Choosing a Retirement Plan for Your Business

by Cathy Butler
Morgan Stanley Smith Barney

One of the most important steps a business owner can take to attract and retain key employees is to offer a retirement plan.

If you own a business, you understand the importance of attracting and retaining key employees. One of the most vital steps you can take to take care of those you hire is to create an appealing benefits package. And one great component of any benefits program is a retirement plan.

In choosing a retirement plan, you should consider, among other things, your company's size, financial situation and ability to comply with regulatory oversight and administrative responsibilities. Below is a summary of many of the options potentially available to you.

IRA-Based Plans
SEP IRAs. A Simplified Employee Pension IRA-based plan may be ideal for a one-person business or one with just a few employees. It is relatively inexpensive and easy to start and administer. The employer—not the employees—contributes to a SEP IRA maintained by each plan participant. Employees are immediately vested, and each employee decides how his or her money is invested.

Although there are some exceptions, a SEP IRA must generally cover any employee who is 21 or older, earned at least a certain amount from the business for the year ($550 for 2013), and has worked there during at least three of the preceding five years. In 2013, the annual contribution limit for each employee is 25 percent of compensation or $51,000, whichever is less (special rules apply for self-employed individuals). SEP IRAs also offer small-business owners flexibility regarding both the amount and timing of contributions. As a result, a SEP IRA may make sense for a business with profits that tend to fluctuate from year to year.

SIMPLE IRAs. The Savings Incentive Match Plan for Employees IRA-based plan is also valued for its ease of administration and is generally available to businesses with 100 or fewer employees. A "matching" SIMPLE IRA plan allows employees to contribute up to $12,000 of salary in 2013 (plus $2,500 in “catch-up contributions” for employees age 50 and over, if permitted by the plan). The employer must then make a dollar-for-dollar matching contribution on elective deferrals of up to three percent of each participant's annual compensation, but the employer has the right to match as little as one percent in two out of any five consecutive years.

The other method for funding a SIMPLE IRA requires the employer to make non-elective contributions equal to two percent of compensation for each worker who has earned at least $5,000 during the year, whether or not the worker has elected to contribute salary. For 2013, the maximum compensation amount that can be used to determine the non-elective contribution amount is $255,000.

Defined Contribution Plans
401(k) Plans. A 401(k) plan allows eligible employees to make pre-tax deferrals. Participants decide how much money to contribute to their individual accounts (up to applicable plan and legal limits) and usually how to manage their investments. The employer can have the option of making matching or profit-sharing contributions. These employer contributions can vest immediately or over a graded or cliff schedule if it is a traditional 401(k) plan, but must vest immediately if it is a safe harbor 401(k) plan. A participant’s elective pre-tax deferrals are always 100-percent vested.

Participants may contribute up to $17,500 for 2013—those age 50 and over may be able to add another $5,500. In 2013, total contributions to an individual's account cannot exceed $51,000 or 100 percent of compensation, whichever is less. Additionally, the plan may allow employee loans and hardship and other in-service withdrawals.

Roth 401(k)s. The difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars, while the traditional 401(k) is funded with pre-tax dollars. An employer may decide to offer both types of accounts.

As with a traditional 401(k), participants can contribute up to $17,500 for 2013—those age 50 and over may be able to add another $5,500. In 2013, total contributions to an individual's account cannot exceed $51,000 or 100 percent of compensation, whichever is less. Employers are permitted to make matching contributions on employees' designated Roth contributions. However, employers' contributions cannot receive the Roth tax treatment. The matching contributions made on account of designated Roth contributions must be allocated to a pre-tax account, just as matching contributions are in traditional 401(k)s.

Profit-Sharing Plans. A profit-sharing plan allows the business owner to decide (within limits) from year to year whether to contribute on behalf of participants. If contributions are made, the business owner needs to adhere to a set formula for determining how the contributions are allocated to participants. This money is accounted for separately for each participant. Contributions to the plan can be subject to a vesting schedule. Consider a profit-sharing plan if your income varies significantly from year to year and you don't want to be committed to an annual contribution.

Money Purchase Plans. Money purchase plans are now subject to the same contribution limits as profit-sharing plans, but offer less flexibility. The percentage of each eligible employee's compensation to be contributed is set when the plan is established and cannot be changed each year. You may want to consider a money purchase plan if your income is stable enough that you don't mind committing to an annual contribution, but as money purchase plans entail more complex administrative responsibilities and are now subject to the same contribution limits as profit-sharing plans, with less year to year flexibility, they have generally fallen out of favor.

Defined Benefit Plans
Traditional Defined Benefit Plans. This is a type of plan in which employee benefits are determined based on a formula using factors such as salary history and duration of employment. Actuaries use statistical analysis to calculate the cost of funding future benefits. The calculation takes into consideration employee life expectancy and normal retirement age, possible changes to interest rates, annual retirement benefit amounts, and the potential for employee turnover. Investment risk and portfolio management are usually entirely the responsibility of the company. Employees are entitled to the vested accrued benefit earned to date upon the occurrence of certain events. If an employee leaves the company before retirement, the benefits earned so far may be frozen and held in the plan’s trust for the employee until he or she reaches retirement age.

Cash Balance Plans. An increasingly popular type of retirement plan is the cash balance plan, which combines aspects of both DB and DC plans. As in a DC plan, cash balance plan participants have their own separate account balances. Like a DB plan, however, the employer is generally responsible for the funding of accounts and bears the investment risk. The amount to be contributed by the employer each year is actuarially determined. The employer must make sure that the plan has enough money to pay out total contributions plus specified interest for each plan participant, regardless of the performance of plan investments. Loans and hardship and other in-service withdrawals are optional.

Keep in mind that regardless of the type of qualified retirement plan a company decides to offer, the federal Employee Retirement Income Security Act (ERISA) stipulates that it must be established and managed in the best interests of its participants. So while it certainly makes sense to determine which option best addresses your company's needs, the final decision must ultimately take into account the long-term needs of your workforce.

Nonqualified Plans
Many companies offer nonqualified plans to certain highly compensated employees. Such plans come in many shapes and sizes, for example: defined benefit excess plans, defined contribution excess plans, voluntary deferred compensation plans and supplemental executive retirement plans (SERPs). Nonqualified plans are usually not subject to ERISA and therefore are more flexible.

Nonqualified plans do have certain common features. Generally speaking, the contribution limits applicable to the qualified plans described above do not apply to nonqualified plans, and thus, contributions can be significantly higher than for qualified plans. As with qualified plans, contributions to properly designed nonqualified plans are tax-deferred; taxes are not paid until funds are distributed. Unlike vested contributions under qualified plans, however, contributions are not technically owned by plan participants until they are paid; plan liabilities—including employee contributions—represent an unsecured promise to pay on the part of the employer. This can present issues in the event of a change of control with the company or if it goes bankrupt.

One popular funding mechanism is corporate-owned life insurance (COLI). In this arrangement, employers fund nonqualified plans with variable universal life insurance. Although COLI-funded plans can be complex, they offer tax-free growth, can be cost-effective, and are attractive to sponsors seeking to match assets with the liabilities created by deferred compensation plans.

Which type of retirement plan works best for your business will depend on a number of factors, including your staffing requirements and available funding. Talk to your financial advisor to identify the program that best suits your specific needs. iBi

Cathy S. Butler, CFP, CRPC is a financial advisor at the Butler/Luthy Group of Morgan Stanley in Peoria. She can be reached at (309) 671-2873. Learn more at morganstanleyfa.com/thebutlerluthygroup.

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