|
|
Financial Life Advisor
Retirement Plans for Small Business and the Self Employed
The self employed have many obstacles that most employees do not have to worry about. Besides the irregular paycheck and lack of unemployment and workmen’s compensation insurance, there is usually difficulty getting reasonably priced health insurance coverage. The self-employed must also pay both sides of Social Security and Medicare which is 15.3% vs. 7.65% for FICA.
On the other side of the self-employed coin, there is that truly American benefit of being your own boss and having no limit to your income potential. For the successful entrepreneur, there are several retirement plan options available which offer significant tax sheltering opportunities. Like most financial decisions, the best plan depends on the specific situation. Read this article to find out more about those potential retirement plan opportunities.
ERISA and Non-Discrimination
One of the major considerations when dealing with group retirement plans are ERISA (Employee Retirement Income Security Act) laws and non-discrimination provisions. ERISA was designed, among other things, to prevent employers from designing retirement plans which only benefit the owners or senior managers of a firm. This is important for small-business owners because when considering retirement plan options, ERISA rules can play a big role in what an employer would be required to do for employees when designing plans. Some of these non-discrimination rules will be discussed when talking about each specific retirement plan option.
Keep in mind that self-employed and small business owners are both the employer and employee. Various retirement plans have restrictions for how each can fund the retirement plan. The owner generally controls the employer side of the equation, the only question is how much of plan contributions must be allocated to other employees. If there are no employees, then the non-discrimination rules do not apply. All amounts quoted are current for 2010.
With all employer plans, non-discrimination rules apply to “eligible employees”. The definition of eligible is different for all retirement plans. Some give a limited amount of employer discretion in defining an eligible employee, but that control is limited. Because of the nuanced differences from plan to plan these definitions are not addressed in this explanation.
Comparison Criteria of the Various Plan Options
Savings Limits: The annual limits for how much money can be placed into the tax shelter.
Funding Flexibility: Some retirement plans require annual funding at certain levels; others can be skipped during lean years.
Plan Design Flexibility: Based upon ERISA and the particular tax code which authorizes each plan, different provisions can be included or modified to make the plan more advantageous to the owner.
Plan Setup & Funding: Some plans must be setup by a certain date and funding must occur during a calendar year or possibly by tax deadlines.
Administrative Cost: Retirement plans have some sort of annual reporting required. The total administrative costs generally vary by complexity and/or plan type.
Traditional & Roth IRA’s
The traditional IRA is available to all taxpayers who earn an income. Contributions can be made non-deductible if certain income limits are exceeded and the taxpayer or spouse is an “active participant” in another retirement plan that year (like a 401(k)). Because of low cost of administration and broad eligibility, the IRA is a great tool to use if eligible. Contributions can be made up to April 15 th for the previous tax year.
The Roth IRA allows for after-tax contributions which are tax-sheltered until 59 ½ and then become tax free. Income limits for participation do apply, but it is possible to convert traditional IRA’s to Roth IRA’s (see related blog article). Annual contribution limits to a Roth or traditional IRA are cumulative, meaning that total between both accounts is the annual limit, not double. There are income limits for Roth eligibility also.
Savings Limits: $5,000 under 50, $6,000 if 50+
Funding Flexibility: Plans can be funded in any particular year where income eligibility requirements and/or active participation status doesn’t disqualify participation.
Plan Design Flexibility: Investment options are very broad, but there is no flexibility in plan design.
Plan Setup & Funding: An IRA can be setup and funded anytime before April 15 th of the following year.
Administrative Cost: Minimal
SIMPLE IRA
The SIMPLE IRA was designed as a lost cost alternative to the 401(k) plan. Only employers with 100 or fewer employees can use a SIMPLE IRA. Just like a 401(k) employees can choose to defer their own salary into the plan pre-tax. The employer must match 3% of salary deferrals or instead of matching, can opt to give 2% to all employees, whether they contribute or not.
Because it is a simplified version of a 401(k), there is limited choice in how the plan is set-up. The employer chooses an investment company or insurance company for the investments in the SIMPLE IRA, but no separate recordkeeping or annual testing is required. It should be noted that a SIMPLE IRA must be set up by October 1st, and employee contributions must come from payroll during the calendar year.
Savings Limits: $11,500 under 50, $14,000 if 50+, plus 2% or 3% of compensation/net income in an employer contribution.
Funding Flexibility: The employer match can be reduced to as little as 1% if needed on a short term basis but generally should be thought of as required. A reduction also requires advance notice to participants.
Plan Design Flexibility: There is minimal control on plan design. The SIMPLE IRA was designed to provide a 401(k) light program to employers of 100 or less, so most provisions and the plan document are standardized.
Plan Setup & Funding: Plans must be setup by October 1 st and employee deferrals must be made by payroll during the plan year, employer contributions must be made by the tax filing deadline plus extensions.
