Better Retirement Planning

Retirement plans provide an essential role in the pursuit of financial security. Whether employer or employee-funded, they offer individuals an opportunity to accumulate assets that can be used later to maintain their standard of living and financial security during their golden years. With retirement being such an important piece of our long-term financial well-being, one would assume that most people are prepared. However, retirement planning has evolved considerably with longer life expectancy and what it means to be retired.

Years ago, most employers provided their workers with a retirement benefit in the form of a pension. Over time, these pensions became very costly to employers and were replaced with plans that shifted the contribution and investment risk away from the company to the individual.

Despite the need to retire, most individuals, whether self-employed or not, are woefully unprepared for retirement. As of 2005, according to the U.S. Department of Labor, an estimated 90 percent of full-time staff working for companies with 100 or more employees was covered by one or more employment-based retirement plans.  However, over half of full-time workers from small businesses were not covered by any type of retirement plan. Nearly four out of ten people in the American workforce are employed by small businesses, and unless small businesses offer an employer-sponsored plan, a high quality retirement will be harder to obtain for many Americans.  Interestingly, over 70 percent of individuals (most with little to no retirement planning), as indicated by the Employee Benefit Research Institute (EBRI), are “somewhat” to “very confident” that they will have sufficient assets to live comfortably throughout retirement.

This is ironic because the vast majority of Americans do not have a tangible retirement plan set up, but believe that they will be financially secure in a retirement that could last more than thirty years.

Small businesses that have not adopted a plan often state they are waiting for business profits to increase, they believe that a plan will be an administrative burden, or they wish key employees would be able to defer and accumulate more.  Although small businesses often cited these factors as reasons why they have not or will not adopt a retirement plan, more than half of the small businesses surveyed in the EBRI study were unaware of plan features that would ease the administrative burden and costs for small employers.  Also, many small business owners are unaware of flexible plan provisions that would provide incentives to sponsor plans.

There are several tax-advantaged options that are more commonly used by small businesses and self-employed individuals which include: The SEP IRA, the SIMPLE IRA and the 401k/Profit Sharing plan (sole proprietors with no employees should not discount this option, because a single participant 401k is possible and may be a suitable option).

SEP-IRAs and SIMPLE-IRAs share many of the following features:

 

•     Designed to meet the needs of small businesses and self-employed individuals
•     Easy to establish and require very minimal administration
•     Contributions go into the IRAs for each participant
•     Tax advantages, including income tax deductions and tax deferred growth

They’re also different in several ways. The differences include how much may be contributed each year, the allowable number of employees, who is required to contribute, who is allowed to contribute and employer matches for employee contributions.

SEP IRA

A Simplified Employee Pension plan (SEP) provides employers with a method to make contributions toward their employees’ retirement and their own retirement. Contributions are made directly to an IRA set up for each employee (a SEP-IRA).

Plan eligibility

 

•     A sole proprietor, in a partnership or a business owner (of either an unincorporated or incorporated business, including Subchapter S corporations)
•     Earn self-employed income by providing a service, either full-time or part-time, even if you are already covered by a retirement plan at your full-time job
•     Must cover all employees (at least twenty-one) that have worked three out of the last five years and earned more than $450 in the current year

Tax advantages

 

•     Tax-deductible contributions
•     Up to 25% percent of compensation and as much as $44,000 for the 2006 plan year
•     Any investment earnings grow tax-deferred until withdrawn

Contribution Requirements

 

•     No annual contribution required
•     Contribution percentage can vary each year, from 0 percent to 25 percent of compensation, up to $44,000 for the 2006 plan year
•     All SEP-IRA contributions must be made by the employer, and the same percentage of compensation must be contributed for each eligible employee (based on W-2 wages) including the employer

SIMPLE IRA Plan

A SIMPLE IRA plan is a Savings Incentive Match Plan for Employees. It gives small employers a method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions, and the employer makes matching or nonelective contributions. All contributions are made directly to an IRA set up for each employee (a SIMPLE-IRA).

