.If you recently starting a new business, you may want to set up a tax-favored retirement plan for yourself and your employees. There are several types of qualified new business retirement plans that are eligible for these tax advantages:
There are two basic types of plans.
A defined benefit plan provides for a fixed benefit in retirement, based generally upon years of service and compensation. While defined benefit plans generally pay benefits in the form of an annuity (for example, over the life of the participant, or joint lives of the participant and his or her spouse), some defined benefit plans provide for a lump sum payment of benefits. In certain “cash balance plans,” the benefit is typically paid and expressed as a cash lump sum.
Adoption of a defined benefit plan requires a commitment to fund it. These plans often provide the greatest current deduction from income and the greatest retirement benefit, if the business owners are nearing retirement. However, the administrative expenses associated with defined benefit plans (for example, actuarial costs) can make them less attractive than the second type of plan.
A defined contribution plan provides for an individual account for each participant. Benefits are based solely on the amount contributed to the participant’s account and any investment income, expenses, gains, losses and forfeitures (usually from departing employees) that may be allocated to a participant’s account. Profit-sharing plans and 401(k)s are defined contribution plans.
A 401(k) plan provides for employer contributions made at the direction of an employee under a salary reduction agreement. Specifically, the employee elects to have a certain amount of pay deferred and contributed by the employer on his or her behalf to the plan. Employee contributions can be made either:
Automatic-deferral provisions, if adopted, require employees to opt out of participation.
An employer may, or may not, provide matching contributions on behalf of employees who make elective deferrals to the plan. Matching contributions may be subject to a vesting schedule. 401(k) plans are subject to testing requirements. Doing so ensures that “highly compensated” employees don’t contribute too much more than non-highly-compensated employees. However, these tests are avoidable if you adopt a “safe harbor” 401(k) plan. An employee earning high compensation in 2020 is seen as one who earns more than $130,000 in the preceding year.
There are other types of tax-favored retirement plans within these general categories, including employee stock ownership plans (ESOPs).
Small businesses can also adopt a Simplified Employee Pension (SEP), and receive similar tax advantages to “qualified” plans by making contributions on behalf of employees. And a business with 100 or fewer employees can establish a Savings Incentive Match Plan for Employees (SIMPLE). Under a SIMPLE, generally an IRA is established for each employee. From there, the employer makes matching contributions based on contributions elected by employees.
There may be other options. Contact our Chicago accounting services team to discuss the types of new business retirement plans available to you.