The Best Plan to Drive Your Retirement Needs



Excuse me, can you tell me what kind of car is best for
me? It is impossible to answer that question without getting more information…how
will the car be used? What is the budget? For fuel efficiency and driving in a
crowded downtown area, maybe a Smart Car is best. Hauling heavy loads of
construction materials? Perhaps a truck makes sense. Have kids that need to be
shuttled from one activity to another? Maybe the less-stylish but
ever-so-practical minivan is the perfect solution.

The same is true when selecting a retirement plan. Although there aren’t as
many makes and models, there are some significant variables, and the most
appropriate option depends on some of the same factors. How will you use the
plan and what is your budget?

Lease or Purchase?

There are two general categories of retirement plans: defined benefit and
defined contribution. Unlike “crossover SUV,” these names give a pretty good
indication of the fundamental characteristics of each. Here is a quick summary.

Defined Benefit (DB) Plan

A DB plan specifies the benefits provided to each participant at retirement
via a formula that considers items such as compensation and length of service
such as 1% of average pay for each year of service. Each year, an actuary
calculates the benefits due each participant, determines how much money is
needed to fund those benefits and compares that amount to actual asset levels to
arrive at how much the company must contribute. A DB plan is kind of like buying
a car…you commit to making the payments over a period of years until your
obligation is paid.

Defined Contribution (DC) Plan

A DC plan sets parameters for the amount that employees and the company
contribute each year. Add investment gains or losses to determine the amount of
retirement benefits each employee ultimately receives. Think of a DC plan as a
series of one-year leases…the participants and the company decide each
year (and sometimes more often than that) how much to contribute, and whatever
is done in one year can be changed the next year.

DB plans allow for larger benefits (as much as $200,000+ per year), but the
fixed nature of the contributions makes them a bigger commitment. DC plans offer
greater flexibility and discretion in determining annual contributions, but the
maximum annual contribution is capped at the lower of $53,000 or 100% of pay per
employee. Although it is not uncommon for companies to sponsor both DB and DC
plans, the remainder of this article will focus on DC plans.

The Car Lot

In addition to the well-known 401(k) plan, Congress created several other
types of DC plans. The Simplified Employee Pension (SEP) and the Savings
Incentive Match Plan for Employees (SIMPLE) are meant to be easy for small
businesses to set up and maintain. The SIMPLE comes in two models—the
SIMPLE IRA and the SIMPLE 401(k).

As with different types of vehicles, these different plan types are suited to
different purposes. SEPs and SIMPLEs require minimal documentation, no annual
testing and limited (if any) ongoing government filings; however, they also
impose more limitations than other plans.

The 401(k) plan, which is really a profit sharing plan with the employee
contribution package added, offers maximum flexibility. There is also the 403(b)
plan for not-for-profit organizations which is similar to a 401(k) plan but has
its own nuances not addressed in this article.

Let’s take a look at some of the specific differences. Keep in mind that
these descriptions are meant to be general. There are exceptions to many of
these general rules, but you would be reading for as long as a cross-country
drive if they were all covered here.

Compact or Full Size?

Employers of any size can implement SEPs and 401(k) plans; however, SIMPLE
plans are only available for companies with 100 or fewer employees with at least
$5,000 in compensation during the immediately preceding calendar year.

One-Car Garage

A SIMPLE plan must be the only plan a company maintains in a given calendar
year. This most often comes into play when a company decides to transition from
a SIMPLE to a regular 401(k) plan. Such a transition can only occur at the
beginning of a subsequent year, and employers must generally provide the
employees with advance notification of the discontinuance of the SIMPLE. So if
you are considering a transition, you generally need to get started no later
than October 1st to prepare for the upcoming year.

There is no similar requirement that applies to other plan types, so
employers can maintain multiple plans or transition from one type to another
without concern for the “exclusive plan” requirement.

Eligibility

401(k) plans and SIMPLE 401(k) plans are allowed to have eligibility
requirements as strict as attainment of age 21 and completion of one year of
service (a 12-consecutive-month period in which an employee works at least 1,000
hours).

By contrast, neither SEPs nor SIMPLE IRAs can limit eligibility the same way.
In a SIMPLE IRA, the maximum is to limit eligibility to those employees who
earned at least $5,000 in compensation in the two prior years and are expected
to again in the current year.

SEPs can limit plan coverage to those employees who have earned at least $600
in compensation in at least three of the last five years. There is no ability to
exclude short service employees—interns, etc.—if they meet these
requirements.

