When choosing a retirement plan, you need to carefully consider the goals involved. It could be any combination of tax deductions and tax-deferred growth, retirement fund accumulation, asset protection, employee attraction and retention, or perhaps a other deduction.
There are two types of pension plan categories: defined benefit pension plans and defined contribution plans. Prior to DC plans, the primary retirement savings vehicle was the DB plan. Employers would fund a pension and employees would enjoy a guaranteed income stream in retirement. Fast forward a few decades after the introduction of the 401(k) plan, and you’ll be hard-pressed to find an employer who offers a DB plan. The reason is simple: cost. The guaranteed aspect of a DB plan is burdensome and, in some cases, detrimental to the health and longevity of the sponsoring employer.
So how do you decide which plan is the right one? Start by asking a fundamental question: what are you trying to accomplish? There are several reasons to set up a retirement plan: tax deductions and salary deferral; accumulation of retirement assets; attraction and retention of employees; your business is a high-risk profession and you want to protect what you have earned through an inviolable trust; and participant education and orientation. These aren’t the only reasons, but they tend to top the list.
As a corporate pension advisor, I urge people to do two things. First, meet with a fiduciary advisor who specializes in the area of pension plans, putting clients’ interests first. Second, consult your tax advisor, the person who knows the most about your financial situation perhaps better than anyone else, besides yourself, of course.
These steps can help you determine which retirement plan option is the right one, based on current facts and circumstances.
401(k) Incentive Plan
401(k) and incentive plans can be separated. But by combining the two, you create plan administration and fee efficiency. The 401(k) allows for participant salary deferrals before taxes or in the form of Roth contributions. The maximum salary deferral for participants in 2022 is $20,500. And if the person is 50 or older, they can defer up to an additional $6,500 of salary as a catch-up contribution. Employers can provide a discretionary or non-optional matching contribution (eg profit sharing). Total contributions from all sources (e.g. salary deferral, matching, and profit sharing) cannot exceed $61,000 for plan year 2022.
It is a 401(k) basic profit sharing plan. Thanks to the design of the plan, you can include important improvements such as security contributions, advanced profit sharing options, automatic subscription and escalation with an unsubscription function. The 401(k) incentive plan offers the greatest flexibility and opportunity for salary deferral for all participants and company-weighted contributions for targeted participants.
The Cash Balance plan is essentially a DB plan, with a few differences that may make it more palatable to business owners. It is often used by businesses made up of owners or small groups with considerable cash flow wishing to maximize the retirement savings of certain people, usually the owners. It also provides a significant benefit to the employee base. It can be a stand-alone plan or combined with a 401(k) profit sharing plan, which maximizes tax deduction and contribution benefits. Annual dues for business owners can reach a few hundred thousand dollars.
But with a DB plan, the plan sponsor is required to make annual contributions. Additionally, through plan design, you can create a cost-benefit scenario that maximizes benefits for key employees (e.g., owners, executives) while minimizing total contribution expenses for remaining eligible employees.
Owner-only 401(k) plan
Here, only owners and owners’ spouses can participate. It provides for discretionary salary deferral and profit sharing contributions. It can be coupled with a cash balance plan, generating additional tax benefits and retirement savings.
Simplified employee pension (SEP)
Often used by small businesses or the self-employed, SEPs only allow employee contributions, not to exceed 25% of earned income. In the year the contributions are made, they must be paid to all eligible employees. The owner contributes to a SEP IRA and the participants invest the money. They are very easy to manage and have no employer deposit requirements. However, counseling training or career guidance is generally not provided to participants.
Employee Savings Incentive Plan (SIMPLE)
SINGLE 401(k): It is a cross between the SIMPLE IRA and the traditional 401(k) plan. It is available to employers with less than 100 employees and is much less complicated to administer and manage. The maximum salary deferral for participants in 2022 cannot exceed $14,000 and the maximum catch-up contribution is $3,000. In addition, employer contributions are mandatory. This can be a 100% match on the first 3% a participant chooses to defer or a non-optional contribution of 2% of the eligible employee’s contribution. It is a “simplified version” of a traditional 401(k) plan.
SINGLE IRA: This is similar to a SINGLE 401(k) with a pair of key differences. First, an employer who chooses to make matching contributions can reduce the amount to less than 3% but not less than 1% twice in five years. This is not allowed in a SINGLE 401(k). Second, loans are not allowed in a SINGLE IRA. They are, however, allowed in the SIMPLE 401(k) plan and in a traditional 401(k) plan.
This allows for salary deferral and employer contribution to those employed in government agencies, educational institutions, and non-profit organizations. It is not subject to the Employees Retirement Income Security Act 1974, unless there is “involvement on behalf of the employer”, such as an employer making a contribution to eligible participants .
Individual Retirement Account (IRA)
This is a non-company retirement account, which means people with earned income can open an IRA account and save for retirement. Maximize employer benefits first, then consider funding an IRA. This option can be set up as a traditional IRA or a Roth IRA.
Due to the many choices available, as well as the levels of complexity of each, it is strongly recommended that you consult with a corporate pension plan specialist willing to engage as plan fiduciary and your tax advisor to determine which plan is the best.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Michael A. Abate, AIF, CRPS, leads the corporate pension practice at EisnerAmper Wealth Management & Corporate Benefits, LLC.
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