Retirement Plans

Starting a retirement savings plan can be easier than most business owners think. What's more, there are a number of retirement programs that provide tax advantages to both employers and employees.

Why Save?

Experts estimate that Americans will need 70 to 90 percent of their pre-retirement income to maintain their current standard of living when they stop working. So now is the time to look into retirement plan programs. As an employer, you have an important role in helping America's workers save.

By starting a retirement savings plan, you will help your employees save for the future. You can establish a plan even if you are self-employed. Retirement plans help secure your own retirement as well as your employees. Retirement plans may also help you attract and retain qualified employees, and offer tax savings to your business.

Any Tax Advantages?

A retirement plan has significant tax advantages:

  • Employer contributions are deductible from the employer's income,
  • Employee contributions (other than Roth contributions) are not taxed until distributed to the employee
  • Money in the plan grows tax-free.
Any Other Incentives?

In addition to helping your business, your employees and yourself, here are some additional reasons to set up a retirement plan:

  • High contribution limits so you and your employees can set aside large amounts for retirement;
  • "Catch-up" rules that allow employees age 50 and over to set aside additional contributions. The "catch up" amount varies, depending on the type of plan;
  • A tax credit for small employers that enables them to claim a credit for part of the ordinary and necessary costs of starting a SEP, SIMPLE, or certain other types of plans (more on these later). The credit equals 50 percent of the cost to set up and administer the plan, up to a maximum of $500 per year for each of the first 3 years of the plan;
  • A tax credit for certain low and moderate-income individuals (including self-employed) who make contributions to their plans ("Saver's Credit"). The amount of the credit is based on the contributions participants make and their credit rate. The maximum contribution eligible for the credit is $2,000. The credit rate can be as low as 10 percent or as high as 50 percent, depending on the participant's adjusted gross income; and
  • A Roth program that can be added to a 401(k) plan to allow participants to make after-tax contributions into separate accounts, providing an additional way to save for retirement. Distributions upon death or disability or after age 591/2 from Roth accounts held for 5 years, including earnings, are generally tax free.
401(k) Plan:

A 401(k) plan is a qualified plan under which an employee can elect to have the employer contribute a portion of the employee's wages to an individual account under the plan. The underlying plan can be a profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan. The deferred wages (elective deferrals) are not subject to federal income tax withholding at the time of deferral, and they are not reflected as taxable income on the employee's individual income tax return.

401(k) plans are permitted to allow employees to designate some or all of their elective deferrals as "Roth elective deferrals" that are generally subject to taxation under the rules applicable to Roth IRAs. Roth deferrals are included in the employee's taxable income in the year of the deferral.

Tax advantages

Two of the tax advantages of sponsoring a 401(k) plan are:

  • Employer contributions are deductible on the employer's federal income tax return to the extent that the contributions do not exceed the limitations described in section 404 of the Internal Revenue Code.
  • Elective deferrals and investment gains are not currently taxed and enjoy tax deferral until distribution.
Types available

There are several types of 401(k) plans available to employers - traditional 401(k) plans, safe harbor 401(k) plans and SIMPLE 401(k) plans. Different rules apply to each. For tax-favored status, a plan must be operated in accordance with the applicable rules. Therefore, it is important that the employer be familiar with the special rules that apply to its plan so the plan is administered in accordance with those rules. To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan's provisions. The following is a brief overview of important qualification rules. It is not intended to be all-inclusive.

Traditional 401(k) plans

A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees' elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee's right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested. Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.

Safe harbor 401(k) plans

A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.

Safe harbor 401(k) plans that do not provide any additional contributions in a year are exempted from the top-heavy rules of section 416 of the Internal Revenue Code.

Employers sponsoring safe harbor 401(k) plans must satisfy certain notice requirements. The notice requirements are satisfied if each eligible employee for the plan year is given written notice of the employee's rights and obligations under the plan and the notice satisfies the content and timing requirements.

403(b) Tax-Sheltered Annuity Plan:

A 403(b) plan (tax-sheltered annuity plan or TSA) is a retirement plan offered by public schools and certain charities. It's similar to a 401(k) plan maintained by a for-profit entity. Just as with a 401(k) plan, a 403(b) plan lets employees defer some of their salary into individual accounts. The deferred salary is generally not subject to federal or state income tax until it's distributed. However, a 403(b) plan may also offer designated Roth accounts. Salary contributed to a Roth account is taxed currently, but is tax-free (including earnings) when distributed.

Eligible employers are a:

  • Public school, college, or university,
  • Church; or
  • Charitable entity tax-exempt under Section 501(c)(3) of the Internal Revenue Code
Profit-Sharing Plan:

Guess what. You don't need profits in order to make contributions to a profit-sharing plan. Of course, having a profit would probably make it easier to actually contribute something.

Contributions to a profit-sharing plan are discretionary. There is no set amount that you need to make. If you can afford to make some amount of contributions to the plan, then go ahead.

If you do make contributions, you will need to have a set formula for determining how the contributions are divided. This money goes into a separate account for each employee.

