As a business owner, it is critically important that you provide for your own retirement. A side benefit is the ability to help your employees save for their retirement.
Benefits of a Retirement Plan
We’ve already covered the first benefit – the ability to put money aside for retirement. A retirement plan can act as anincentive to help you recruit and retain qualified and competent employees. The contribution limits for an employer plan are higher than those for an IRA and the catch-up limits for those age 50 or older during the year are also higher. In addition, there are tax benefits for both the employer and the employee.
The employer gets a tax deduction for employer contributions to the plan. The employee’s deferrals to the plan are not taxed until they are distributed to the employee. Growth in the plan is not taxed until it is distributed to the employee. Deferrals to designated Roth accounts are not tax deferred, but the growth in those plans is generally tax-free. There may also be tax credits for small employers and for certain lower income individuals.
Types of Plans
Generally all employer plans will be one of the following:
IRAs – While IRAs are usually set up by individuals on their own, an employer can help employees set up and fund IRAs. By deducting the IRA contributions from the employee’s paycheck, the employer can encourage the employee to save for retirement.
Defined Contribution Plans – These plans are based on a set amount of contributions by the employer and/or the employee. There is no guaranteed benefit and the amount the individual has in their account at retirement is based on the amount they contribute and the gains or losses in the account. The most common types of plans in this category are 401(k)s, SEP IRAs and SIMPLE IRAs.
Defined Benefit Plans – These plans are based on a set amount of contributions by the employer and/or the employee. There is no guaranteed benefit and the amount the individual has in their account at retirement is based on the amount they contribute and the gains or losses in the account. The most common types of plans in this category are 401(k)s, SEP IRAs and SIMPLE IRAs.
Defined Benefit Plans – These plans are funded solely by employer contributions based on the amount of the benefit the employee is to receive at retirement. All things being equal, the older the employee, the more that will have to be paid into the plan each year. The risk and burden of funding falls on the employer for these plans. These are true pension plans.
Carefully consider the type of plan you want to establish. A retirement plan is intended to be a long-term venture. It is not a good idea to change types of plans frequently. In addition, some plans require that they be the only plan for the business. Always keep in mind that these are NOT savings accounts where anything goes. They are retirement accounts with many rules that must be followed. Know and understand the rules for the type of plan you choose and, in particular, know the rules for the plan that you establish. In many cases, a small business owner will serve as their own plan administrator. That title comes with responsibilities for operating the plan correctly. Make sure that the plan is operated correctly because the ultimate consequence of repeated plan failures is disqualification of the plan. That means taxable distributions and the loss of tax deductions that the business has taken. There are guides on the IRS website to help the employer make sure the plan is operated correctly. There are also fix-it guides to help the employer fix any mistakes that may have been made. Many mistakes can be corrected at no cost to the employer.