Small Business Retirement Realities

Putting a retirement program into effect at your small business can be a win-win for you and your workers. Retirement plans can help your company compete for and retain top talent. An owner can help employees and him or herself accumulate enough assets so they can retire at a desirable age and at the standard of living to which they have become accustomed. And don’t forget that a company can receive tax deductions for contributions it provides to employees’ retirement accounts. However, the best program for one company may not be the ideal option for another. There are several options available to small business owners, and such factors as employee demographics, costs and employer objectives all help determine which you should choose. For a broad overview of plans available to small business owners, see page 42. Here we’ll focus on several options available in a typical company-sponsored retirement program.

401(k) plans are probably the best-known retirement savings vehicles offered by companies. They have been around for 25 years and are popular for good reason: A traditional 401(k) allows employees to contribute their own compensation to a retirement plan with tax-advantaged dollars.

A traditional 401(k) allows employees to defer their compensation, before taxes are applied, into an individual account, where the proceeds can grow tax-free until retirement. At that time, the individual can take distributions, which are taxed at the individual’s marginal tax rate in retirement. Employer contributions are also considered to have been pre-tax, and so are taxable as ordinary income when they’re withdrawn.

Rolled out in January 1, 2006, the Roth 401(k) is a brand-new plan that can be added into a retirement program. This is similar to the traditional 401(k), except the employee contributions are funded with after-tax compensation into an individual account and the proceeds grow tax-free and are distributed tax-free.

In a nutshell, the difference between a traditional 401(k) and a Roth 401(k) is that in the traditional version an individual pays the taxes at retirement, but in a Roth a participant pays the taxes when the contribution is made. Trying to figure out which option is a better retirement vehicle for an individual is not an easy analysis; however, assuming all else is equal and there are no changes in tax law, the longer the investment horizon, the better the Roth 401(k) option becomes. The shorter the investment horizon, the more likely the traditional 401(k) is the better investment.

There are a few drawbacks with having a 401(k) option only in a retirement program. First, the contribution limit for 2006 is one flat amount, regardless of whether you are a higher-paid or lower-paid individual. The limit is $15,000 (if the individual is over 50, he can defer up to an additional $5,000 for 2006). Second, unless a “Safe Harbor” plan design is chosen (see below) the higher-paid individuals may be limited to what they contribute unless the lower-paid individuals utilize the 401(k) plan.
The match feature of 401(k)s encourages employees to use the retirement program by “matching” their 401(k) deferrals with employer money. This can work with either a traditional or Roth 401(k). An example of an employer match would be a plan that matches 50% of the first 6% an employee defers into her account. So if an employee defers 6%, she receives a 9% contribution (6%of her own money and a 3% employer contribution). Similar to the401(k) option, a drawback to a match feature is that if the lower-paid employees do not participate, even with the match encouragement, the higher-paid employees may be restricted in regard to the amount they can defer and therefore be matched on.

Another common feature in a retirement plan is a profit sharing option. This option is a discretionary employer-paid contribution that is allocated equally across a reasonable classification of employees. One example of this may be that all employees receive a 6% profit sharing contribution. An alternative example could be that all shareholders receive a 10% allocation and all non-share-holders receive a 4% allocation. A plan that provides different allocation percentages to different classes of employees is called a cross-tested retirement plan. This type of plan must pass specific tests to make sure it doesn’t benefit the highly paid employees disproportionately compared to the lower-paid employees.

Many retirement plans combine a profit sharing option with a 401(k); it’s also possible to have a stand-alone profit sharing plan. Offering both the traditional 401(k) and Roth 401(k) options in a retirement plan represents little additional cost to the employer and allows for all employees to use the alternative that best fits their situation. Also, although the savings plan may allow for a match and profit sharing feature, there is no requirement to utilize them. Just having them as plan features adds a measure of flexibility for future use.

If your employees don’t utilize their 401(k) and the more highly paid employees (including owners) are limited in the amount of compensation they can defer, opting for a Safe Harbor plan design may be a good solution. A Safe Harbor plan provides a minimum of either a 3% profit sharing or a 4% match contribution to employees, and as a result it does not limit what higher-paid employees can defer (up to $15,000) to the retirement plan. This could really help shareholders of organizations that don’t have good staff participation in the retirement plan.