Retirement planning describes the financial strategies individuals employ during their working years to ensure that they will be able to meet their goals for financial security upon retirement. Making sound decisions about retirement is particularly important for self-employed persons and small business owners. Unlike employees of some large companies, who can simply participate in the pension plans and investment programs offered by their employers, entrepreneurs must set up and administer plans for themselves and for their employees.
In recent years there has been a shift away from company-funded, defined-benefit pension plans. These plans were common within large firms during the 1950s through 1970s and into the 1980s. A defined-benefit pension plan is one in which the employer pays into and manages a plan based on calculations of how much the fund will need in order to provide an employee with a particular, defined post-retirement income. Such a plan guarantees all qualified employees with a predetermined retirement benefit. Many things have combined to cause a shift away from defined-benefit plans and towards defined-contribution plans. One of the more important of these, other than substantial demographic pressure that the retirement of the baby boom generation is having on all retirement issues, was the passage of an obscure provision in the Tax Revenue Act of 1978, the 401(k) provision. This provision went largely unnoticed for two years until Ted Benna, a Pennsylvania benefits consultant, devised a creative and rewarding application of the law, an application which became what is known today at the 401(k) plan.
A 401(k) plan is just one of various types of plans which fall under the umbrella of defined-contribution plans, as opposed to defined-benefit plans. A defined-contribution plan is one in which there is no guaranteed post-retirement benefit but rather a defined monthly or yearly contribution to a plan. How the plan's assets are invested and how much they are worth at retirement is not defined by the plans. Employees are responsible, in most cases, for investment decisions and the level of contribution made to the plan. With defined-contribution pension plans employees pay into the plan on a tax-deferred basis and in most cases, the employer agrees to a minimum contribution or agrees to match some percentage of the contribution made by the employee. Many business writers believe that this shift from defined-benefit plan to defined-contribution plan has helped to level the playing field for small businesses. Smaller companies are now able to offer the same type of retirement benefits as many larger employers.
Though establishing and funding retirement plans can be costly for small businesses, such programs also offer a number of advantages. In most cases, for example, employer contributions to retirement plans are tax-deductible expenses. In addition, offering employees a comprehensive retirement plan can help small businesses attract and retain qualified people who might otherwise seek the security of working for a larger company. The number of small firms establishing retirement plans grew during the 1990s, but small employers still lag far behind larger ones in providing this type of benefit for employees.
Retirement planning is a topic of interest to all Americans, not only to small business owners and entrepreneurs. The debate over whether Social Security will be available for the younger members of the current work force adds legitimacy to the need for early retirement planning. Longer life expectancies mean that more money must be set aside for retirement, while the uncertainty of investment returns and inflation rates makes careful planning essential. In fact, some experts recommend that individuals invest a minimum of 14 percent of their gross income from the time they enter the work force to guarantee a comfortable retirement.
Unfortunately, most of us are not doing this. In fact, most Americans approaching retirement in 2005 do not have enough to retire on according to Jack VanDerhei, Senior Research Fellow at the Employee Benefit Research Institute (EBRI). In response to an interviewer's question on the Public Broadcasting System's Frontline show, VanDerhei explained that most people approaching retirement now have about three times their annual salary saved for the post-retirement period. The EBRI recommends that a man have 6.3 times his annual salary available for post-retirement living and a woman 6.7 times her annual salary. (Women have a longer life expectancy than men and therefore need slightly more retirement savings.) Financial planners and insurance analysts recommend even higher retirement savings goals—10 to 15 times annual salary—as necessary for a reasonable retirement. What is clear in all studies on this subject is the fact that as Americans, we are not now saving adequately for retirement.
LAWS GOVERNING RETIREMENT PLANS
The Social Security Administration was created in the 1930s as part of President Franklin Roosevelt's New Deal. Private pension plans mushroomed shortly thereafter, offering coverage to millions of employees. In 1962 the Self-Employed Individuals Retirement Act established tax-deferred retirement plans from which account holders could withdrawals starting between the ages of 59 1/2 and 70 1/2. These plans—also known as Keogh plans after their originator, New York Congressman Eugene J. Keogh—were intended for the self-employed and for those who have income from self-employment on the side. Embezzlement from pension plans by trustees led to the passage of the Employee Retirement Income Security Act of 1974 (ERISA). One of the main provisions of ERISA was to set forth vesting requirements—time periods over which employees gain full rights to the money invested by employers on their behalf. ERISA governs most large-employer-sponsored pension plans, but does not apply to those sponsored by businesses with less than 25 employees.
TYPES OF RETIREMENT PLANS
The two main categories of retirement plans are defined-contribution and defined-benefit. Perhaps the most significant difference between defined-benefit and defined-contribution plans is the voluntary nature of defined-contribution plans. Such plans are usually fully voluntary, so that hourly or salaried employees elect to have a certain percentage of money deducted—before taxes—from their paychecks. Conversely, defined-benefit plans involve automatic contributions made by the employer, with no active participation on the part of the employee.
