It's easy to neglect setting up a retirement plan when you own your own business. With so many existing administrative tasks--payroll taxes, insurance benefits, bookkeeping--adding one more benefit may seem overwhelming.
But retirement creeps up on you much faster than you'd expect. Setting up a retirement plan is essential--and the sooner you do it, the better.
Tax Incentives for Setting Up a Plan
Thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001, if you set up a plan after Dec. 31, 2001, you may be eligible for a tax credit for 50% of the cost of setting up the plan and educating your employees. The maximum credit is $500 per year for up to three years. For additional information, see IRS Publication 560.
What Are Your Options?
To help you decide which plan to use, you need to understand the pros and cons of the different plans available. Details of all of these plans can be found in IRS Publication 560. Think about your own situation as you consider the following:
SEP (Simplified Employee Pension) Plan
The Basics: A retirement plan that uses an IRA as a funding vehicle.
How to Set It Up: Either you or your employee opens an account with a fund company, brokerage, bank, or other financial institution. You have until the due date of your tax return (including extensions) to set up the accounts.
Contribution Limits: The employer can contribute up to the lesser of 25% of employee compensation (up to a compensation maximum of $210,00 for 2005; $220,000 for 2006) or $42,000 for 2005 ($44,000 for 2006) to each participant account. The employer can deduct a maximum of 25% of the total compensation paid or accrued during the year to eligible participants in the plan. The employee can also contribute subject to the regular rules regarding IRAs. As an employer, you are not required to make a contribution every year. When you do make a contribution, you can't discriminate in favor of highly compensated employees.
Pros:
• Easy and cost-efficient to set up and maintain.
• Annual employer contributions are discretionary.
• No annual IRS forms to file.
• Contributions can be made after plan year-end (up until tax-filing deadline).
• Employees have investment responsibility for their own accounts.
Cons:
• Plan must cover all employees, even part-time employees.
• No loans allowed.
• Employer can't contribute as much as other plans allow.
Profit Sharing Plan
The Basics: A qualified retirement plan that allows an employer to make flexible, discretionary contributions on behalf of employees.
How to Set It Up: You need a written plan which you can get from an outside administrator, or you can adopt a prototype plan at most mutual fund companies, banks, or brokerages. The plan has to be in place by the end of the calendar year.
Contribution Limits: The employer can contribute up to 100% of compensation (up to a max of $210,000 for 2005; $220,000 for 2006) or $42,000 for 2005 ($44,000 for 2006)-- whichever is less--to each participant account. The employer can deduct a maximum of 25% of the total compensation paid or accrued during the year to eligible participants in the plan. Employees cannot make their own contributions to the plan.
Pros:
• Flexible employer contributions--you don't have to contribute every year.
• Employees have investment responsibility for their own accounts.
Cons:
• More filing requirements for employer than other plans.
• No employee contributions.
• Plan has to be set up by the end of the calendar year.
• Employer can't contribute as much as other plans allow.
Money Purchase Plan
The Basics: A qualified plan that sets a fixed percentage contribution that must be met every year.
How to Set It Up: You need a written plan which you can get from an outside administrator, or you can adopt a prototype plan at most mutual fund companies, banks, or brokerages. The plan has to be in place by the end of the calendar year.
Contribution Limits: The employer can contribute up to 100% of compensation (up to a max of $210,000 for 2005; $220,000 for 2006) or $42,000 for 2005 ($44,000 for 2006)--whichever is less--to each participant account. The employer can deduct a maximum of 25% of the total compensation paid or accrued during the year to eligible participants in the plan. Employees cannot make their own contributions to the plan.
Pros: There's little reason to set up this type of plan anymore. It used to be that you needed this plan (paired with a Profit Sharing Plan) to be able to get to a 25% contribution of compensation. Since EGTRRA, you can get to 25% with just a Profit Sharing Plan or a SEP-IRA.
Cons:
• Required employer contributions, i.e. once you set your contribution percentage, you must make contributions.
• More filing requirements for employer than other plans.
• No employee funding.
• Employer can't contribute as much as other plans allow.
401(k) Plan
The Basics: A qualified retirement plan that allows for salary deductions for employees (salary-deferral) and matching contributions from employers.
How to Set It Up: Traditional third-party plan administrators can design a plan or you can go to one of the newer online providers such as Fidelity's e401(k).
