There’s a menu of retirement plans for the small employer

When selecting a retirement plan to offer employees, employers and their tax advisors should consider the business’s goals, finances, employees – and the tax implications

By: Gil Charney  /  November 20, 2015

Have you ever gone to lunch at a restaurant where the server hands you a thick, heavy menu, filled with tantalizing entrees, sandwiches, salads, and desserts? Chances are, the server will be back to take your order before you finish browsing page 24.

A small business employer’s choice of retirement plans is only slightly less varied, but ordering the wrong plan can be significantly more expensive than the regret of having polished off that last bite of $10 cheesecake.

Although businesses are not required to offer a retirement plan to employees, every employer should consider the benefits of offering one. Employees enjoy the benefit of deferring taxable income and saving for retirement. But employers also enjoy some tax-related benefits, such as deductions for plan contributions and credits for starting a retirement plan – as well as non-tax benefits, such as recruiting and keeping employees, and remaining competitive with other employers.

Everything on the menu has a price. This article will examine the factors that small business employers and their tax advisors should consider when deciding whether to offer a retirement plan, and how that plan will factor into the business’s future.

The changing menu of retirement for employees and businesses

The golden age of generous pension plans has long passed. Now, most employees must take retirement planning into their own hands. Higher medical costs, rising longevity, and the uncertain long-term viability of Social Security all increase the risk that many people who retire may outlive their savings, if they have saved at all. In fact, a recent study by the Federal Reserve Board revealed that 31 percent of active workers had no retirement savings at all.

Employers can help their employees save for retirement by offering retirement plans that promote participation, with features such as automatic enrollment and matching contributions.

It may be challenging, however, for smaller employers to choose among qualified plans. Qualified plans are subject to a host of rules and requirements, including minimum funding and contribution limits, minimum vesting schedules, deduction limits, and top-heavy restrictions. Business owners (including self-employed owners) should seek additional professional and tax guidance on selecting the right retirement plan for their business.

Three types of plans

Employers commonly offer retirement plans in the form of an individual retirement account (IRA), a defined contribution plan, or a defined benefit plan. The menu gets complicated quickly, though, because each category contains several flavors of plans with varying rules. Here’s a broad look at these common types of plans.

IRA-based plans

 Technically, IRAs are not qualified retirement plans, but they can allow employers to offer an inexpensive retirement vehicle with low administrative costs. Two IRA-based plans that are easy and inexpensive to set up and maintain are the Simplified Employee Pension (SEP) plan and the aptly named SIMPLE IRA.

SEP plans

With a SEP plan, the employer establishes a SEP-IRA at a financial institution for each eligible employee. The employer funds the IRA annually, and the employee vests immediately. Employers are not required to make contributions to the plan, which can help with cash flow during business downturns. However, if the employer makes contributions, the employer must contribute the same percentage of pay for each eligible employee. For 2015, employers can make percentage contributions (up to 25 percent) on the first $265,000 of employee income, with an annual contribution limit of $53,000 per employee. For a self-employed person contributing to his or her own SEP-IRA, the percentage limit (up to 20 percent) is based on the net earnings from self-employment, which is also referred to as a self-employed individual’s “compensation.”

Simple IRA Plans

Unlike the SEP plan, which has no limit on the number of employees who can participate, the Savings Incentive Match Plan for Employees (SIMPLE) IRA has a limit of 100 employees. Employers are required to fund the SIMPLE IRA, and employees can also fund it. One of the most salient differences between the SEP-IRA and SIMPLE IRA is the SIMPLE IRA’s “match” feature. This means that employers can match employee contributions on up to 3 percent of compensation. (Employers can reduce the contribution match to 1 percent in no more than two of the previous five years, or contribute 2 percent of each employee’s compensation up to $5,000 with no contribution by the employee.)

Because of the 100-employee limit, a business with 80 to 90 employees may want to avoid offering a SIMPLE IRA if the business anticipates growth.

One unique characteristic of the SIMPLE IRA is the two-year waiting period, which starts on the first day the employer contributes to the employee’s plan. If the employee takes nonqualified distributions during the first two years, the distributions are taxable to the employee and subject to a 25 percent penalty. This is far more punishing than the 10 percent penalty assessed for early distributions from IRAs and qualified plans. In addition, during the two-year waiting period, the employee cannot roll over funds from a SIMPLE IRA into a traditional IRA to take advantage of the lower 10 percent penalty for early distributions.

Defined contribution plans

 The characteristics of defined contribution plans can vary, but generally, each participating employee owns an account funded by the employee, the employer, or both, depending on the terms of the plan. Examples include:

  • Profit-sharing plans
  • Money purchase pension plans
  • Any of the various types of 401(k) plans (traditional, Roth, or safe-harbor plans)

Defined contribution plans offer several tax benefits to employers and employees. Employer contributions to the plan are deductible when made, up to limits per IRC §404. Employees are taxed only when they take distributions from the plan.

Employers can tailor the design of a defined contribution plan to their needs, as long as the plan meets all of the requirements to be a qualified plan. For a plan to be qualified, the IRS requires several tests, one of which is designed to prevent “top heavy” plan design that would otherwise allow highly compensated employees a disproportionate level of benefits through the employer-sponsored 401(k).

Safe-harbor 401(k) plans

Because these plan-discrimination tests can be expensive for businesses to administer, small employers may offer a safe harbor 401(k) plan, which automatically satisfies the tests. However, the safe-harbor 401(k) plan requires that the employer match employees’ contributions and that employees vest immediately. Safe harbor 401(k)s are often attractive to small-business owners because these plans not only avoid expensive plan-discrimination testing, but they also allow owners to defer as much compensation as possible.

Solo 401(k) plans

If a small-business owner is a sole proprietor or sole shareholder, he or she can set up a “solo 401(k)” plan. As with the safe harbor 401(k), a solo 401(k) plan automatically satisfies plan-discrimination tests, because no other employees are permitted under this plan (other than the owner’s spouse). In a solo 401(k), a business owner younger than 50 can contribute a maximum of $53,000 for 2015. This limit includes the employee’s maximum elective deferral of $18,000, plus the maximum employer contribution of 20 percent of compensation for self-employed individuals (up to $265,000 of compensation in 2015). A self-employed business owner who is at least age 50 can contribute an additional $6,000 in catch-up contributions.

Defined benefit plans

Defined benefit plans, such as pension plans and certain annuities, are qualified plans in which a participant’s benefits are determined by a formula. Actuarial calculations determine how much funding the employer must contribute to ensure a “defined benefit” will be paid to the participant when he or she retires.

Because defined benefit plans are employer-funded and expensive to maintain and operate, they are not among the top choices of small employers. However, a defined benefit plan could be attractive to a small-business owner who is near retirement and wants to quickly fund his or her plan at a level that far exceeds the maximum contribution allowed under a defined contribution plan. Defined benefit plans are not limited to 25 percent of employee compensation (20 percent for self-employed individuals), or the overall limit of $53,000 per employee, as discussed above.

So, what’s the best choice on the menu?

The answer is easy, but may not be satisfying: It depends. With the multitude of choices, from out-of-the-box model plans to highly customized defined contribution plans, the answer depends on the employer’s goals, financial health, and desire to help his or her employees save for their retirement.

Author Name

Gil Charney

Gil Charney, CPA, CFP, CMA, CGMA, MBA, is director of tax law and policy analysis at The Tax Institute. Gil oversees a team of tax attorneys and CPAs who review and analyze legislation and the impact of tax laws on taxpayers. He has more than 30 years of experience in tax, accounting, and financial management.


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