One significant advantage of defined-contribution plans is that the amount invested by employees can be rolled over into another account with another employer. Rollover activity into similar tax-deferred plans has continued to increase as tax laws require a 20 percent withholding tax to be paid on the lump sum if it is not rolled over. Nonetheless, defined-contribution plans continued to face scrutiny by many financial advisers for two reasons: 1) the investment decisions made by the company may be too restrictive for employees to meet individual goals; and 2) many times employees are not educated about the risk and returns associated with the investment vehicles available through the company plan. Similarly, the voluntary nature of defined-contribution plans makes detractors wonder if ill-informed employees will have less money in their defined-contribution accounts at retirement than they would have had under a defined-benefit plan.
OPTIONS FOR SMALL BUSINESSES
Small business owners can set up a wide variety of retirement plans by filling out the necessary forms at any financial institution (a bank, mutual fund, insurance company, brokerage firm, etc.). The fees vary depending on the plan's complexity and the number of participants. Some employer-sponsored plans are required to file Form 5500 annually to disclose plan activities to the IRS. The preparation and filing of this complicated document can increase the administrative costs associated with a plan, as the business owner may require help from a tax advisor or plan administration professional. In addition, all the information reported on Form 5500 is open to public inspection.
The most important thing to remember is that a small business owner who wants to establish a qualified plan for him or herself must also include all other company employees who meet minimum participation standards. As an employer, the small business owner can establish retirement plans like any other business. As an employee, the small business owner can then make contributions to the plan he or she has established in order to set aside tax-deferred funds for retirement, like any other employee. The difference is that a small business owner must include all nonowner employees in any company-sponsored retirement plans and make equivalent contributions to their accounts. Unfortunately, this requirement has the effect of reducing the allowable contributions that the owner of a proprietorship or partnership can make on his or her own behalf.
For self-employed individuals, contributions to a retirement plan are based upon the net earnings of their business. The net earnings consist of the company's gross income less deductions for business expenses, salaries paid to nonowner employees, the employer's 50 percent of the Social Security tax, and—significantly—the employer's contribution to retirement plans on behalf of employees. Therefore, rather than receiving pre-tax contributions to the retirement account as a percentage of gross salary, like nonowner employees, the small business owner receives contributions as a smaller percentage of net earnings. Employing other people thus detracts from the owner's ability to build up a sizeable before-tax retirement account of his or her own. For this reason, some experts recommend that the owners of proprietorships and partnerships who sponsor plans for their employees supplement their own retirement funds through a personal after-tax savings plan.
Nevertheless, many small businesses sponsor retirement plans in order to gain tax advantages and increase the loyalty of employees. A number of different types of plans are available. The most popular plans for small businesses all fall under the category of defined-contribution plans. In nearly every case, withdrawals made before the age of 59 1/2 are subject to an IRS penalty in addition to ordinary income tax. The plans differ in terms of administrative costs, eligibility requirements, employee participation, degree of discretion in making contributions, and amount of allowable contributions. Brief descriptions of some of the most common types of plans follow:
Simplified Employee Pension (SEP) Plans
SEP plans are employer-funded retirement accounts that allow small businesses to direct at least 3 percent and up to 15 percent of each employee's annual salary, to a maximum of $30,000, into tax-deferred individual retirement accounts (IRAs) on a discretionary basis. SEP plans are easy to set up and inexpensive to administer, as the employer simply makes contributions to IRAs that are established by employees. The employees then take responsibility for making investment decisions regarding their own IRAs. Employers thus avoid the risk and cost involved in accounting for employee retirement funds. In addition, employers have the flexibility to make large percentage contributions during good financial years, and to reduce contributions during hard times. SEP plans are available to all types of business entities, including proprietorships, partnerships, and corporations. In general, eligibility is limited to employees 21 or older with at least three years of service to the company and a minimum level of compensation. The maximum level of compensation for SEP eligibility is $170,000.
Savings Incentive Match Plan for Employees (SIMPLE)
SIMPLE plans take two forms: a SIMPLE IRA and a SIMPLE 401(k). Both plans became available in January 1997 to businesses with less than 100 employees, replacing the discontinued Salary Reduction Simplified Employee Pension (SARSEP) plans. They were intended to provide an easy, low-cost way for small businesses and their employees to contribute jointly to tax-deferred retirement accounts. An IRA or 401(k) set up as a SIMPLE account requires the employer to match up to 3 percent of an employee's annual salary, up to $6,000 per year. Employees are also allowed to contribute up to $6,000 annually to their own accounts. Companies that establish SIMPLEs are not allowed to offer any other type of retirement plan. As of early 1997, most small businesses chose the SIMPLE IRA option, as the SIMPLE 401(k) proved more expensive than a regular 401(k) due to the company matching requirements. The main problem with the plans, according to many financial planners, was that legislation is already being drafting that would make SIMPLE less simple and more expensive for the businesses that the plans were created to serve.
