Offering a retirement plan is often necessary for a business to attract and retain the best employees. There are seven major types of retirement plans utilized by companies:
- Defined Benefit Plans
- Defined Contribution Plans
- Profit Sharing Plans
- 401(k) Plans
- Roth 401(k) Option
- Simplified Employee Pension Plans
- SIMPLE Retirement Plans
Determining which type is best for a business is important when attracting and retaining key employees. Each plan offers different benefit features, but all allow for employees to save for retirement.
Defined Benefit Plans
As suggested by the name, a defined benefit plan spells out the benefit that is paid at retirement. This specific amount can be a flat dollar amount or a formula generated benefit.
- Flat Dollar Amount – Every plan participant receives the same dollar amount at retirement. For example, a retiree would receive $300 per month for life.
- Flat Percentage – A fixed percentage is received by each plan participant as a retirement benefit. For example, an employee would receive 25% of their average salary for the last three years of work. An employee who made $100,000 yearly for the last three years of work would receive an annual pension benefit of $25,000.
- Unit Benefit – Based on the number of years, a flat dollar amount or percentage of salary is paid for every completed year of service. For example, a $70 monthly pension payment would be paid for all employees who completed 30 years of service.
Defined Contribution Plans
In this type of plan, the employer makes a predetermined annual contribution to a defined contribution plan. Then, the amount is invested into the plan participants’ accounts on their behalf. At retirement, the benefit amount is based on the value of the account at retirement.
Profit Sharing Plans
The contributions to a profit sharing plan may vary by amount from year to year. Therefore, there is no definite determinable benefit as in other plans. Although the employer is not required to make yearly contributions to the plan, substantial, recurring contributions are required in order for the plan to remain a qualified retirement plan.
How the contributions are determined are specified in the profit sharing document. There is significant flexibility available in a profit sharing plan. Yearly contributions might be based on a specific percentage of net profits, or they may be equal to an amount determined by a board of directors yearly, or even an amount equal to an amount that exceeds profits by a specified dollar amount.
One of the most common profit sharing plans is a 401(k) plan. Under this plan, employees choose between being taxed on current compensation or deferring the tax and making a contribution on a 401(k) through a cash or deferred arrangement (CODA). Commonly, employers match contributions up to a certain percentage.
Additionally, a 401(k) plan can provide for employer profit sharing contributions and allocated to the accounts of all plan participants in a uniform, non-discriminatory manner. Usually, plan participants are able to allocate their contributions between the varied investment alternatives that are available in the plan. Based on the value of the participant’s account value at retirement, the retirement benefit is set.
Contributions to 401(k) plans usually comes from three sources:
- Salary Reduction – An employee agrees to a salary reduction where the employer contributes to the plan on behalf of the employee. In return, the employee is able to eliminate the deducted amount from current income.
- Matching Employer Contribution – Agreeing to match a percentage of an employee’s salary deferral, the employer typically matches each dollar deferred by the employee, up to a certain maximum amount.
- Profit Sharing Contribution – A profit sharing contribution, made by the employer, may be taken in cash, deferred to the 401(k) plan, or a combination of the two by the employee.
Roth 401(k) Option
The Roth 401(k) option allows employees to contribute a portion or all of their 401(k) salary deferrals to the Roth 401(k) account. Similar to a Roth IRA that uses after-tax dollars toward contributions, a Roth 401(k) also uses after-tax dollars. This means that the account grows tax-free and qualified distributions at retirement are received free of federal income tax.
In order to be deemed a qualified distribution, the Roth 401(k) account must be established for more than 5 years, the plan participant must be aged 59 ½, is disabled or deceased, or the funds are used toward the purchase of a first home.
Additionally, participants may be able to roll over all or part of a regular 401(k) into a Roth 401(k) account inside of the plan. Federal income tax must be paid on the rolled over amount in the year the rollover takes place, but any qualified distributions will be received income tax-free.
Simplified Employee Pension Plans (SEPs)
With fewer IRS reporting and disclosure requirements, a SEP is easier to administer than many other types of retirement plans. Consisting of an employer-funded individual account, a SEP is provided for each participating employee. On an optional basis, the employer makes contributions.
Each employee who participates must have an individual retirement account (IRA). Then, the employer makes contributions up to certain specified limits. A SEP cannot discriminate in favor of employees who are highly compensated. All contributions are deductible by the employer. The employee’s current income is excluded from any contributions. Therefore, an employer provides the IRA for every employee who participates and allows for higher contribution limits than traditional IRAs.
SIMPLE Retirement Plans
A Savings Incentive Match Plan for Employees (SIMPLE) retirement plan is for businesses with 100 or fewer employees. A SIMPLE allows employees to defer a portion of their salary to a retirement plan on a before-tax basis. In addition, employers must match contributions up to a certain amount.
There are two types of SIMPLE plans:
- SIMPLE IRA Plan – Employees own the IRA and make elective salary deferrals up to a certain maximum amount. Generally, the employer is required to match the employee’s deferral up to 3% of the employee’s compensation. However, instead of matching any employee contributions, an employer may elect to contribute 2% of an employee’s compensation amount with at least $5,000 in compensation.
- SIMPLE 401(k) Plan – Operating much like a regular 401(k), the SIMPLE 401(k) plan complies with specific vesting and contribution requirements. However, an advantage to an employer that chooses to adopt a SIMPLE 401(k) plan, they do not have to comply with particular 401(k) plan nondiscrimination or top-heavy rules.
Based on an employer’s desires for current employees, there are many different plans to choose from to provide employees with retirement options that will best suit their retirement needs.