As a business owner, hiring and retaining employees who are loyal and become an integral part of the company dynamic is key. Providing these employees with more than just a paycheck may mean the difference between a business thriving and one that fails. The power of a qualified retirement plan helps business owners attract and keep those employees who make a significant impact on the success of the business.
Critical Key Employees
Key employees are critical to any business. When deciding which employees fall into that category, some questions to ask include:
- Does this employee contribute substantially to the success of the business?
- What would be the financial impact of losing this employee?
- Would a competitor want to lure this employee away from the business?
- What types of retirement plans are available to this employee from the business/competitors?
After finding employees that a business owner deems “key,” the next step is to create a qualified retirement plan available to these employees.
Qualified Retirement Plans – Tax Advantages
An employer-sponsored qualified retirement plan provides employees retirement benefits which meet specific rules, such as:
- Established by the employer exclusively for employees and their beneficiaries, all plans must be put in writing.
- Assets from the plan can only be used for the benefit of employees and their beneficiaries.
- Benefits or contributions may not exceed specified amounts.
- The plan must be available to all employees.
- Certain distribution amounts must meet certain requirements.
- Death benefits may be included, but only as incidental additions.
Overall, the ability to accumulate a substantial amount of money for retirement is the primary advantage of a qualified retirement plan. When compared to an employee trying to save with after-tax contributions, which are ultimately taxed each year, the before-tax contributions and tax-deferred growth are an enormous advantage to a qualified retirement plan.
Take a hypothetical employee who is in a 24% income tax bracket, over a 20-year period. For every $1,000 annual contribution to a qualified retirement plan, that employee would earn approximately $49,423 at an 8% before-tax annual rate of return.
If that same hypothetical employee invests in an after-tax plan (such as a Roth IRA) and earns a 6% after-tax annual rate of return, the total at the end of 20 years would only be $29,634. If the employee is in a higher income tax bracket, the amount becomes even less.
Some argue that the before-tax investment would become equal to the after-tax investment when the money is drawn out. However, if the hypothetical employee decides to take a lump sum at the end of the 20th year, at a 24% income tax rate, the final amount, once deducted from the lump sum amount, is $37,561. This is still thousands more than the after-tax investment.
Establishing a Qualified Retirement Plan
Whether a business is a sole proprietorship, partnership, or corporation, any business can set up a qualified retirement plan for their employees. This includes owner-employees.
The question then becomes what type of qualified retirement plan to implement: a pension plan or a profit-sharing plan.
- Pension Plan – A pension plan is established and maintained by an employer to provide payments of definitely determinable benefits to employees, usually for life, after retirement. By providing either a specified retirement benefit (defined benefit plan) or a specified annual contribution (defined contribution plan), the requirements of definitely determinable benefits are met.
- Profit Sharing Plan – A profit sharing plan provides flexibility of contributions and are designed to share profits from the company with employees. There is no definite predetermined formula, as in a pension plan, that specifies the amount of profits to be shared. Contributions may be determined on an annual or arbitrary basis.
Explaining a Defined Benefit Plans Formulas
A specified retirement benefit plan that promised a specific benefit is paid at retirement is known as a defined benefit plan. This promised amount can be a flat dollar amount provided to every employee, or a benefit determined by a specific formula.
- Flat Dollar Amount – Under this type of defined benefit plan, all plan participants receive the same amount at retirement regardless of position or annual salary.
- Flat Percentage – As a retirement benefit, this type of defined benefit plan pays plan participants a fixed percentage of compensation. For example, an employee receives an annual pension benefit based on 20% of the average compensation for three of the highest years paid equaling a $15,000 annual pension benefit for someone who made $75,000.
- Unit Benefit – Based on either a flat dollar amount or percentage of compensation for each year of service, a unit benefit can vary greatly in the amount paid. For example, someone who made $5,000 per month with 20 years of service might receive $25 per month for every year of service equaling $500 per month. That same employee, if receiving a 2% of monthly compensation for each year of service would net $2,000 a month.
The Advantages of a Defined Benefit Plan
For a business with older, higher paid employees, a defined benefit plan allows a business to shelter large amount of current business income and provide meaningful retirement benefits to older employees who are close to retirement.
The Disadvantages of a Defined Benefit Plan
A defined benefit plan requires a periodic annual review to determine the amount of contributions needed to provide the promised retirement benefits. The administration of this type of defined benefit plan can be complex.
In addition, an employer takes on the risk of how the investment will perform. If an investment performs less than the assume rate of return, an employer will need to increase contributions in order to provide the necessary funds for the promised retirement benefits.
Retirement benefits may seem expensive and a drain on company assets, but retaining key employees who will help a business grow are valuable.
The famous hotelier J.W. Marriott once said, “If you take care of your employees, they will take care of your customers and your business will take care of itself.” Taking care of employees begins with the end in mind…retirement benefits.