Administrative Cost: Minimal
SEP IRA
A SEP (Simplified Employee Pension) IRA is more like a profit sharing plan than a traditional 401(k). Employees can not contribute any money to the SEP IRA. The employer is the only source of funding. In order to keep things simple and non-discriminatory, the SEP IRA rules require that all employees receive the same percentage of their salary when contributions are made. The percentage contributed by the employer can fluctuate from year to year, but it must always be allocated in an equal percentage.
In the case of the self employed, there is no concern to allocate anything if there are no employees. In short, the SEP IRA is like a supercharged personal IRA. With little additional expense, it can be a powerful tool. It does not provide flexibility in plan design though.
Savings Limits: Employer contribution of up to 25% of compensation with a maximum of $49,000
Funding Flexibility: Funding does not have to be made every year and can change from year to year.
Plan Design Flexibility: There is minimal control on plan design. Just about all employees must be given an identical percentage contribution by the employer
Plan Setup & Funding: Can be setup and funded anytime up to the tax return filing plus extensions
Administrative Cost: Minimal
401(k)
The 401(k) has become the most common retirement savings vehicle in the United States. There are numerous ways to customize a 401(k) plan to suite the specific needs of each employer. An employer can set up a 401(k) plan and not provide any employer contributions. It can simply be set up as a savings vehicle for employees to defer their own savings into for pre-tax contributions. Recently, under the Pension Protection Act (PPA) of 2006, the Roth 401(k) was authorized. The major benefit is like that of a Roth IRA—after-tax payroll deferrals can be made which will be tax free in retirement. Unlike the Roth IRA, though, there is no income limit for participation.
An employer can design a 401(k) plan which has matching funds to employee deferrals and can add a profit sharing component which allows the employer to make additional contributions to employees. Those contributions can be made on a percentage basis of salary or several other methods which may maximize the allocation to certain employees. In order to use the 401(k) as a retention tool, a specific vesting schedule can be applied to employer contributions.
Under ERISA, 401(k) plans are required to be non-discriminatory. This means that when designing the allocation formula for profit sharing, the employer must use pre-approved allocation criteria to keep the plan qualified. Otherwise, an employer would just allocate the entire profit sharing allocation to themselves. The point of a group retirement is to benefit the employees, so those profit sharing allocations must be non-discriminatory.
Even when talking about a 401(k) plan without profit sharing, there are non-discriminatory concerns. The plan must be checked annually to make sure that the highly paid employees are not the only ones contributing to the plan or own too high percent of the plan assets. If the highly paid employees don’t meet the annual testing, the future contributions may not be allowed or prior contributions may need to be refunded. Top heavy plans can be “corrected” by the employer making contributions for lower paid employees.
The flexibility of plan design makes the 401(k) very attractive compared to other retirement plan options, but with the flexibility comes added administrative cost and responsibility. The employer takes on a fiduciary role for the employees in the plan and a Third Party Administrator (TPA) is usually required to oversee the operation and reporting of the 401(k) plan. The services of a TPA can easily range in the thousands of dollars annually. These costs may be outweighed by the tax-sheltering or other benefits of a 401(k), but should be considered.
Using a prototype plan document approved by the IRS can help save time and money when setting up a plan. Additionally, most of the annual testing can be ignored if the 401(k) is a safe-harbor plan. With a safe-harbor plan, the employer must make matching contributions up to 4% of compensation, and those contributions must vest immediately. Of course, the cost of a safe harbor contribution may be more than the additional testing might cost.
The self-employed can open a solo 401(k). This is the same as a normal 401(k), but because there are no employees, there is no annual testing required. A solo 401(k) allows for a higher level of tax deferral than a SEP IRA at a lower income. The downside is that a solo 401(k) still has some annual reporting which is more than a SEP IRA.
Savings Limits: Employee Deferrals of $16,500 under 50, $22,000 if 50+, Employer Contributions up to 25% of compensation with combined limit of $49,000.
Funding Flexibility: Under certain plan designs the employer contribution can be discretionary from year to year, but cannot be discriminatory. Other designs can require significant annual funding.
Plan Design Flexibility: A 401(k) can be designed in many different ways. The main limiting factor is making sure the plan is non-discriminatory to all eligible employees. The design has the most flexibility of all defined contribution plans.
Plan Setup & Funding: Plans can be setup anytime during the calendar year and employee deferrals must be made by payroll during each plan year, employer contributions must be made by the tax filing deadline plus extensions.
Administrative Cost: Moderate, annual reporting and plan accounting can be a significant expense, especially on small plans. More exotic plan designs can add to administrative cost considerably. The solo 401(k) plans can be much lower than a regular 401(k), but will still be more than a SEP or SIMPLE IRA.
Posted by Ben Gurwitz on 2nd March, 2010 | Comments | Trackbacks
Tags: Retirement Accounts, Financial Planning, Mar 10
The trackback URL for this page is http://www.fladvisors.com/trackback?post=17921807 TrackbacksThere are no trackbacks for this post There are no comments for this post Post a CommentHTML is not allowed in comments, http://... will be automatically linked.
|
|
|