Employee Deferrals

Salary deferrals are generally not allowed in SEPs. SIMPLEs and 401(k) plans
allow deferrals but there are some critical differences. First, a 401(k) plan
allows deferrals up to $24,000 per year ($18,000 plus an additional $6,000 for
those age 50 or older). A SIMPLE caps deferrals at $15,500 ($12,500 plus
$3,000)…a whopping $8,500 less. For a business owner seeking to maximize his or
her deferrals, the tax savings alone can more than offset any additional cost of
having a regular 401(k) plan.

Another important difference is that SIMPLE plans do not allow Roth
deferrals, which could limit the plan’s utility as an estate planning tool.

Matching Contributions

SIMPLE plans require a company contribution, which can be either a match or
profit sharing contribution. For the match the required formula is 100% of the
first 3% deferred, and no additional matching contributions are permitted.

A 401(k) plan can include a discretionary matching feature, allowing the
company to decide each year whether to make a match and, if so, how much. Since
SEPs do not allow deferrals, they also do not provide for matching
contributions.

Profit Sharing Contributions

The profit sharing version of the SIMPLE must be 2% of compensation for each
eligible employee. No additional profit sharing contributions are permitted.

SEPs and 401(k) plans allow discretionary profit sharing contributions of up
to 25% of pay in total. That discretion provides business owners with
flexibility as to if/how much they wish to contribute.

With a SEP, each employee must receive a uniform contribution (as a
percentage of pay). So, if the owner contributes 10% of pay for him or herself,
each employee must also receive 10% of pay. In a 401(k) plan, there is much
greater flexibility to provide larger contributions to those who earn more than
the taxable wage base (referred to as Social Security integration) or target
contributions based on job classification, e.g. owners and non-owners.

Vesting

A 401(k) plan can impose a vesting schedule of up to six years on employer
contributions; however, both SIMPLEs and SEPs require employees to be
immediately vested in all company contributions.

Loans and In-Service Withdrawals

Neither SEPs nor SIMPLEs allow participant loans like 401(k) plans do. If a
participant takes an in-service withdrawal from a 401(k) plan prior to age 59½,
it is subject to regular income tax as well as a 10% early withdrawal penalty.
SEP distributions are taxed similar to distributions from a regular IRA and
those rules generally resemble the 401(k) rules. For a SIMPLE, however, if
withdrawals are made within the first two years of participation, the 10%
penalty is increased to 25%!

Plan Documents

All of these plans require some documentation of the provisions. For SEPs and
SIMPLEs that truly keep it simple—little (if any) creativity in plan
design, no related companies or complex ownership structures, etc.—the IRS
has forms that are allegedly DIY: Form 5305-SEP; Form 5304-SIMPLE (each employee
selects his or her own financial institution); and Form 5305-SIMPLE (the
employer selects a single financial institution for all accounts).

A 401(k) plan (or a SEP/SIMPLE that cannot use the IRS form) must use a more
traditional plan document which can follow an IRS pre-approved format, such as a
prototype, or be individually customized. Some organizations offer DIY
prototypes which may look straightforward on the surface; however, given the
importance of the plan document, it is highly recommended that you work with
someone with expertise in that area.

Annual Compliance Testing

SEPs and SIMPLE IRAs are not required to go through the battery of annual
compliance tests. However, as we have described in this article, there are
plenty of rules that must be monitored to ensure ongoing compliance.

SIMPLE 401(k) plans are required to satisfy the minimum coverage test but are
exempt from most of the other tests normally associated with retirement plans. A
traditional 401(k) plan must comply with a series of tests to ensure enough of
the rank-and-file employees are receiving adequate benefits but, given the added
flexibility of plan design, the testing can be a trade-off that is well worth
it.

Government Reporting

Similar to annual testing, neither the SEP nor the SIMPLE IRA is required to
file a Form 5500 each year, whereas both the SIMPLE 401(k) and the “regular”
401(k) must do so. In addition, they must file Form 8955-SSA to report former
employees with remaining balances in the plan.

Conclusion

Similar to Smart Cars, SUVs and luxury sedans, each type of plan suits
different needs. SEPs and SIMPLEs can be extremely effective tools for meeting
the retirement plan needs of small businesses that want to offer a plan but
don’t have the bandwidth to deal with details; however, those plans also offer
less flexibility.

A 401(k) plan offers many more optional add-ons but comes with more involved
maintenance. At the end of the day, it is important to first understand the
goals for the plan and then select the option that fits best and can adapt with
your business over time. Regardless of how simple or complex your needs, working
with an experienced professional is invaluable to the decision-making process.

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