How can you get a leg up? Consider that a prospective hire will choose the employer with the most attractive work environment. In this case, “attractive” translates to “great benefits.” You need to make sure your own offerings meet or exceed those of other employers.
Right now you’re thinking “health insurance.” But don’t overlook another equally attractive benefit: Retirement plans. These can improve the lives of your employees’ families over the long haul. They can also provide significant tax benefits. Neither the employee’s contributions to the plans, nor the earned interest and dividends, are taxed until distributed to the recipient.
Retirement plans may soon become an even more important recruiting and retention tool. “Health insurance and retirement plans are the number one and two benefits any business can provide employees,” says Yannis P. Koumantaros, principal and director of Spectrum Pension Consultants, Tacoma, Wash. As Obamacare goes into effect, he says, there will be less differentiation among employers in the area of health insurance. As a result, retirement plans will offer the best opportunities for distinguishing one workplace over another.
Like many employers, you may be daunted by the prospect of investigating the confusing array of retirement plans on the market. It can all seem like too much trouble. Yet understanding the topic is in your best interest: Well-designed retirement programs benefit employers as well as employees.
“The first benefit of retirement plans is to business owners who want to contribute money for their own retirement,” says Tracy Davidson, president of Davidson Pension Consulting, Corte Madera, Calif. “The plans also promote employee loyalty and retention, because they give people an opportunity to contribute tax deferred money out of their payroll accounts.”
If you don’t already have a retirement plan, start laying the groundwork now. Already got one? Take some time to review your current plan to make sure you are maximizing the benefits for owners and employees.
Starting Simple
As a general rule, the better a plan’s tax benefits, the more complicated the recordkeeping. As a result, the decision to go with a specific plan can require a judgment call, balancing value with the requisite clerical work.
You can reduce costly paperwork by considering simpler plans first.
“Always look first at the plans that do not require annual governmental reporting,” advises Barry R. Milberg, managing member of Milberg Consulting, Plymouth Meeting, Pa. “Just consider the more complex plans if you are ready to contribute a substantial amount of money and are willing to pay someone to help you remain compliant with federal regulations.”
So what plans are the easiest to administer? They are called “IRA-based plans” and they come in three varieties:
1. Payroll deduction IRA (Individual Retirement Account), also called a “traditional IRA.” Are you looking for a simple way to get into a retirement plan? The payroll deduction IRA is the way to go. Just fill out an application form from any financial institution, such as a bank or an insurance company, that offers the plans. You have no annual reporting requirements.
Payroll deduction IRAs are flexible as well as simple. Employees get to decide how much money to deduct from their salary to invest in their plans. Participants can vary the amounts each year, and can even skip some years. As the employer, you contribute no money to these plans.
With simplicity comes restriction: The annual contributions for tax year 2013 are limited to $5,500 per employee, plus an additional $1,000 for employees over the age of 50.
It’s true that these plans can be established by individuals without the assistance of employers. Even so, few people will take the initiative to start their own plans without some workplace encouragement. Also helpful is the discipline of the weekly payroll deduction mechanism, investing funds before they enter recipients’ pockets.
2. Simplified employee pension plan, also called the “SEP IRA.” This one is very like the payroll deduction IRA described above. Yet this plan is a more powerful retention tool, because only the employer makes contributions.
These plans are also more valuable to employees because more money can be invested. The employer may contribute up to 25 percent of each employee’s compensation, with a 2013 cap of $51,000.
Like the payroll deduction IRA, contributions are not required: Each year the employer can decide how much to contribute, or whether to contribute at all. And clerical work is still minimal: The plans require little paperwork beyond the initial completion of the two-page IRS Form 5305-SEP. This needs to be retained by the employer. Also, the employer must maintain records of payroll and contributions made.
As mentioned above, only the employer makes contributions to a SEP IRA. In general, the employer must contribute a uniform percentage of pay for each employee who satisfies eligibility requirements. Those include being over age 21, earning $550 or more annually, and being employed by the business for three of the last five years. (Less restrictive age and employment duration parameters may be specified in the previously mentioned Form 5305-SEP).
3. SIMPLE IRA Plan, formally referred to as “Savings Incentive Match Plan for Employees of Small Employers.” Davidson calls the SIMPLE IRA “a kind of simplified 401(k) plan.” That’s because the SIMPLE IRA’s paperwork is uncomplicated, and — as is the case with a 401(k) — both employer and participant may contribute to an employee’s account.
You get the plan started by completion of IRS Form 5304-SIMPLE which you must retain along with the requisite payroll records. Your employees decide how much to contribute each year, up to $12,000 in 2013 (with additional $2,500 allowed for those 50 and over). The business must then either match each employee’s contribution (up to three percent of each employee’s compensation) or contribute a universal two percent of the compensation of all employees eligible to participate, regardless of whether individual employees actually opt to participate.
To use a SIMPLE IRA Plan, you must meet certain requirements. Your business must employ fewer than 100 people and you must maintain no other retirement plan during the same calendar year. And you must offer the plan to all employees who have earned income of at least $5,000 in any prior two years, and are reasonably expected to earn at least $5,000 in the current year. (Alternatively, you may opt to offer the plan to all employees.)