One common method for determining each participant's allocation in a profit-sharing plan is the "comp-to-comp" method. Under this method, the employer calculates the sum of all of its employees' compensation (the total "comp"). To determine each employee's allocation of the employer's contribution, you divide the employee's compensation (employee "comp") by the total comp. You then multiply each employee's fraction by the amount of the employer contribution. Using this method will get you each employee's share of the employer contribution.

If you establish a profit-sharing plan, you:

  • Can have other retirement plans.
  • Can be a business of any size.
  • Need to annually file a Form 5500.

As with 401(k) plans, you can make a profit-sharing plan as simple or as complex as you want to. Pre-approved profit-sharing plans are available to cut down on administrative headaches.

Who Contributes:

Employer contributions only.

Defined Benefit Plan:

Defined benefit plans provide a fixed, pre-established benefit for employees at retirement. Employees often value the fixed benefit provided by this type of plan. On the employer side, businesses can generally contribute (and therefore deduct) more each year than in defined contribution plans. However, defined benefit plans are often more complex and, thus, more costly to establish and maintain than other types of plans.

If you establish a defined benefit plan, you:

  • Can have other retirement plans.
  • Can be a business of any size.
  • Need to annually file a Form 5500 with a Schedule B.
  • Have an enrolled actuary determine the funding levels and sign the Schedule SB
  • Can't retroactively decrease benefits
  • Substantial benefits can be provided and accrued within a short time - even with early retirement
  • Employers can contribute (and deduct) more than under other retirement plans
  • Plan provides a predictable benefit
  • Vesting can follow a variety of schedules from immediate to spread out over seven years
  • Benefits are not dependent on asset returns
  • Plan can be used to promote certain business strategies by offering subsidized early retirement benefits
  • An excise tax applies if the minimum contribution requirement is not satisfied
  • An excise tax applies if excess contributions are made to the plan
Who Contributes:

Generally, the employer makes contributions. Sometimes, employee contributions are either required or voluntary.

Money Purchase Plan:

Money purchase plans have required contributions. The employer is required to make a contribution to the plan each year for the plan participants.

With a money purchase plan, the plan states the contribution percentage that is required. For example, let's say that your money purchase plan has a contribution of 5% of each eligible employee's pay. You, as the employer, need to make a contribution of 5% of each eligible employee's pay to their separate account. A participant's benefit is based on the amount of contributions to their account and the gains or losses associated with the account at the time of retirement.

That type of arrangement is different than a profit-sharing plan. With the profit-sharing plan, you, the employer, can decide that you'll contribute a certain amount, say $10,000. Then, depending on the plan's contribution formula, you allocate that $10,000 to the separate accounts of the eligible employees. Also, in past years, money purchase plans had higher deductible limits than profit-sharing plans. This is no longer the case.

If you establish a defined benefit plan, you:

  • Can have other retirement plans.
  • Can be a business of any size.
  • Need to annually file a Form 5500
  • Possible to grow larger account balances than under some other arrangements.
  • Need to test that benefits do not discriminate in favor of the highly compensated employees.
  • An excise tax applies if the minimum contribution requirement is not satisfied
Who Contributes:

Employer and/or employee contributions.

Contribution limits:

The lesser of 25% of compensation or $52,000 (for 2014)

Cash Balance Plan:
What is a Cash Balance Plan?

There are two general types of pension plans - defined benefit plans and defined contribution plans. In general, defined benefit plans provide a specific benefit at retirement for each eligible employee, while defined contribution plans specify the amount of contributions to be made by the employer toward an employee's retirement account. In a defined contribution plan, the actual amount of retirement benefits provided to an employee depends on the amount of the contributions as well as the gains or losses of the account. A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.

How do Cash Balance Plans work?

In a typical cash balance plan, a participant's account is credited each year with a "pay credit" (such as 5 percent of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks are borne solely by the employer.

When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity based on that account balance. Such an annuity might be approximately $8500 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance.

If a participant receives a lump sum distribution, that distribution generally can be rolled over into an IRA or to another employer's plan if that plan accepts rollovers. The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.

How do Cash Balance Plans differ from traditional pension plans?

While both traditional defined benefit plans and cash balance plans are required to offer payment of an employee's benefit in the form of a series of payments for life, traditional defined benefit plans define an employee's benefit as a series of monthly payments for life to begin at retirement, but cash balance plans define the benefit in terms of a stated account balance. These accounts are often referred to as "hypothetical accounts" because they do not reflect actual contributions to an account or actual gains and losses allocable to the account.

How do Cash Balance Plans differ from 401(k) plans?

Cash balance plans are defined benefit plans. In contrast, 401(k) plans are a type of defined contribution plan. There are four major differences between typical cash balance plans and 401(k) plans:


Participation in typical cash balance plans generally does not depend on the workers contributing part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to make a contribution to the plan.

Investment Risks:

The investments of cash balance plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks of the investments. Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their own investments within certain categories. Under 401(k) plans, participants bear the risks and rewards of investment choices.

Life Annuities

Unlike 401(k) plans, cash balance plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities.

Federal Guarantee

Since they are defined benefit plans, the benefits promised by cash balance plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.