Profit Sharing Plans
Profit sharing plans enable employers to make a discretionary, tax-deductible contribution on behalf of employees each year, based on the level of profits achieved by the business. The total annual contribution is generally allocated among employees as a percentage of their compensation. Plan costs are tax deductible for the employer, and plan earnings are tax deferred for employees. Profit sharing plans are easy to implement, offer design flexibility, and provide a wide range of investment choices. Eligibility is typically limited to employees who are at least 21 years of age and who have at least one year of service. The employer's maximum deduction is 15 percent of the total annual salaries paid to nonowner employees (adjusted to 13.04 percent for the small business owner).
A common variation is the age-based profit sharing plan, in which contributions are based on an allocation formula that factors in the age or number of years to retirement of participants. Age-based profit sharing allows employers to reward valued older employees for their length of service. Another variation is the new comparability profit sharing plan, which allows employers to define classes of employees and set up the retirement plan so that certain classes benefit the most in terms of allocation. These types of profit sharing plans are similar to defined-benefit plans, but the employer contributions are discretionary.
Money Purchase Pension Plans
Money purchase pension plans are similar to regular profit sharing plans, but the employer contributions are mandatory rather than discretionary. The main advantage of money purchase plans is that they allow larger employer contributions than regular profit sharing plans. The employer determines a fixed percentage of profits that will be allocated to employee retirement accounts according to a formula. The maximum employer contribution jumps to 25 percent of payroll for nonowner employees (adjusted to 20 percent for the small business owner) or a total of $30,000 per employee. There are also combination money purchase-profit sharing plans that allow employers to select a fixed percentage for mandatory contribution and also retain the option of contributing additional funds on a discretionary basis when cash flow permits.
401(k) Profit Sharing Plans
The popular 401(k) plans are profit sharing plans that include a provision for employees to defer part of their salaries for retirement. The employer can make annual profit sharing contributions on behalf of employees, the employees can contribute up to $10,000 of pre-tax income themselves, and the employer can choose to match some portion of employee contributions. 401(k) plans offer a number of advantages. First, they allow both employer and employee to make contributions and gain tax advantages. Second, they can be set up in such a way that employees can borrow money from the plan. Third, 401(k) plans enable employees to become active participants in saving and investing for their retirement, which raises the level of perceived benefits provided by the employer. The main disadvantages are relatively high set-up and administrative costs. Eligibility for 401(k) plans is typically limited to employees at least 21 years of age who have at least one year of service with the company.
Small businesses that establish 401(k)s must be careful to avoid liability for losses employees might suffer due to fluctuations in the value of plan investments. Under ERISA, plan sponsors can avoid liability by ensuring that their 401(k) meets three criteria: offering a broad range of investment options to employees; communicating sufficient financial information to employees; and allowing employees to exercise independent control over their accounts.
Nonqualified Deferred Compensation Plans
Finally, there is a type of plan often used by businesses to supplement existing qualified plans and provide an extra benefit to key personnel and highly compensated employees. In small businesses, this usually includes the owner and founder. Broadly defined, a nonqualified deferred compensation plan (NDCP) is a contractual agreement in which a participant agrees to be paid in a future year for services rendered this year.
There are two broad categories of nonqualified deferred compensation plans: elective and non-elective. In an elective NDCP an employee chooses to receive less current salary and bonus compensation than he or she would otherwise receive postponing the receipt of that compensation until a future tax year. Non-elective NDCPs are plans in which the employer funds the benefit and does not reduce current compensation in order to fund future payments. Such plans are, in essence, post-termination salary continuation plans. The argument behind such non-elective plans, funded by employers, is the retention of key employees.
One feature in particular of nonqualified deferred compensation plans that has made them a very popular tool for use by large corporations and some small businesses, is the fact that they are not limited by the same non-discrimination rules imposed on qualified plans. NDCPs may be offered to a select group of employees only, unlike qualified plans to which all employees are eligible by definition. Consequently, the cost of this benefit is lower since it accrues to fewer people. NDCPs are a type of plan that is particularly useful for small business owners in augmenting their own retirement savings plans.
WHICH PLAN TO CHOOSE
Small business owners must carefully examine their priorities when selecting a retirement plan for themselves and their employees. If the main priority is to minimize administrative costs, a SEP plan may be the best choice. If it is important to have the flexibility of discretionary contributions, a profit sharing plan might be the answer. A money purchase plan would enable a small business owner to maximize contributions, but it would require an assurance of stable income, since contributions are mandatory. If the small business counts upon key older employees, an age-based profit sharing plan or a defined-benefit plan would help reward and retain them. Conversely, an employer with a long time horizon until retirement would probably do best with a defined-contribution plan. Finally, a small business owner who wants employees to be able to fund part of their own retirement should select a SIMPLE or a 401(k) plan. There are also many possibilities for combination plans that might provide a closer fit with a small business's goals. Free information on retirement plans is available through the Department of Labor at 800-998-7542, or on the Internet at http://www.dol.gov/ebsa/savingmatters.html.
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