Retirement Plans – 401(k)/Profit Sharing
Due to healthier lifestyles and medical advances, we are living longer than ever. That means that retirement income may be needed for 20 years or more after your regular paycheck stops. Expenses tend to decrease in retirement. The mortgage may have been retired and there is no longer the expense of commuting to work. As a result, it is estimated that at least 80% of your final annual salary will be needed in retirement.
It is wrong to rely on government retirement supplements to take care of you. Social Security covers only about 38% of the average retiree's income. The average paid in Social Security benefit to a retiree in 2001 was just $844 per month.
Retirement may seem like a long time away. Do not be tempted to put off saving. Each year it becomes more and more difficult to make up for lost time. In order to realize the goal of retirement with dignity , it is important to start early.
As an employer, you need to keep in mind that plan design is critical to the success of your retirement plan. There are several types of employer sponsored retirement plans.
There are two broad categories: qualified and nonqualified. A qualified plan is a tax-advantaged plan. A qualified plan must be nondiscriminatory, permanent, in writing and must comply with IRS and ERISA guidelines. Why have a qualified plan? Money contributed grows tax-deferred; contributions are tax deductible to the employer and are not treated as current income, no FICA is required on employer contributions; it is creditor proof; it attracts and retains employees.
Qualified plans may be sorted into two categories: defined-benefit plans and defined contribution plans.
- A defined benefit plan defines the benefits payable to a plan participant. The burden of providing the retirement benefit rests with the employer. It is dependent on an actuarial calculation of the amount of funding required to provide a specified benefit at the time of retirement. A defined benefit plan is an “insurance-type” solution to risk of lost income due to retirement. In fact, early defined benefit plans were funded with life insurance. There are two types of defined benefit plans: defined-benefit pension plans and cash-balance pension plans.
- A defined contribution plan, on the other hand, uses an approach where plan contributions are allocated to the individual plan participant similar to opening a savings account at a bank Unlike the defined benefit plan, the defined contribution plan provides a variable benefit with the cost predetermined to the employer. Unlike the defined benefit plan, the employee and the investment elections made have more of a determining factor on the retirement results. Plans such as a profit sharing plan or a 401(k) plan along with a stock bonus plan and an ESOP would fall into this category.
Profit sharing plans offer employees participation in company profits. A profit-sharing plan may be designed with no benefit formula. The contribution may be discretionary determined annually by the board of directors. The maximum deductible contribution is 25% of payroll up to a maximum of $41,000 for 2004. Contributions are tax deductible and accumulate tax-deferred. Several allocation Formulas may be used: pro rata, integrated, age weighted or new comparability.
The most popular defined contribution plan is the 401(k) . This is a salary reduction plan where the employee may defer income. The deferral limit for 2004 is $13,000. In 2004, the catch-up contribution for participants age 50 and older is $3,000. Insurance carriers offer annuity contracts which contain a variety of mutual fund options. The better portfolios will include several fund selections described by their investment philosophy as growth, value and blend among the large, mid and small capitalization sector. For the more aggressive investor Sector funds will be available. To provide balance, stable value funds including cash management and bond funds are foundational. Employee deposits are usually self-directed.
For the for-profit employer, there are a couple of popular tax-sheltered, nonqualified plans:
- Simplified Employee Pension IRC Sec. 408(k) (SEP) – The SEP is a great plan for an employer looking to avoid an annual commitment and adopting a plan that is easy to administer. A SEP uses an individual retirement account (IRA) as the receptacle for employer contributions. It is a simplified alternative to a profit sharing or 401(k) plan. Contributions can be discretionary but must be allocated as level percentage to all eligible employees. An eligible employee is defined as having attained age 21, performed services for 3 out of the 5 years immediately preceding 5 years and received a minimum of $450 in compensation for the year for 2004.
- A Savings Incentive Match Plan for Employee (SIMPLE) is for the employer looking for a plan that allows participants to make pre-tax contributions. It is a low cost plan with few administrative burdens. There is no annual reporting to the IRS or DOL. No discrimination test is required. Here are a few characteristics. Participants must be fully vested; no loans are allowed. Unlike the SEP, the SIMPLE has only a two-year waiting period. Unlike the SEP there is no age requirement. Any employee earning $5,000 in any pervious two years and is reasonably expected to earn the same in the coming year is eligible. The maximum deferral limit in 2004 is $9,000. The SIMPLE will appeal to the employer who may have never maintained a plan before.
- For tax-exempt 501(c)(3) industry and public schools, the 403(b) plan is available. The Tax Reform Act of 1986 limited not-for-profit organizations to a 403(b) plan. That changed in 1996 with passage of the Small Business Job Protection Act restoring the option of adopting a 401(k) to the not-for profit. Both 403(b) and 401(k) plans are salary deferral plans that place the responsibility for results of the program on the plan participant. The deferral limits are the same as in the 401(k). Because the 403(b) plan does not have to satisfy the actual deferral Percentage (ADP) test highly compensated employees are not limited in the amount they may contribute unlike a 401(K) plan. Participation in the 403(b) is voluntary; whereas, participation must be encouraged in the 401(k) so that highly compensated employees may contribute.
According to the 2002 annual 401(k) Benchmark Survey by Deloitte & Touche, the key to success of a retirement plan is participation. The greatest barrier to participation is communication. The survey results were that 42% did not have a Stable Value Fund, 61% did not offer an investment advise feature to plan participants, 49% cited lack of employee understanding of the plan.
Investment expertise and performance are another key component to the success of a plan. A smart and balanced selection of investment options with a proven track record is the measure of profitable portfolio.
The quality of the administration of the plan must be considered. Service and support must be comprehensive, reliable and timely. A plan must comply with complex Employee Retirement Income Security Act of 1974 (ERISA) laws and IRS regulations. The ERISA fiduciary standard is that a pension or welfare plan must be operated for the benefit of the participants. ERISA sets minimum standards such as providing participants with plan support. A plan fiduciary must perform the duties of the plan with a high standard of care, skill prudence and due diligence.
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