Eligibility

Generally, any small business that employs 100 or fewer employees can establish a SIMPLE-IRA plan and must cover employees that earned more than $5,000 in the past two preceding years.

Tax Advantages

 

•     Contributing to a SIMPLE-IRA plan can help small business owners save on their business taxes, as well as their personal income taxes.
•     As an employer, you can generally deduct any contributions you make on behalf of your plan participants from your business expenses.
•     A special non-refundable tax credit of certain plan expenses for the first three plan years may be available.
•     Defer part of your salary and direct that money into an individual SIMPLE-IRA, reducing contributing participants’ current taxable income.
•     A tax credit may be available to individuals who make pre-tax contributions to a SIMPLE-IRA.
•     Any earnings within a SIMPLE-IRA enjoy tax-deferred growth until withdrawn.

Contribution Requirements

 

•     Eligible employees can elect to contribute up to 100 percent of compensation up to a maximum of $10,000 for the 2006 plan year through salary reduction.
•     Participants 50 and older in 2006 may be able to make an additional annual $2,500 catch-up elective deferral contribution to their SIMPLE-IRA.
•     Employers can choose from two different contribution methods and can even switch between these options each year, provided certain notification requirements are met.
•     Matching Option-requires the employer to match each participant’s contributions dollar-for-dollar up to 3 percent of compensation, but no more than $10,000 for the 2006 plan year
•     Non-Elective Contribution Option-requires employer to contribute 2 percent of each eligible employee’s compensation each year

Single 401(k) Plan

A 401k plan/Profit Sharing plan is typically associated with larger employers, due to increased administrative burden, and it is an often overlooked option by sole proprietors.  However, it is possible for a one-man shop to create a 401(k) plan.  This is referred to as a Single 401(k). Implementing this option may allow for greater contributions than allowed under a SEP IRA or SIMPLE IRA.

Eligibility

A Single 401(k) is available to self-employed individuals or business owners with part-time employees who work less than 1000 hours per year, other than a spouse, including sole proprietors, partnerships, corporations, and “S” corporations.

Tax Advantages of a Single 401(k)

A Single 401(k) may substantially reduce your current income taxes because generally, you can deduct the entire amount of your plan contributions from your taxable income each year.

 

•     If your business is unincorporated, you can deduct contributions for yourself from your personal income
•     If your business is incorporated, you can generally deduct contributions as a business expense

Contribution Requirements

 

•     A Single 401(k) allows you to make tax-deductible 401(k) salary deferrals to the plan of up to $15,000 for 2006.
•     If you are 50 or older you can make an additional catch-up salary deferral contribution of $5,000 for 2006.
•     In addition, a profit sharing feature also lets the business owners make tax-deductible profit sharing contributions of up to 25 percent of compensation, up to the annual maximum of $44,000 for the 2006 plan year.
•     Note that the total of salary deferrals and profit sharing contributions cannot exceed $44,000 for 2006 (or $49,000 if 50 or older).

The following illustrates a situation in which a self-employed business owner, who is age 50 with $100,000 in compensation may save more with a Single 401(k) than with a SEP-IRA.

 

Administration

 

•     A plan document must be completed to create the plan.
•     Once the plan reaches $100,000 in assets, IRS form 5500 is required to be filed once a year.
•     Service providers can administer your plan in a cost-effective manner

Additionally, there are other plan options that may be used to allow owners and key employees to receive more contributions and greater benefits than rank-and-file employees.

It is important that small businesses provide retirement plans for themselves and their employees.  Reluctance to implement a plan is due in part to perceptions that a retirement plan is costly, administratively burdensome or inflexible. However, options and provisions may be implemented to loosen the perceived rigidity of a retirement plan.  Everyone in America deserves a quality retirement.


Construction Business Owner, May 2006