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The phrase “retirement plan” may send you into a panic attack, but setting one up for you and your employees is an important way to ensure that your people (and yourself) are taken care of in the long run. Let’s push through the panic and get you started with some retirement plan basics.
Our goal here is to give you some base-level familiarity with retirement accounts. This article can prepare you for a future conversation with a financial advisor who has your own best interest at heart (the legal term for this is fiduciary duty). Retirement plans should be custom-fit to your needs, your employees’ needs, and the available resources of your business.
We’ll talk about a few commonly-used retirement plans after briefly mentioning the most common retirement plan from 50 years ago.
How Retirement Used to Look: The Pension
Pensions: where did they all go? Except for the military and other government jobs, pensions in America have gone the way of the dinosaur. We can speculate about why this has happened: increased life expectancy, the changing nature of the relationship between employer and employee, or perhaps the difficulty for a company to maintain a regular pay-out during lean times.
Pensions are also known as defined benefit plans because the benefit to the employer is set in stone: each employee who works for at least X years at Y employer gets $Z per month, starting from a specified age and lasting for the rest of the employee’s life.
The other thing to know about pensions is that we do not recommend that you set up a pension for your employees! Trust us, you don’t want to be in the position of being sued because you can’t afford to pay your retirees’ pensions. The worst time to get sued is when you’re already low on funds.
The New Reality: Plans That Have Balances
Generally, today’s retirement accounts work like savings accounts. Accounts have a balance that hopefully grows more than it declines, snowballing over time with contributions by the employee and possibly also the employer. As opposed to pensions, these accounts can run out!
Retirement accounts that are not pensions are called defined contribution plans.
Defined contribution plans have many things in common, but here are some major attributes that will help you to distinguish them:
Is it tax-deferred?
Many retirement accounts are tax-deferred, meaning that the money you put into them goes in untaxed and is taxed later (sometimes decades later). The two major benefits of tax-deferred plans are:
- The balance can grow faster because every percentage gain is based on a higher starting point. Gains build on each other over time, much like compound interest.
- People who earn most of their income as employees often expect to retire in a lower tax bracket than the bracket they are in during their working years. This would translate to permanent tax savings!
There is a disadvantage: If you expect to still be working at an age where you’ll also be drawing retirement benefits, you may be at the top of the corporate ladder and hence in a higher tax bracket than you were in when you made the contributions so many years ago…at least until you retire.
Does the employer contribute?
Another critical consideration with employer retirement plans is whether, how, and how much the employer will contribute to the employees’ plans. If the employer contributes, it’s generally a percentage of income: 2 to 6 percent of wages is typical.
Employer contributions are sometimes automatic (they contribute the money regardless), but often the employer will match the employee’s contribution. For example, if the employer matches 3% of your contribution, it behooves the employee to max out your contributions. This basically earns them a “free” 3% of their wages into retirement.
What are the contribution limits?
Retirement accounts have contribution limits, often with a catch-up provision for employees closer to retirement (based on age).
What happens if you pull money out early? (Can you pull out money early?)
Retirement accounts also differ regarding whether you can pull money out early, and what happens when you do. Generally there is going to be a penalty if you pull money early unless your withdrawal falls under a specified exception.
Without further ado, let’s get right to the plans!
You almost can’t have an article about retirement without mentioning the 401(k). You probably recognize the term, but do you know all the details?
Before getting started, it’s important to note that 401(k) plans are more complex and more expensive to establish and administer than the simpler plans you’ll see further below. A good rule of thumb is this: If you don’t have any dedicated HR employees, then it may be best to wait until your company grows in size before signing up for a 401(k).
401(k) fast facts:
- Investments are tax-deferred.
- Typically the employer matches or contributes to employee accounts.
- Contributions are limited to $19,500 for 2020, plus up to $6,500 catch-up for employees over age 50. These amounts are subject to change for 2021.
- Generally, once the money is in your 401(k) you cannot withdraw it before retirement age.
- One way to access your funds is by taking out a loan from your 401(k). Keep in mind that this means you will be paying interest to your employer in order to access your own retirement funds!
There are other plans similar to the 401(k), namely the 403(b) and 457 plans. We will not be covering the differences here for the sake of brevity; just note that the 403(b) is designed for non-profits and the 457 is for government employees.
The SIMPLE IRA
The SIMPLE plan is far less complex than the 401(k), and is only for organizations with fewer than 100 employees. SIMPLE stands for “Savings Incentive Match Plan for Employees,” a good general description for the plan. This plan is much like a 401(k).
SIMPLE IRA fast facts:
- Investments are tax-deferred.
- Employers can choose to match, with the option of contributing 2% of employee wages automatically or match for up to 3% of wages.
- Contributions are limited to $13,500 for 2020, plus up to $3,000 catch-up for employees over age 50. These amounts are subject to change for 2021.
- There is an early withdrawal penalty of 10 or 25% if you pull your money out early, with few exceptions. The 25% penalty applies if you’ve been on the plan for under 2 years.
There is a SIMPLE 401(k) plan that does allow loans from the retirement balance if “no loans” is a deal-breaker for you.
The SEP IRA
The SEP (Simplified Employee Pension) IRA is a bit of a misnomer – it’s not like the pensions we discussed above. SEP plans are defined contribution plans because they’re all about the employer contributing specified percentages of wages into employee accounts.
As opposed to the 401(k) or the SIMPLE IRA, the SEP IRA does not have an employee matching option. The SEP is all about contributing the same percentage of wages to every employee’s account at the same time that you contribute to your own account.
The major benefit of a SEP IRA is flexibility. You don’t have to contribute money every year if business is down, but you can contribute quite a lot during a good year.
Fast facts about the SEP IRA:
- Investments are tax-deferred.
- The employer sets a contribution percentage every year at their discretion.
- Contributions are limited to 25% of wages up to $57,000 for 2020.
- There is a 10% early withdrawal penalty if you pull your money out early, with a few exceptions such as up to $10,000 for a first-time home purchase or withdrawals for health expenses.
TL;DR: Two of the best employer-sponsored retirement plans for small businesses with employees are the SIMPLE IRA and the SEP IRA, depending on how much you want to put into your own account and whether you want the option to match employee contributions. You probably don’t want a 401(k) plan unless you have a dedicated HR employee to help administer it. Choosing an old-school defined benefit pension plan for your people would be questionable at best.
Want to speak with a CPA to discuss a retirement strategy for yourself and/or your employees? That’s what we do! Use our calendar to schedule a short meeting.