Businesses have many options when setting up a retirement plan for their employees. Some of the most popular retirement plans for small to large businesses include pensions, profit-sharing plans, and 401(k) plans. Each of these plans have benefits and drawbacks and the decision of which plan to implement will depend on the individual needs and goals of your business.
Qualified retirement plans are regulated by the Employee Retirement Income Security Act of 1974, as amended (ERISA). ERISA is a federal law that establishes the minimum standards for most private-sector pension and health plans. ERISA mandates fiduciary duties for plan managers and those who control plan assets or provide investment advice for a fee requires disclosure of plan financing information, allows individuals to file legal claims for benefits and breaches of fiduciary duty, and establishes federal income tax rules for benefits transactions.
Pension plans are generally categorized as defined benefit plans and defined contribution plans. A defined benefit plan promises a specific monthly benefit amount upon retirement, traditionally based on factors including salary and years with the company. A defined contribution plan, on the other hand, is funded by a specified amount contributed to the plan, with benefits based on how the investments of the amounts contributed have performed.
A Simplified Employee Pension (SEP) is a defined contribution plan that offers a simple way for employers to contribute to their employees' retirement plans on a tax-favored basis through funding Individual Retirement Accounts (SEP-IRA). SEP-IRAs are treated like traditional IRAs, with the same IRS investment, distribution, and rollover rules.
Any employer can set up a SEP through a standardized IRS-approved SEP or a SEP custom designed for their company that meets IRS requirements. Contributions are generally based on employee compensation, and limited to a percentage of employee compensation or maximum contribution amount determined by the IRS.
One of the benefits of a SEP plan is that it allows employees to make tax-deductible traditional IRA contributions to their SEP-IRA. Rather than requiring separate IRA accounts, the SEP-IRA is funded by employer contributions which an employee can supplement through traditional IRA contributions.
An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that invests primarily in employer securities. ESOPs allow employees to share in ownership of their employer. Eligible employees are provided stock ownership as a benefit of working for the company. There are many benefits to providing an ESOP to employees, including the ability to maintain a certain corporate culture and provide employer-funded retirement benefits. For more information on ESOPs, click here.
Profit Sharing Plans
A profit-sharing plan allows employers to contribute to the plan through cash or employer stock on a year-to-year basis. This plan is one of the most flexible defined contribution plans that allow the company to make annual changes to contributions based on company profits or cash flow. Contributions by the employer are entirely discretionary. Thus, the company can make a large contribution to the plan in a profitable year or make no contribution to the plan if the company is struggling.
If the company does implement a profit-sharing plan, the contributions need to be allocated to employees on a set formula. This is generally done based on the “comp-to-comp” (or ratio of compensation) method, where contributions are distributed to each employee's account based on the employee's relative compensation compared to total employee compensation.
As with other qualified retirement plans, there are regulations and restrictions to maintaining a profit-sharing plan, including annual filing requirements, participant disclosures, and ensuring benefits do not discriminate in favor of highly-compensated employees. There are also contribution limits to employer contributions set by the IRS. In 2017, the limit for employer contributions is 25% of compensation, or $54,000, whichever is lower.
401(k) Retirement Plans
A 401(k) plan is one of the most common qualified plans established by employers. Employees can elect to defer some percentage of their salary, which the employer puts into a 401(k) plan sponsored by the employer. The employee is not taxed on this contribution until they money is distributed from the account.
Employers have the option of making additional contributions to the employee's 401(k). This is often done by matching the employee contribution up to a designated limit pursuant to the terms of the plan. As an example, if an employer matches the employee's contribution up to 4% of compensation contributed, the employee could contribute 10% of their salary, and the employer would make a matching contribution of 4% of the employee's compensation for the year. If the employee only contributed 3% of their compensation the next year, the employer would match the employee's 3% contribution.
Another benefit for employees is that the 401(k) plan allows them to make higher contributions than under a traditional IRA plan. Like other qualified plans, there are annual contribution limits. However, for 2016, an employee may defer $18,000 or 100% of compensation, whichever is greater. Employees age 50 or older may make an additional "catch-up" contribution of $6,000, for a total contribution limit in 2016 of $24,000. These limits are subject to adjustment annually by IRS regulations. The employee's contribution is also 100% vested, while employer contributions can vest on a graduated schedule. Additionally, like other qualified plans, there are annual reporting and filing requirements for 401(k) plans.
A 401(k) plan could be based on IRS-approved plans or custom designed to help the business take full advantage of the flexibility a 401(k) plan can provide.
Deciding on the Best Qualified Plan
The best-qualified plan will depend on the individual facts, situation, and goals each business. Some plans provide far greater flexibility, while others can be more simple to establish and maintain without the added flexibility. In some cases, an employer can offer a combination of qualified plans. Factors to examine when determining which plan is best for your business may include its size, accounting methods, and purpose for providing a retirement plan to employees.
Once your business has established a qualified retirement plan, you should consider revisiting your options every few years. Over time, tax laws and ERISA regulations may change. Other changes in the market or how your business operates may also change the advantages of one plan over another.
Employers should also be aware of potential challenges to their qualified plan from the IRS. If IRS regulations are not followed, an audit could potentially result in disqualification of the plan and the loss of tax-favored treatment of contributions made to the plan. Additionally, plan participants may challenge the denial of benefits through judicial review.
Talk to your employee benefits legal services professionals before you decide on a plan for your business. A standardized plan may allow you to easily maintain basic administration of your plan, while a custom-designed plan would allow you to take full advantage of all tax benefits while maximizing contributions for you and your employees.
San Diego Employee Benefits Attorneys
Butterfield Schechter LLP is San Diego County's largest law firm focusing primarily on employee benefit legal services. We provide our clients with cutting edge employee benefit plan design. The attorneys of Butterfield Schechter LLP meet with their clients to determine which type of qualified plan works best for their business. Once the type of plan is determined, the plan is custom designed to the needs and goals of each client.
Our attorneys will help establish a plan that meets regulatory requirements as a tax-qualified plan. Following implementation, our attorneys can assist clients and their plan administrator by counseling and advising them on their fiduciary responsibilities under ERISA and with regular reviews and updates to help with regulatory compliance for the plan's operation, as well as continued effectiveness in meeting the client's specific goals. Contact our office today with any questions on how we can help you and your business succeed.