Profit-sharing Plan
A profit-sharing plan can be a good savings option for small businesses with one or more employees. It’s a tax-qualified plan with employer contributions only. However, those contributions can be discretionary, and depending on what the plan document says, may not even have to be made if economic conditions are poor. You must cover all employees at least 21 years old and who worked at least 1,000 hours in a year.
Contributions limits are the lesser of 100% of employee pay or $66,000 (contribution amounts are indexed annually for inflation). You as the employer can deduct amounts that don’t exceed 25% of pay for all employees. Plans may allow for loans, hardship withdrawals, and early withdrawals. Contributions may vest over time.
Profit-sharing plans need a plan document and must file annual governmental forms such as a Form 5500; since they have more than 100 eligible employees, they must also have an audit. IRS pre-approved plan documents can be obtained from financial and other types of organizations; many also offer help with plan administration.
Traditional 401(k) Plan
401(k) plans are one of the most popular retirement plans in the U.S. Many business owners think they’re designed mostly for large companies. Not so. They’re also great savings vehicles for mid-sized companies.
A 401(k) plan allows employees to defer part of their salary. Deferrals are usually made on a pre-tax basis, but the employee can elect to contribute them on an after-tax basis into a Roth 401(k) if the plan so allows. Many plans provide for employer matching contribution as well.
401(k) plans may allow for a menu of options including loans, hardship withdrawals, and in-service distributions. Company contributions, if any, may vest over time.
Employees can contribute up to $22,500 in 2023, with an added $7,500 available in catch-up contributions if you’re age 50 or older. Contribution amounts are indexed annually for inflation. You must cover employees at least age 21 who work at least 1,000 hours in a year.
The combination of employee and employer contributions, if any, cannot exceed $66,000 in 2023.
In addition, if you’re thinking of setting up a brand new 401(k) plan, the government offers start-up tax credits of 100% for companies with 50 or fewer employees with a maximum of $5,000 per year for the first three years of the plan. Plus tax credits of up to $1,000 per employee for employer matching contributions are available for employers with 50 or fewer employees, phased out for employers with 51-100 employees.
Variations on a traditional 401(k) design include Safe Harbor 401(k)s and Automatic Enrollment 401(k)s.
Multiple Employer Plan (MEP)
A MEP is a pooled plan covering the employees of employers that share a common interest or industry. It’s sponsored by a single entity who is responsible for selecting plan design and investment options.
Employers who adopt a MEP frequently do so to limit their fiduciary liability, their fiduciary liability limited to selecting and monitoring the MEP sponsor. The MEP sponsor also takes on most of the legal responsibilities related to the MEP. In addition, only one Form 5500 needs to be filed, and only one audit performed, with all plans sharing in the cost.
MEPs offer small businesses access to the benefits of a large plan with lower costs due to economies of scale. In return the small business can transfer administrative duties, including plan document preparation and maintenance, to the MEP and gain access to institutionally priced investments. Trade-offs are limited options in plan design features and investments.
Pooled Employer Plan (PEP)
PEPs are the new kid on the block, created by the SECURE Act of 2019.
A PEP is a pooled plan covering the employers that do not share a common interest or industry. They are frequently 401(k) plans.
In many other ways, a PEP is like a MEP. One difference is that a PEP is administered by an independent Pooled Plan Provider (PPP) who ensures there are no conflicts with other service and investment providers.
Cash Balance Plan
A cash balance plan can also be a good plan for a medium-sized business or professional group that wants to make large contributions toward retirement for business owners and/or key executives aged mid-40s or older.
It’s a hybrid pension plan – part defined benefit plan and part defined contribution plan. The benefit is guaranteed, like defined benefit plan benefits are, but is expressed in terms of a “hypothetical account” that is equal to “pay credits” and “interest credits” earned by a participant that resemble defined contribution contributions and investment returns; the final benefit is generally a cash payment based on the participant’s “hypothetical account.”
The plan is funded solely with employer contributions as determined by an actuary. Contributions must be made at least once a year and can vary based on interest rates and market returns. Since cash balance plans must be funded on a regular basis, your company should have consistent profits from year to year and a predictable cash flow.
One of the main attractions of a cash balance plan is that when it’s paired with a 401(k) and/or profit-sharing plan it can provide a substantial benefit. Executives and key employees are limited in what they can contribute to 401(k)/profit-sharing plans ($66,000 in 2023). But add in a cash balance plan ($265,000 accrual in 2023) and not only could tax-deductible contributions be increased dramatically, but so could tax-deferred retirement benefits.
You must cover all employees 21 years old with 1 year of service and at least 1,000 hours in a year; contributions may vest over time.
You are also responsible for the investment selection and monitoring of the investment providers. Poor investment returns can increase the amount of funding required in a given year.
Cash balance plans are complicated to set up and expensive to administer and fund. Professional administration, actuaries, and consultants are frequently required. And once they have over 100 eligible participants, they are subject to a large Form 5500 and audit which add to the complexity and expense.
Defined Benefit Plan
Another plan that can be a good fit for larger companies is the traditional defined benefit plan. A defined benefit plan uses a fixed formula usually based on a combination of service, salary, and age. Benefits are generally paid as a lifetime monthly annuity at retirement.
The plan is funded solely with employer contributions as determined by an actuary. Contributions must be made at least once a year and can vary based on interest rates and market returns. Since defined benefit plans must be funded on a regular basis, your company should have consistent profits from year to year and a predictable cash flow.
You must cover all employees at least 21 years old who work at least 1,000 hours in a year; contributions may vest over time.
You are also responsible for the investment selection and monitoring of the investment providers. Poor investment returns can increase the amount of funding required in a given year.
Defined benefit plans are complicated to set up and expensive to administer and fund. Professional administration, actuaries, and consultants are frequently required. And once they have over 100 eligible participants, they are subject to a large Form 5500 and audit which add to the complexity and expense.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
