Business owners shouldn't neglect setting up retirement plans

Dollars & Sense

November 09, 2003|By Sue Stevens | Sue Stevens,MORNINGSTAR.COM

It's easy to neglect setting up a retirement plan when you own a business. With so many administrative tasks - payroll taxes, health insurance benefits, bookkeeping - adding one more benefit might seem overwhelming.

But retirement creeps up on you much faster than you'd expect. Setting up a retirement plan is essential, and the sooner, the better.

What are your options?

The first step is understanding the pros and cons of the plans available to you. A lot has changed since the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Details on all of these plans can be found in IRS Publication 560. Think about your own situation as you consider the following:

Simplified Employee Pension (SEP):

What is it? A retirement plan that uses an IRA as a funding vehicle.

How do you set one up? Either you or your employee opens an account with a fund company, brokerage, bank, or other financial institution. You have until the due date of your tax return (including extensions) to set up the accounts.

How much can the employer and employee contribute? The employer can contribute up to the lesser of 25 percent of employee compensation (up to a compensation maximum of $200,000) or $40,000 to each participant account. The employer can deduct a maximum of 25 percent of the total compensation paid or accrued during the year to eligible participants in the plan. The employee can also contribute subject to the regular rules regarding IRAs. As an employer, you are not required to make a contribution every year. When you do make a contribution, it can't discriminate in favor of highly compensated employees.

Pros: Easy and cost-efficient to set up and maintain. Annual employer contributions are discretionary. No annual IRS forms to file. Contributions can be made after plan year-end (up until tax-filing deadline). Employee has investment responsibility for his or her own account.

Cons: Must cover all employees, even part-time. No loans allowed. Can contribute more through other types of plans.

Profit sharing plan:

What is it? A qualified retirement plan that allows an employer to make flexible, discretionary contributions on behalf of employees.

How do you set one up? You need a written plan. You can get one from an outside administrator or you can adopt a prototype plan at most mutual fund companies, banks, or brokerages. The plan has to be in place by the end of the calendar year.

How much can the employer and employee contribute? The employer can contribute up to 100 percent of compensation (up to a max of $200,000) or $40,000 (whichever is less) to each participant account. The employer can deduct a maximum of 25 percent of the total compensation paid or accrued during the year to eligible participants in the plan. The employee cannot make his or her own contributions to the plan.

Pros: Flexible employer contributions - you don't have to contribute every year. Employee has investment responsibility for his or her own account.

Cons: More filing requirements for employer. No employee contributions. Can contribute more in other types of plans. Plan has to be set up by year-end.

Money purchase plan:

What is it? A qualified plan that sets a fixed percentage contribution that must be met every year.

How do you set one up? You need a written plan. You can get one from an outside administrator or you can adopt a prototype plan at most mutual fund companies, banks, or brokerages. The plan has to be in place by the end of the calendar year.

How much can the employer and employee contribute? The employer can contribute up to 100 percent of compensation (up to a max of $200,000) or $40,000 (whichever is less) to each participant account. The employer can deduct a maximum of 25 percent of the total compensation paid or accrued during the year to eligible participants in the plan. Employees cannot make their own contributions to the plan.

Pros: There's not much reason to set up this type of plan anymore. It used to be that you needed this plan (paired with a Profit Sharing Plan) to be able to get to a 25 percent contribution of compensation. Since EGTRRA, you can get to 25 percent with just a Profit Sharing Plan or a SEP-IRA.

Cons: Required employer contributions. Once you set your contribution percentage, you must make contributions. More filing requirements for employer. No employee funding. Can contribute more through other types of plans.

401(k) plan:

What is it? A qualified retirement plan that allows for salary deductions for employees and matching contributions for employers.

How do you set one up? Traditional third-party plan administrators can design a plan or you can go to one of the newer online providers.

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