Small business owners who choose to provide employees with a retirement plan are making a smart choice, as retirement plans help attract and retain employees and present tax advantages to workers and owners alike.
What type of retirement plan should you offer to your employees? That depends on a number of factors such as:
- Who you want to contribute to the plan
- The amount you want to contribute
- Your preferences for the pre- or post-tax contribution structures
Here is a closer look at four of the most commonly offered plan types and the advantages each offers to business owners and employees. When selecting the right plan and other business financial services for your company, it is prudent to seek counsel from proven experts in these fields.
Profit Sharing Plans
Profit sharing plans offer the employer the most flexibility, allowing business owners the ability to make contributions that match the growth of the business.
Under such plans, employees receive a portion of a company’s profits, based on quarterly or annual earnings results. These plans give employees a true sense of ownership and investment in the company’s success.
The business can determine how much it wants to allocate to each employee and can adjust the levels of contribution each year, including offering zero. When contributions are made, the company must use a set formula to determine the contributions.
One of the most common ways to determine contribution levels is to base it on compensation. Employees receive a percentage of the available contribution based on what percentage of the overall company’s compensation they earn.
The most commonly provided retirement plan, the 401(k) allows employees to contribute portions of their wages pre-tax to an investment account. An employer can make contributions or match employee contributions to the plan.
There is no minimum requirement for contributions, unless specified by the plan document. The 2017 contribution limits are capped at $18,000 annually until age 50. After age 50, plan participants are eligible to contribute up to $6,000 more (for a total of $24,000), and is known as a catch-up contribution.
Any deferred wages generally are not subject to federal income tax withholding at the time of their contribution to the plan and are not reported as taxable income on an employee’s individual tax return, although they may be subject to state and local taxes.
For employers, there are tax advantages, too. Employer contributions are deductible on federal income tax returns (up to certain legal limits). Employers should check with the state revenue agency to determine if state income tax must be withheld from pre-tax 401(k) contributions.
Roth 401(k) Plans
These plans are similar to traditional 401(k) plans but have several notable differences. The most significant is that with a Roth 401(k), participants pay tax prior to making a contribution to the fund. The limits are the same as with a traditional 401(k).
The tax rules for distributions from Roth 401(k) accounts differ significantly from those of traditional pre-tax 401(k) accounts. No income tax applies to qualified distributions from a Roth 401(k) account since taxes were paid at the time of the original contributions. Additionally, the earnings are tax-free, as long as the as the plan participant has satisfied the five-year rule and the distrubution falls under the qualified purpose.
A distribution from a Roth 401(k) account satisfies the qualified purpose rule if the distribution is due to:
- attainment of age 59.5
After age 70.5, distributions are required, unless the participant is still employed and not a five percent owner of the business, or if the Roth 401(k) has been rolled into a Roth IRA, although, like the rules for a Roth 401(k), the plan must have been established for at least 5 years.
Defined Benefit Plans
Also known as a qualified benefit plan or a pension plan, a defined benefit plan uses formulas, usually based on salary history and length of employment, to determine the level of benefit. The sponsoring company manages the investment portfolio and assumes the risk.
In some cases, employees can make contributions to the plan.
The employer’s contribution is known ahead of time, which differentiates this type of plan from other pensions, where payouts depend on returns. In a defined benefit plan, if investment returns do not meet the required funding level, the employer must tap into earnings to make the plan whole.
These plan types guarantee a specific payout upon retirement, either a set amount or an amount based on years of service, salary, and age.
Determining the right plan for your company requires a great partner. At Benetrends, we provide small business owners with expert advice and retirement plan management services. To learn more about how Benetrends can help you select and manage a company retirement plan, contact us today.