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Which retirement plan is best for your company?

By Daniel C Dearing    

True or false? Retirement plans are a benefit only large companies can afford. The answer is false. Small businessesretirement can afford to offer their employees a retirement plan—and it makes good business sense to do so.

Having a retirement plan helps you recruit and retain good employees (and thus cut down turnover costs), and it can be a way for you to defer a large amount of tax liability—always a nice “surprise” at the end of the year.

The more difficult decision to make is not if you should offer a retirement plan, but what kind of plan should you offer? A number of different kinds of plans are available such as 401(k), profit sharing, defined benefits, SIMPLE, and SEP. (Others are available but these are the most common types.) Each of these plans has its pros and cons; here are some to consider:

• 401(k) plans. The most common type of retirement plan offered by employers today, a 401(k) allows employees to make tax-deferred contributions to their retirement account. Some plans—a Roth 401(k) — also allow for contributions to be made on an after-tax basis. Each employee is permitted to defer up to $16,500 ($22,000 for employees over age 50) into their account in 2009.

Note: The employer may match employee 401(k) contributions, but this is not required, so it is possible to offer a 401(k) plan without incurring expenses other than administrative costs.

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). This act benefitted small businesses by creating the Safe Harbor 401(k). In a Safe Harbor 401(k), the company offers a specified amount of contribution for each employee (3% to 4%, depending on plan type) in exchange for being exempted from discrimination and top-heavy testing. A Safe Harbor 401(k) thus allows an owner over age 50 to defer the full $22,000 into a 401(k) plan regardless of the voluntary participation of their staff.

The typical annual administrative fee for a 401(k) plan with 15 employees ranges from $800 to $1,500 and some pension companies offer a discount for using the Safe Harbor provisions.

• Profit sharing plans. These plans are very popular among companies whose revenues fluctuate, because the business has the flexibility to make significant contributions in good years and little or no contribution in lean times. (If a plan makes a $0 contribution for too many years, the IRS may terminate it; however the IRS does not have a set rule concerning termination.)

In a traditional profit sharing plan, the company makes a contribution of an identical percentage of salary for every eligible employee.

In 2001, EGTRRA created an improved version of this plan called a “New Comparability Profit Sharing Plan,” which allows employers to give certain classes of employees—typically owners or managers—a higher percentage of contribution than they give to other classes. The disparity is limited by certain non-discrimination rules and requires the work of a third party administrator (TPA), but this type of profit sharing can be very attractive in companies in which the owner is older than most of the staff.

The contribution limit on a profit sharing plan is 25% of the total eligible employee payroll, up to a maximum contribution of $49,000 per participant. Contributions to a profit sharing plan can be placed on a vesting schedule of up to six years before an employee becomes 100% vested in the employer contribution.

Profit sharing is commonly used in conjunction with a 401(k). This combination allows the employee to defer income and the employer to make contributions in good years. Surprisingly, a company does not need to have profits to be able to make a profit sharing contribution.

• Defined benefit (DB) plans. DB plans give a specific benefit (for example, 50% of an employee’s final salary) to an employee at retirement.

The amount of the annual contribution by the employer is whatever amount an enrolled actuary calculates to be sufficient to fund the prescribed benefit. Needless to say, the calculations and administration of DB plans can be complex.

Although these plans are much less popular than their 401(k) counterparts, they are still very useful in certain circumstances. Defined benefit plans have no annual contribution limits. The only limit in a DB plan is the limit on the amount of retirement benefit provided to an employee ($195,000 per year for 2009).

An important disadvantage in all types of DB plans is their rigidity. A company does not have the choice of not funding the plan in a down year. For this reason, you should certainly consult with a pension specialist and your accountant before proceeding with a DB plan.

Tax law changes in the 2006 Pension Protection Act (PPA) gave a big boost in popularity to a specific type of DB plan called a cash balance plan. Although cash balance plans are complex, they are likely to replace traditional defined benefit plans in small to medium companies that want to make higher contributions to a retirement program.

• Savings Incentive Match Plans for Employees (SIMPLE). This type of plan allows employees to defer some of their salary—up to $11,500 annually ($14,000 if over age 50). Employers must make contributions of 2% to 3%, depending on plan options chosen, and all employer contributions are immediately vested.

If you are looking to offer an employee benefit at the lowest possible administrative cost, SIMPLE is a good choice. The lower contribution limits and inability to pair this with any other type of plan are disadvantages that should be considered, however.

• Simplified Employee Pensions (SEP). This plan closely resembles traditional profit sharing since each employee receives an identical percentage of salary from the employer. Employees are not permitted to make salary deferrals. All contributions are immediately vested, and most part-time employees must be included once they have enough tenure.

Similar to a SIMPLE, this plan can be offered with almost no administrative costs, but there is also no opportunity to take advantage of the design benefits offered by EGTRRA and PPA.

Which of these five types of plans—or others, which are also available—is best for your company? To help you decide, you should consider:

• Do you want the plan to be primarily for the benefit of employees or will it be used mostly to provide tax deferred savings for the business owner?

• Can you fund the plan at a consistent level each year, or do your revenues fluctuate such that you will need significant funding flexibility?

• Is it important to allow the employees the ability to defer some of their own income into the plan?

• What are the demographics of your company? Are you much older or younger than the average age of your staff? Do you have high turnover? Do you employ a number of part-time or seasonal workers?

Answering these questions (in consultation with a pension specialist and your accountant) is the first step in deciding which type of plan is best for your business. Other issues to consider include ongoing operation of the plan, employee education, and investment monitoring. Although these issues may sound intimidating, most of them are resolved by choosing a good plan record keeper and a servicing agent who specializes in retirement plans. These individuals can help you avoid making basic mistakes that could trigger an IRS audit.

dan dearingsmallDaniel C Dearing, MSM, CRPS, is president of Professional Retirement Services, Inc. and is a Chartered Retirement Plan Specialist. PRS is a full-service financial service company located in Jacksonville, Fla. Dan can be reached at 866-479-401K or 904-381-9080.


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