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Types of Retirement Plans

Employee benefits are an important part of a small business owner's business plan. Prospective employees want to know what retirement benefits they can expect when hired by a new company. Any employer can set up a retirement plan for their employees. Once an employer has a plan, they must comply with ERISA, which can deter some small businesses from offering plans.

This article discusses the types of pension plans available and the benefits to employers and employees.

Visit FindLaw's Wages and Benefits page for more information.

Qualified Retirement Plans

A qualified retirement plan is any business-established retirement plan that meets IRS and ERISA requirements. Qualified plans are eligible for tax benefits for both the employer and the employee. The employer's contribution is tax deductible. Employees pay no taxes on their plan contributions until they withdraw the funds.

There are two basic types of qualified plans.

  • A defined benefit plan gives the employee a set amount at retirement. The plan may pay monthly, like an annuity, or pay out a lump sum.
  • A defined contribution plan is an investment plan, and employees set aside a specific amount for their plan each month. The amount available at retirement depends on the amount invested and the success of the investments.

The IRS Tax Code has a detailed list of rules for qualified retirement plans, including vesting, employer matching contributions, distributions, and participation requirements.

401(k) Plans

A 401(k) is the best-known defined contribution plan. Employees contribute a portion of their pre-tax income to their plan. Employer matching contributions are subject to a nondiscrimination test by the IRS. 401(k) plans have maximum annual contribution limits.

Employers and plan administrators must follow IRS guidelines to get all of the tax advantages of the plan. Employers may charge plan fees to offset administration costs. ERISA requires these fees to be reasonable,  so you should discuss them with your administrator before charging your employees for their retirement plans.

Employees can withdraw their 401(k) funds before retirement. Withdrawals are taxed at the same rate as other income and penalties may apply.

Pension Plans and SIMPLE IRA Plans

Pension plans take employee contributions from their paychecks before taxes and are often matched by employer contributions. Unlike 401(k) plans, pension plan funds are unavailable until the plan matures.

Pensions pay out a specified amount at the end of the term, making them defined benefit plans. Plan participants can opt for monthly payments after retirement or the entire cash value of the pension. Defined-benefit plans have higher tax deductions than 401(k)s.

Simplified Employee Pension (SEP)

SEPs allow employers to contribute up to 25% of the employee's pay to an employee's own IRA. Employees create their IRAs, and employers contribute up to the allowable amount. SEPs do not allow employee contributions. Since employers must contribute equally to all eligible employees, SEPs may not be ideal for small businesses.

SIMPLE IRA Plans

The Savings Incentive Match Plan for Employees (SIMPLE) is available for any business with 100 employees or more. A SIMPLE IRA has no filing requirement and a non-elective contribution option for employees. Employees may elect to contribute or not. Employers must contribute a matching contribution if the employee contributes or a smaller amount if the employee does not.

Either type of plan has pros and cons. Employers should discuss them with their financial advisors before setting up these employee retirement plans.

Alternative Pension Plans

Employers with fewer employees should consider other retirement plan options. These plans are usually more paperwork-intensive than 401(k)s or pension plans but have flexible contribution requirements.

  • Profit-sharing plans use a formula to calculate the employer's contribution, if any. Employers are not required to contribute to employee profit-sharing plans.
  • Employee stock ownership plans (ESOPs) invest employee wages in the company's stock. ESOPs are similar to money purchase plans or stock bonus plans. The IRS has complex regulations for ESOPs.

Safe Harbor Plans

Safe harbor plans allow small businesses to offer employees a retirement savings plan without ERISA paperwork or administrative costs. Safe harbors will not allow employers to claim any tax credits. Startups can benefit from offering their employees a retirement account.

To be exempt from ERISA, safe harbor group insurance or pension plans must meet all four of these criteria:

  • No compulsory participation: Employees must be allowed to opt out of any group plan.
  • No employer contributions to the plan: All contributions come from employee wages.
  • No employer profits: Employer profits are not an option.
  • No employer participation: Other than collecting premiums and sending them to the financial agent, employer participation is limited.

A safe harbor plan's primary benefit to employees is that the employer arranges for the setup and contributions to the fund. Safe harbor 401(k)s make good additions to benefits packages that include health insurance and other traditional perks.

Self-Employed Individuals and Sole Proprietors

The entrepreneurs who start small businesses are often sole proprietors. As self-employed individuals, they miss some of the tax breaks that other business owners get from offering retirement plans to their workers.

Keogh plans meet the requirements of qualified retirement plans. Also known as an “HR 10," they have higher contribution limits but greater administrative and upkeep costs.

With either type of plan, the individual directs the investments. Keogh plans can invest in stocks, bonds, mutual funds, and other traditional retirement options.

Seek Advice From a Legal Professional

Small business owners should discuss their small business retirement plans with an ERISA attorney. Any business retirement plan is subject to ERISA regulation. Be sure you protect yourself and your employees in setting up your pension or accounts.

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