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Employee Retirement Plans

You’ve probably heard it before: Social security won’t be around forever. That’s why people in the workforce depend on their employers to provide an option that will let them save for life after retirement. These days, more and more employers offer employee retirement plans to help workers save and to retain valuable employees that are concerned about their long-term future. And it’s not nearly as expensive nor as time-consuming as it once was.

The most common of the employee retirement plans is the 401(k) plan. A 401(k) allows you to invest pre-tax dollars up to a certain limit and pay taxes upon withdrawal once the employee reaches 59½ years of age. Businesses may also choose to match a certain amount of employee contributions to encourage participation.

Employee retirement plans offer significant tax benefits for businesses and their workers. For employees, contributing to a retirement plan lowers their taxable income. The money is allowed to grow tax-free until the employee takes money out. Businesses can get tax deductions for matching employee contributions and they even get a small tax credit just by starting up an employee retirement plan. So everyone wins!

In addition to traditional 401(k) plans, you can also consider other employee retirement options such as SEP IRA and SIMPLE IRA, traditional pension, non-profit retirement accounts (403(b)), or KEOGH.

How the 401k plan works

While there are many variations of the 401(k) plan, the traditional 401(k) is tried and true. Most employees are familiar with it and it typically provides the best mix of investment choices, low fees, and light administrative responsibilities.

401(k) plans offer the most flexibility and allow participants to contribute far more than most other retirement plans whether you have two employees or several hundred. Rollovers from previous employers are easy to implement and most times employees don’t even notice the changeover.

The maximum contribution level for 401(k) is $15,500 (as of 2007) and this amount increases every year. For employees who started contributing late in life, the government offers a “catch up” provision which allows people 50 years of age and older to contribute up to an additional $5,000 each year until retirement.

As previously mentioned, all contributions to the 401(k) come from pre-taxed income. This allows participants to get more power from their investment dollars as it grows tax-free. They only pay taxes upon withdrawals which you can start taking at age 59½ or older. Younger employees can take out money prior to that, but there are several restrictions. It’s generally not recommended and typically reserved only for economic hardships and medical emergencies.

Matching

The power of a 401(k) plan begins to take hold when employers match a certain percentage of employee contributions. For a cost of about 1% of total payroll, you can match up to 6% of total compensation or a fixed dollar amount for each eligible employee. To prevent employees from taking the money when they leave the company, you can develop a vesting schedule that ensures the employee only gets the matching funds if they stay with the company for a certain period of time. Meanwhile, every penny the employee contributes is 100% vested from the start.

If you operate a non-profit organization or government office, the 403(b) plan is similar to the 401(k) except you have fewer investment choices. Also, you have an opportunity to invest more with the “15-Year-Rule” which permits additional investments up to $15,000 for those employees who worked 15 years or more with the same company.

What is discrimination testing?

The IRS ensures that nobody abuses the vast tax privileges of the 401(k) plan by requiring discrimination testing. The testing must prove that all employees are contributing equally to the plan.

If the government determines that a plan is too top heavy (meaning higher compensated employees are contributing the maximum while rank and file employees don’t contribute at all), businesses could face significant penalties.

You can avoid discrimination testing by educating your employees about the benefits to saving for retirement early, or by using the Safe Harbor 401(k) option. This requires businesses to contribute up to 4% of employee salaries or a fixed contribution of 3% to ALL workers even if they don’t contribute on their own. These funds are vested for all eligible employees (21 years old, 1,000 hours of service) from the first day. You can then allow all employees to contribute freely up to the federally regulated maximums.

Other retirement plan options

You can go other routes for an employee retirement plan if you don’t feel the 401(k) is right for you. With all of these plans, all eligible employees vest from day one, meaning they are entitled to all matching contributions you deposit into their accounts.

• If you operate a business with 100 employees or less, an Individual Retirement Account (IRA) features the same pre-tax benefits without the complexity or testing requirements of 401(k). However, investment options are limited and the plan limits are lower.
• Even smaller companies (5 to 20 employees) or the self-employed can go with a variation of the IRA - the SEP IRA. This allows you to contribute 0% to 25% of each employee’s salary. While you don’t have to contribute every year, you must contribute the same percentage to all eligible employees
• With a SIMPLE-IRA, businesses with 100 or fewer employees can contribute a fixed 2% of employee salary or 3% of employee salary for all those eligible. It’s easy to administer but you must not have any other retirement plan in place. There are lower limits than the 401(k) and businesses can lower contributions but there are restrictions.
• A SIMPLE 401(k) combines the benefits of 401(k) and SIMPLE IRA for businesses with 100 employees or fewer and no other retirement plans. Eligible employees must be 21+ and employed for a full year. Like other plans, the maximums are lower than the 401(k) but administration is far easier. You avoid discrimination testing by contributing 3% of salary (up to $6,000) or a flat contribution of 2% to all employees. With a SIMPLE 401(k), you can’t stop contributions for any reason.
• If you own your own business and don’t have any other employees other than a spouse, don’t fret. The government makes sure you can reach retirement goals with a Solo 401(k) plan. It’s very inexpensive with similar tax benefits and very high contribution limits to cover both you and your spouse (up to $45,000 per year plus $5,000 annual catch up if you’re over 50.)
• For very small companies with 10-15 highly-compensated employees, you can elect for a profit-sharing plan called the KEOGH. It features very high limits, but it’s the most expensive to implement.

ERP administration

We talked a lot about how there is less administration with an employee retirement plan than in years past. This is because a plan provider takes that burden off your shoulders. Plan providers help you select the plan that’s best for your company, establish the investment options and recordkeeping procedures, and maintain and grow the plan within federal guidelines.

You can select from a bundled plan provider or an unbundled plan provider. Bundled plans offer everything under one umbrella (administration, multiple investment options, documentation, employee education). It’s simple and affordable, but you don’t have a lot of investment choices.

Unbundled providers offer different staff members to administer different parts of the plan. They offer several additional plan options than a bundled provider, but their services are much more expensive because of the increase in administrative responsibilities.