By Kevin FitzGerald
Seven years ago I founded my business and I’m glad to say that we have grown both our profits and employees. I’m thinking of adding some kind of retirement account for my business, but I’m not sure what kind of plan may be best. Could you please give me some guidance?
— A.L., Long Island
When the Social Security system was founded, it was intended to be the major part of a "three-legged stool" (Social Security, private pensions, and individual savings) that would provide people with income after they retired. Today, however, as the "baby boomers" begin to plan for retirement, people are finding that the Social Security leg is getting wobbly. Some startling facts have emerged: it’s estimated that you’ll need approximately 75 percent of pre-retirement income to maintain your present standard of living after retirement, and Social Security will provide less than half of that amount. That means that individuals who are working now must strengthen the stool’s other two legs if they expect to be supported in their golden years.
As a business owner, your challenge is twofold; not only do you have to plan for your own retirement, but you may also want to help your employees meet their retirement goals. Company-sponsored retirement plans are becoming an increasingly popular method of bridging the gap between Social Security benefits and retirement income needs.
While helping employees plan for retirement is the primary goal of a company-sponsored plan, establishing the right plan also makes good sense. First, company contributions to a qualified retirement program are made on a pre-tax basis, thereby reducing the business’ tax expenses. Second, a retirement plan can be integral part of a benefits package that can help you attract and retain top-quality employees. And finally, the money in a qualified retirement plan will grow tax-deferred, a major benefit for both you and your employees.
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Business retirement plans can be set up in many different forms, depending on your company’s needs. Whether you’re starting a new program or you’re evaluating your current program in light of recent tax law changes, it’s important that you understand your options.
What are your options?
There are two basic types of qualified retirement plans: defined benefit plans and defined contribution plans. In addition, there are simplified employee pension plans, or SEPs, and SIMPLEs.
A defined benefit plan is most appropriate for business owners seeking to provide employees with a predetermined benefit at retirement, and/or to maximize plan benefits for older employees, (including the owner) who have less time to accumulate retirement assets.
Contributions are based on the amount required to provide the stated, or "defined," benefit. The closer eligible employees are to retirement, the larger the permitted tax-deductible contribution will tend to be. Therefore, it may be possible to contribute more in a defined benefit plan than in other types of plans having fixed contribution limits.
With defined benefit plans, the employer’s contributions are typically determined by an actuary. The risk of fluctuations in investment performance is assumed by the employer. If investment performance doesn’t meet expectation, the employer is often required to increase funding. Therefore, these plans are better suited for businesses with stable profit history.
By comparison, a defined contribution plan provides retirement benefits based on the level of employer and employee contributions and investments performance. Employees’ benefits are based on the amount of assets in their individual accounts at retirement. With a defined contribution plan, the employee takes on the investment risk. Among the types of defined contribution plans are: profit sharing, money purchase, target benefit and 401(k).
In profit-sharing plans, employer contributions are flexible and are based on a percentage that can vary each year. A profit-sharing plan can be drafted to require no contribution in less profitable years. Thus, profit sharing plans are suitable as a first retirement plan for a new business or for a company with a volatile profit history.
With a money-purchase plan, the same percentage of an employee’s compensation is contributed each year regardless of profits. Because contributions under this type of plan are not flexible, a company must be willing to commit to a fixed annual contribution expense.
A target-benefit plan is a cross between a defined benefit and a money purchase plan. The annual contribution is determined by the amount needed each year to accumulate enough assets to pay a projected retirement benefit. Benefits payable to the participant may increase or decrease based on investment performance. This type of plan works well when you are seeking to weight plan benefits toward older, key employees.
A 401(k) plan allows employees to contribute pre-tax dollars through a salary reduction agreement. The plan can also be designed to provide for matching or discretionary employer contributions.
The SEP-IRA, may be especially suitable for new businesses or companies with cyclical profit histories seeking a flexible, low-cost retirement plan. SEP-IRAs are simplified alternatives to profit sharing plans, involving less paperwork and cost to the employer.
The SIMPLE (Savings Incentive Match Plan for Employees) is a retirement vehicle designed for businesses with 100 or fewer employees. SIMPLE plans are appropriate for employers seeking to establish a 401(k)-type employee savings plan without the administrative costs and complexities associated with a traditional 401(k) plan. A SIMPLE can be established as a SIMPLE IRA, in which contributions would be made to an IRA — established on behalf of each participating employee, or as a SIMPLE 401(k).
Where to get help
Developing and managing a good retirement program for your business may not be easy, but there are professionals who can help you to choose and administer a plan. Financial advisors can also offer other services such as plan design, investment management and pre-retirement employee counseling. You should discuss your options with your tax advisor and accountant. Similarly, employees who can also benefit from the advice of a professional when choosing from among the various investment options available under their plans.
Retirement planning for you and your employees is far too important to put off. Take the time now to understand your choices and clarify your goals. There are a number of tools available to help analyze the future needs of both you and your employees. Remember that professional advice can be crucial in creating a plan that is appropriate for you and your business.
The information contained herein has been obtained from sources believed to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.
Kevin FitzGerald is First Vice President-Investments at PaineWebber. He focuses on the areas of professional money management, asset allocation and retirement planning. He can be reached at 1-800-654-6162 x 448.