Starting a small business retirement savings plan is easier than most people think. What's more, there are a number of small business retirement programs that provide tax advantages to both employers and employees.
Why Do Entrepreneurs Need to Save?
Experts estimate that Americans will need 60 to 80 percent of their pre-retirement income – lower income earners may need up to 90 percent – 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 to play in helping America’s workers save. By starting a retirement savings plan, you will help your employees save for the future. Retirement plans may also help you attract and retain qualified employees, and they offer tax savings to your business. You will help secure your own retirement as well. You can establish a plan even if you are self-employed. Better yet, you will join more than one million small businesses with 100 or fewer employees that offer workplace retirement savings plans.
Are There Any Tax Advantages?
A retirement plan has significant tax advantages:
- Contributions are deductible by the employer when contributed;
- Employer and employee contributions are not taxed until distributed to the employee; and
- Money in the retirement program grows tax-free.
Any Other Incentives?
In addition to helping your business, your employees and yourself, recent tax law changes have made it easier than ever to establish a retirement plan. They include:
- Higher contribution limits so your employees (and you) can set aside larger amounts for retirement;
- "Catch-up" rules that allow employees age 50 and over to set aside an additional $500 (or $1,000, depending on the type of plan) for 2002;
- Tax credit for small employers that would enable them to claim a tax 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; and
- Tax credit for certain low- and moderate income individuals (including self-employed) who make contributions to their
plans ("Saver’s tax 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.
A Few Retirement Plan Facts
Most private-sector retirement vehicles are either Individual Retirement Arrangements (IRAs), defined contribution (DC)
plans, or defined benefit (DB) plans.
An IRA is the most basic sort of retirement arrangement. People tend to think of an IRA as something that individuals establish on their own, but an employer can help its employees set up and fund their IRAs. With an IRA, the amount that an individual receives at retirement depends on the funding of the IRA and the earnings (or income) on those funds. Defined contribution plans are employer-established plans that do not promise a specific amountof benefit at retirement. Instead, employees or their employer (or both) contribute to employees’ individual accounts under the plan, sometimes at a set rate (such as 5 percent of salary annually). At retirement, an employee receives the accumulated contributions plusearnings (or minus losses) on such invested contributions.
Defined benefit plans, on the other hand, promise a specified benefit atretirement – for example, $1,000 a month at retirement. The amount of thebenefit is often based on a set percentage of pay multiplied by the number ofyears the employee worked for the employer offering the plan. Employer contributions must be sufficient to fund promised benefits.
Small businesses may choose to offer IRAs, DC plans or DB plans. Many financial institutions and pension practitioners make available one or more prototype retirement plans that have been pre-approved by the IRS.
Even if an employer does not want to adopt a retirement plan, it can allow its employees to contribute to an IRA through payroll deductions, providing a simple and direct way for eligible employees to save. The decision about whether to contribute, and when and how much to contribute to the IRA (up to $3,000 per year for 2002 through 2004, increasing thereafter) is always made by the employee in this type of arrangement.
Many individuals eligible to contribute to an IRA do not. One reason is that some individuals wait until the end of the year to set aside the money and then find that they do not have sufficient funds to do so. Payroll deductions allow individuals to plan ahead and save smaller amounts each pay period. Payroll deduction contributions are tax-deductible by an individual, to the same extent as other IRA contributions.
Simplified Employee Pensions (SEPs)
A SEP allows employers to set up a type of IRA for themselves and each of their employees. Employers must contribute a uniform percentage of pay for each employee, although they do not have to make contributions every year. For the year 2002, employer contributions are limited to the lesser of 25 percent of pay or $40,000. (Note: the dollar amount is indexed for inflation and will increase.) Most employers, including those who are self-employed, can establish a SEP.
SEPs have low start-up and operating costs and can be established using a two-page form. And you can decide how much to put into a SEP each year ¨C offering you some flexibility when business conditions vary.
SIMPLE IRA Plans
This savings option is for employers with 100 or fewer employees and involves a type of IRA.
A SIMPLE IRA plan allows employees to contribute a percentage of their salary each paycheck and requires employer contributions. Under SIMPLE IRA plans, employees can set aside up to $7,000 in 2002 (increasing by $1,000 increments each year thereafter until the limit reaches $10,000 in 2005) by payroll deduction. Employers must either match employee contributions dollar for dollar - up to 3 percent of an employee's compensation - or make a fixed contribution of 2 percent of compensation for all eligible employees.
SIMPLE IRA plans are easy to set up. You fill out a short form to establish a plan and ensure that SIMPLE IRAs (to hold contributions made under the SIMPLE IRA plan) are set up for each employee. A financial institution can do much of the paperwork. Additionally, administrative costs are low.
Employers may either have employees set up their own SIMPLE IRAs at a financial institution of their choice or have all SIMPLE IRAs maintained at one financial institution chosen by the employer.
Employees can decide how and where the money will be invested, and keep their SIMPLE IRAs even when they change jobs.
401(k) plans have become a widely accepted retirement savings vehicle for small businesses. Today, an estimated 42 million American workers are enrolled in 401(k) plans that have total assets of about $2 trillion.
With a 401(k) plan, employees can choose to defer a portion of their salary. So instead of receiving that amount in their paycheck today, the employee can contribute such amount into a 401(k) plan sponsored by their employer. These deferrals go into a separate account for each employee. Generally, the deferrals (plus earnings) are not taxed by the Federal government or by most state and local governments until distributed.
401(k) plans can vary significantly in their complexity. However, many financial institutions and other organizations offer prototype 401(k) plans, which can greatly lessen the administrative burden on individual employers of establishing and maintaining such plans.
Employer contributions to a profit-sharing plan are discretionary. Depending on the plan terms, there is often no set amount that an employer needs to contribute each year.
If you do make contributions, you will need to have a set formula for determining how the contributions are allocated among plan participants. The funds go into a separate account for each employee.
As with 401(k) plans, profit-sharing plans can vary greatly in their complexity. Similarly, many financial institutions offer prototype profit-sharing plans that can reduce the administrative burden on individual employers.
Money Purchase Plans
Money purchase plans are defined contribution plans that require fixed employer contributions (contributions are not discretionary). With a money purchase plan, the plan document specifies the employer contribution that is required each year. For example, let¡¯s say that your money purchase plan requires a contribution of 5 percent of each eligible employee¡¯s pay. The employer needs to make a contribution of 5 percent of each eligible employee¡¯s pay to a separate account within the plan for each employee each year.
Many financial institutions offer prototype money purchase plans that can lessen the administrative burden on individual employers.
Defined Benefit Plans
Defined benefit plans provide a fixed, pre-established benefit for employees.
Some employers find that defined benefit plans offer business advantages. For instance, employees often value the fixed benefit provided by this type of plan. In addition, employees in DB plans can often receive a greater benefit at retirement than under any other type of retirement 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.