As an employer, you may want to establish one or more retirement plans for yourself and/or your employees. Having a plan can provide significant benefits for both you and your employees (if any). There are many different types of retirement plans, however, and choosing the right one for your situation is a critical decision. You want a plan that will meet both your goals as the employer and the needs of any employees you may have. In addition, it is important to balance the cost of establishing and maintaining a plan against the potential benefits.
By establishing and maintaining a retirement plan, you can reap significant benefits for both your employees (if any) and yourself as employer. From your perspective as an employer, one of the main advantages of having and funding a retirement plan is that your employer contributions to the plan are generally tax deductible for federal income tax purposes. Contributing to the plan will therefore reduce your organization's taxable income, saving money in taxes. The specific rules regarding deductibility of employer contributions are complex and vary by type of plan, however, so you should consult a tax advisor for guidance.
For many employers, perhaps the greatest advantage of having a retirement plan is that these plans appeal to large numbers of employees. In fact, offering a good retirement plan (along with other benefits, such as health insurance) may allow you to attract and retain the employees you want. You will save time and money in the long run if you can hire quality employees, and minimize your employee turnover rate. In addition, employees who feel well rewarded and more secure about their financial future tend to be more productive employees, further improving your business's bottom line. Such employees are also less likely to organize into collective bargaining units, which can cause major business problems for some employers.
So, why are retirement plans considered such a valuable employee benefit? From the employee's perspective, key advantages of a retirement plan may include some or all of the following:
Caution: Distributions taken before age 59½ may also be subject to a 10 percent federal penalty tax (25 percent in the case of certain distributions from SIMPLE IRA plans).
If you are an employer who is considering setting up a retirement plan, be aware that many different types of plans exist. The choices can sometimes be overwhelming, so it is best to use a systematic approach to narrow your options. Your first step should be to understand the distinction between a qualified retirement plan and a nonqualified retirement plan. Virtually every type of retirement plan can be classified into one of these two groups. So what is the difference?
Qualified retirement plans offer significant tax advantages to both employers and employees. As mentioned, employers are generally able to deduct their contributions, while participants benefit from pretax contributions and tax-deferred growth. In return for these tax benefits, a qualified plan generally must adhere to strict IRC (Internal Revenue Code) and ERISA (the Employee Retirement Income Security Act of 1974) guidelines regarding participation in the plan, vesting, funding, nondiscrimination, disclosure, and fiduciary matters.
In contrast to qualified plans, nonqualified retirement plans are often not subject to the same set of ERISA and IRC guidelines. As you might expect, this freedom from extensive requirements provides nonqualified plans with greater flexibility for both employers and employees. Nonqualified plans are also generally less expensive to establish and maintain than qualified plans. However, the main disadvantages of nonqualified plans are (a) they are typically not as beneficial from a tax standpoint, (b) they are generally available only to a select group of employees, and ©) plan assets are not protected in the event of the employer's bankruptcy.
Most employer-sponsored retirement plans are qualified plans. Because of their popularity and the tax advantages they offer to both you and your employees, it is likely that you will want to evaluate qualified plans first. (See below for a discussion of types of qualified plans.) In addition to providing tax benefits, qualified plans generally promote retirement savings among the broadest possible group of employees. As a result, they are often considered a more effective tool than nonqualified plans for attracting and retaining large numbers of quality employees.
Tip: There are several types of retirement plans that are not qualified plans, but that resemble qualified plans because they have many similar features. These include SEP plans, SIMPLE plans, Section 403(b) plans, and Section 457 plans. See below for descriptions of each type of plan.
Qualified retirement plans can be divided into two main categories: defined benefit plans and defined contribution plans. In today's environment, most newer employer-sponsored retirement plans are of the defined contribution variety.
The traditional-style defined benefit plan is a qualified employer-sponsored retirement plan that guarantees the employee a specified level of benefits at retirement (e.g., an annual benefit equal to 30 percent of final average pay). As the name suggests, it is the retirement benefit that is defined. The services of an actuary are generally needed to determine the annual contributions that the employer must make to the plan to fund the promised retirement benefits. Defined benefit plans are generally funded solely by the employer. The traditional defined benefit pension plan is not as common as it once was, as many employers have sought to shift responsibility for retirement to the employee. However, a hybrid type of plan called a cash balance plan has gained popularity in recent years.
Unlike a defined benefit plan, a defined contribution plan provides each participating employee with an individual plan account. Here, it is the plan contributions that are defined, not the ultimate retirement benefit. Contributions are sometimes defined in the plan document, often in terms of a percentage of the employee's pretax compensation. Alternatively, contributions may be discretionary, determined each year, with only the allocation formula specified in the plan document. With some types of plans, employees may be able to contribute to the plan. A defined contribution plan does not guarantee a certain level of benefits to an employee at retirement or separation from service. Instead, the amount of benefits paid to each participant at retirement or separation is the vested balance of his or her individual account. An employee's vested balance consists of: (1) his or her own contributions and related earnings, and (2) employer contributions and related earnings to which he or she has earned the right through length of service. The dollar value of the account will depend on the total amount of money contributed and the performance of the plan investments.
There are many different factors to consider when choosing a retirement plan for your company. In some cases, more than one type of plan will meet your needs in one vital area. If this is the case, you will need to further refine your choices by looking at how each type of plan meets your needs and their limitations in other key areas.
You can zero in on the key areas of importance and take the first step to finding the right plan by answering the following questions:
Here is where your answers to the above questions can be utilized to determine the most appropriate and beneficial plan for your company. Every type of plan has its own advantages and disadvantages. You can find the right type of plan for your company by:
To make it easier for you, we have prepared the essential information for you in more than one way. First, we have identified seven key areas that can be used to determine how each type of plan stacks up against other types of plans. In addition, we have provided a brief overview of each type of plan that links to a more detailed discussion of pros and cons and other information. Finally, we have listed types of plans that are generally considered appropriate for certain types of employers.
Tip: In addition to your own research, it is best to have a tax advisor and other professionals help you evaluate your options and select an appropriate retirement plan.
You can determine the best plan for your company by first seeing how the various types of plans compare in these seven key areas:
To determine the right retirement plan for your organization, keep your most important goals in mind as you evaluate plans in terms of these seven key areas.
In addition, there are two types of retirement plans that are especially popular with tax-exempt organizations:
Retirement plans most appropriate for small businesses and the self-employed
If you are self-employed, a sole proprietor, or a partner and want to establish a retirement plan, there are five types of plans you should consider:
Retirement plans most appropriate for corporations
If your form of business entity is a corporation and you want to establish a retirement plan, you should consider the following types of defined contribution plans:
Retirement plans for tax-exempt organizations
If you are involved with a tax-exempt or government organization and you want to establish a retirement plan, your options typically include a qualified plan, section 403(b) plan, and/or section 457 plan. However, not every employer is eligible to maintain every type of plan. For example, governmental employers generally can not adopt 401(k) plans. And only certain religious, public educational, and 501(c)(3) tax-exempt organizations can maintain 403(b) plans. For more detailed information, see our separate topic discussion, Retirement Plans for Tax-Exempt Organizations.