Contribution Limits: Employees can defer up to $15,000 in 2006, with an additional catch-up contribution of $5,000 if they are over age 50. The employer may match a portion of the employee contribution. The match is in addition to the employee contribution, so for example, if you contribute $20,000 in 2005, your employer can add a match on top of that.
What is a one-person 401(k)? This is a traditional 401(k) that avoids some of the problems of nondiscrimination testing by having only one participant.
Pros:
• Employees contribute part of their salary.
• Less financial burden on the employer than other plans.
• Employer can offer other features, such as employee loans.
• Employees have investment responsibility for their own accounts.
Cons:
• More administrative work than other plans.
• More expensive to set up than other plans.
• Employer can't contribute as much as other plans allow.
Paired Profit Sharing and 401(k) Plan
The Basics: A Profit Sharing Plan combined with an elective salary deferral, or 401(k), plan. Employer makes the Profit Sharing contributions. Employees can defer part of their salary into a 401(k) plan. Employers also can choose to match part of the employee salary deferral.
How to Set It Up: See rules for Profit Sharing and 401(k) plans above.
Contribution Limits: Employer contributions can go up to the lesser of 100% of compensation (up to a max of $210,000 for 2005; $220,000 for 2006) or $42,000 for 2005 ($44,000 for 2006). In addition, the employee can put up to $15,000 into the plan ($20,000 if participant is over age 50).
Pros:
• Allows employees to make contributions through salary deferral, or 401(k), and allows employers to make contributions to the Profit Sharing Plan.
• Employees have investment responsibility for their own accounts.
Cons:
• More administrative work by combining the plans.
• More expense in having two plans.
• Employer can't contribute as much as other plans allow.
SIMPLE (Savings Incentive Match Plan for Employees) Plan
The Basics: A retirement plan available to employers with 100 or fewer employees who received $5,000 or more in compensation for the preceding year. Employees contribute using salary deferral. Employers must contribute a match for all eligible employees.
Set It Up: There are two types of SIMPLE plans: SIMPLE IRAs and SIMPLE 401(k)s. Use IRS Form 5304-SIMPLE or 5305-SIMPLE to set up a plan. Most people set up the SIMPLE IRA because it is less expensive to maintain and has fewer reporting requirements.
Contribution Limits: Employees can contribute up to 100% of compensation up to a maximum of $10,000 for 2005 ($10,000 for 2006). Employees can also make catch-up contributions of $2,000 for 2005 ($2,500 for 2006). Employers must match contributions from 1% to 3% of compensation.
Pros:
• Minimal reporting requirements for the employer.
• Works well in companies where salaries are relatively low.
• Inexpensive to set up and maintain.
• Employees have investment responsibility for their own accounts.
Cons: Employer can't contribute as much as other plans allow.
Pension (Defined Benefit) Plan
The Basics: A qualified retirement plan where the employer makes contributions based on an actuarial formula. Employer has funding and investment responsibility for the plan.
How to Set It Up: First you adopt a written plan. Then your administrator figures out how much you should contribute each year. The plan must be in place by the end of the calendar year. The employer chooses how this money is invested within a trust or custodial account.
Contribution Limits: The employer contributes the actuarially determined amount to provide a benefit that's the lesser of 100% of the participant's average compensation (not to exceed $210,000 for 2005; $220,000 for 2006) for his or her highest-paid three consecutive calendar years, or $170,000 for 2005 ($175,000 for 2006). You must make quarterly installment payments subject to minimum funding requirements.
Pros: Employers can put away more money for employees than in other plans. Cons:
• More expensive to set up and maintain than other plans.
• More administrative burden than other plans.
• Employer is responsible for investment choices.
Paired Defined Benefit and Defined Contribution Plan
The Basics: A combination of a pension plan (defined-benefit) and a 401(k) or Profit Sharing Plan (or other types of defined contribution plans).
How to Set It Up: See notes for each type of plan.
Contribution Limits: If you contribute to both a Defined Benefit Plan and a Defined Contribution Plan, your deduction is limited to the greater of 25% of compensation paid (for the defined contribution plan) or no more than the amount needed to meet the year's minimum funding standard (for the defined benefit plan). If you are self-employed, the rules are even more complicated (see IRS Publication 560).
Pros: Allows maximum contributions.
Cons:
• Expensive to set up and maintain.
• More administrative burden than other plans.
Note: If you are considering this type of plan arrangement, you should also consider a cross-tested defined benefit cash balance plan (which is beyond the scope of this article).