In all three of the above plans, the amounts employees receive at retirement depends on two things: First, the amounts they have invested in the plans over the years. Second, the earnings that have resulted from the investments. Funds are taxable only when withdrawn by the retired employees. Early withdrawals are subject to penalties.
Moving Up
401(k) plans get their name from the relevant section number of the IRS Code. These plans are popular because they allow contributions by both employer and employee. They also allow a high level of contributions, which can be beneficial in terms of reducing current taxes and of building greater retirement savings.
For tax year 2013, employees may contribute up to $17,500 annually (and an additional $5,500 for those 50 or older). The employer may also opt to contribute to each employee’s retirement account. For 2013, the maximum allowed combined contributions are the lesser of 100 percent of each employee’s compensation or $51,000 ($56,500 if you are age 50 or older.)
“401(k) plans have additional attractive features,” says Davidson. “These include the ability to make loans to employees, to make hardship withdrawals and to make additional after tax contributions.” Unlike the SIMPLE IRA plans, these plans can be used by businesses with more than 100 employees. (They can also be used by smaller employers.)
The downside? 401(k) Plans must conform to more complex legal requirements and require more recordkeeping. You must pass an annual “non-discrimination test” to make sure benefits to owners and highly compensated individuals do not exceed established limits. You are required to include everyone who is age 21 or older and who has worked 1,000 hours in any given calendar year. Finally, you must file an annual return with the IRS for your 401(k) plan, adding to your usual tax overhead headache.
These complexities mean that 401(k) Plans are more expensive to set up than the simpler plans discussed earlier in this article. However, if your current retirement plan has accumulated a high level of invested funds, 401(k) plans can end up actually being more economical. “Once you accumulate $500,000 or more in your plan, you may want to test the market and get some competitive bids on qualified 401(k) plans,” says Koumantaros. (See the sidebar, “Should You Start a 401(k) Plan?”)
Covering Bases
Whatever retirement plan you select, get advice from your accountant and attorney. If you seek the assistance of a retirement plan consultant, pick one with no vested financial interest in a given program. “It’s not easy to find someone who does not have an axe to grind,” says Milberg. “The financial services industry sees retirement plan assets as pots of gold.”
You might also obtain assistance in filing the requisite paperwork and assuring you are making the right contributions. “Errors are often made with retirement plan designs,” says Davidson. “You need to make sure you understand the rules.” Errors, she cautions, can result in costly tax liabilities. Finally, you may obtain information from the website of the Internal Revenue Service at www.irs.gov/Retirement-Plans.
While it can be challenging to assemble the confusing pieces of the retirement plan puzzle, the result can pay off in terms of employee recruitment and retention. “Now is a good time for all small businesses to start looking at retirement benefits as a way to help their employees retire with dignity,” says Koumantaros.
Should You Start a 401(k) Plan?
Maybe your business already offers employees a basic retirement plan such as a SEP or a SIMPLE IRA. At what point, if any, should you trade up to a 401(k)?
Start considering these more comprehensive programs when your own plan’s funds accumulate to a level where your increased buying power more than offsets the high administrative fees characteristic of the 401(k) plan.
“Once you accumulate $500,000 or more in your plan you may want to test the market and get some competitive bids on qualified 401(k) plans,” says Yannis P. Koumantaros, principal and director of Spectrum Pension Consultants, Tacoma, Wash.
Getting to a “yes” decision relies on a favorable cost benefit analysis. On the one hand, qualified retirement plans have administrative expenses while many SEP or SIMPLE IRAs do not. However, the 401(k)’s administrative expense may be more than outweighed by the cost savings you can obtain as a result of lower annual expense fees charged for purchase and ownership of mutual finds in the plan.
Here’s an example. “Suppose you have a ‘free’ SEP plan in which you are paying a 2.5 percent mutual fund expense ratio,” posits Koumantaros. “If you can change to a 401(k) plan in which you are only paying one percent expense ratio because of the plan’s greater buying power, you can save $1,500 in annual expenses for every $100,000 invested.” That $1,500 in savings may more than offset any administrative fees you pay the firm providing the 401(k) plan.
Lower expense ratios result from the highly competitive 401(k) marketplace. Firms offering 401(k) plans are highly regulated and have to disclose all of their fees. These firms (sometimes called “platform providers” because of the array of mutual finds they maintain) are often able to negotiate institutional buying power with Wall Street mutual funds rather than accepting shares priced at retail.
A 401(k) plan requires more set-up savvy than other plans discussed in this article. “To set up a 401(k) plan you really need to hire a third party administration firm,” says Tracy Davidson, president of Davidson Pension Consulting, Corte Madera, Calif. “These firms do the basic work such as maintaining the employee census, keeping track of hire dates, birth dates and other required data.”
The administration firm will also prepare reports for participating employees. “These statements are often done on a daily basis by way of the administration firm’s web site,” says Davidson. “The market fluctuates and employees are interested in following their balances.”
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