harbor plans). There are annual filings and additional administrative costs associated with the operation of a 401(k) plan; however, with the flexibility you are afforded and the potential cost savings in taxes and employer contributions, the benefits of offering a 401(k) plan may far outweigh the costs.
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Employer contributions provided under any of the plan designs discussed above would be business deductions. In addition, any fees for the administration of the plan would be deductible (tax credits may also apply). Highlights of the plan designs described above are set forth in the comparison table below.
Choosing the right plan design depends on your company’s size, your company’s financial position, and the objectives of the company and the business owner…which retirement plan design is right for you and your company?
