Retirement Benefit Plans

A financially secure retirement is a goal of all Americans. Since many of us will spend one-fourth to one-fifth of our lives in retirement, it is more essential than ever to begin preparations at an early age. Many financial planners report that an individual requires about 75% of his or her pre-retirement income to maintain the same standard of living enjoyed during one's working years.

Social Security, employer-sponsored retirement programs and personal savings are the three sources of post-retirement income.

Social Security Benefits Social Security provides retirement benefits for most persons employed or self-employed for a set period of time (currently 40 quarters; about 10 years). Benefits paid at retirement, traditionally age 65, are based on a person's earnings history. The age at which you can retire at full benefits increases depending upon your current age. For younger individuals full benefits begin at about age 67. Payments may begin at age 62 at a reduced rate or, if delayed until age 70, at an increased rate.

For a person with earnings equal to the U.S. average, the benefit will be about 40% of pay. For someone with maximum earnings, the benefit would be about 25% of the portion of pay subject to Social Security tax.

TIP: Every worker should understand Social Security retirement benefits. By completing  Form SSA-7004, "Request for Social Security Earnings and Benefit Estimate Statement," you can receive a projection of benefits. Forms can be obtained through  Social Security Online, local Social Security offices or by calling 1-800-772-1213.   

Business Retirement Plans:

Depending on whether you are a sole proprietor, a partnership or a small corporation, the following plans are available: 

• Defined benefit — A retirement plan favoring older, more highly paid employees.
• Profit-sharing — A flexible plan based on profits and contributions that can be discretionary from year to year.
• Money purchase — A method that often favors younger workers. Steady plan contributions are required.
• Individual retirement accounts (IRAs) — A simple plan; allowing modest contributions.
• Simplified employee pension (SEP) — A plan for small businesses combining features of IRA and profit-sharing plans, offering flexibility and easy self-administration.
• 401(k) — The most popular plan today for businesses with employees, providing employees with the ability to save for their retirement with pre-tax dollars. Can be at low cost to employers.
• SIMPLE Plans – A new type of plan which combines IRA and 401(k) features.
• Stock bonus — Benefits in the form of company stock.
• Employee Stock Ownership Plan (ESOP) — Another plan based on company stock.

Designing the Right Corporate Plan Selecting the right pension plan for a corporation results from a process of identifying business needs and expectations, including 

• Need for flexibility.
• Current age of key employees.
• Current number of employees and plans for growth.
• Maximization of retirement benefits.

Although there are many different types of retirement plan options available to corporations, they fall into two general categories: defined benefit plans and defined contribution plans:

Defined Benefit Plans. With this plan, the benefits an employee will receive are predetermined by a specific formula — typically tied to the employee's earnings and length of service. The law allows a pension of up to $160,000 a year. This figure is indexed for inflation; the 2004 amount is $165,000. The employer is responsible for making sure that the funds are available when needed (the employer bears funding and investment risks of the plan).

Such a plan can provide larger benefits faster (through tax-deductible contributions) than other plans. The price of providing a higher degree of tax savings and being able to rapidly shelter larger sums of retirement capital is having to meet additional reporting requirements. Defined benefit plans typically cost more to administer, requiring certifications by enrolled actuaries, and insurance payments to the Pension Benefit Guaranty Corporation (PBGC), which may review plan terminations.

Defined Contribution Plans. Also known as individual account plans, defined contribution plans specify the amount of funds placed in a participant's account (for example, 10% of salary). The amount of funds accumulated and the investment gains or losses solely determine the benefit received at retirement. The employer bears no responsibility for investment returns, although the employer does bear a fiduciary responsibility to select or offer a choice of sound investment options.

TIP: Defined benefit plans are typically better for older employees (usually age 45+). For example, these plans can provide the ability to fund for years of employment before the inception of the plan. While some contribution flexibility is available, factors determining the cost of promised benefits (e.g., number and ages of employees, rates of return on investments) will mandate the level of required deposits to the plan. There are several basic types of defined contribution plans, including (1) simplified employee pension plans, (2) profit-sharing plans, (3) money purchase plans, (4) 401(k) plans, (5) stock bonus plans, (6) employee stock ownership plans, and (7) SIMPLE plans.

1.   Simplified Employee Pension Plans. Simplified Employee Pension Plans. A simplified employee pension (SEP) suits many small corporations. It requires no IRS approval, no initial filings and no annual reporting to the government. Although SEPs are called "pensions," they are actually IRAs, except that contributions to them aren't subject to the IRA dollar limits. The total deferral each year can be up to $40,000 (indexed; the 2004 amount is $41,000) or 25% of annual earnings, whichever is less. There is also a limit on how much of your earnings may be included in the percentage computation.

Contributions must be made on a nondiscriminatory basis to all employees who are at least age 21 and who have worked for any part of three of the past five years earning a minimal amount. Contributions can vary from year to year — you may even skip entire years. To be deductible for a year, contribution must be paid no later than the due date of an employer's income tax return for the year, including extensions. Once made, the entire contribution is owned by the employee.

TIP: Complete specifications for the plan can be found in IRS Form 5305. The form itself serves as the plan document, requiring only the insertion of business name, the checking of three boxes and a signature. The form is not filed with the IRS, but rather copied for all employees and then placed in the firm's files. Many employers instead use plan documents provided by financial institutions. 2.   Profit-Sharing Plans. Similar to a SEP, a profit-sharing plan offers the flexibility of making contributions — up to the lesser of $40,000 (indexed; the 2004 amount is $41,000) or 25% of compensation.

TIP: Alternatively, rather than selecting a percentage, a flat amount (for example, $100,000) could be allocated among eligible employees, generally proportionate to compensation. Historically, contributions were paid out of profits; this is no longer required. Profit-sharing plans differ from SEPs in several distinct ways. An employer can apply a vesting schedule to the company's contributions, based on an employee's length of service with the company after the contribution is made. If an employee is terminated before becoming "fully vested," his or her funds will revert to the plan (reducing future contributions) or be reallocated among the remaining participants. In addition, profit-sharing plans permit the exclusion of part-time employees, and can allow participants to borrow from the plan.

Profit-sharing plans, as all other qualified retirement plans, require the preparation of formal master documents as well as annual tax filings. A standardized master or prototype plan will often satisfy requirements and will typically be less expensive and simpler to set up and operate than an individually designed plan.

3.   Money-Purchase Plans. With a money purchase plan, the employer is usually committed to making annual contributions equal to a designated percentage of each employee's compensation. This percentage may not exceed 25% of compensation, with a maximum contribution of $40,000 a year (indexed; the 2004 amount is $41,000). Contributions must be made even in years in which there are no profits.

4.   401(k) Plans. These tax-deferred savings plans have become highly popular in recent years. The basic idea of a 401(k) is simple: it is a profit-sharing plan adopted by an employer that permits employees to set aside a portion of their compensation through payroll deduction for retirement savings. The amounts set aside are not taxed to the employee and are a tax deductible business expense for the employer. Set-asides (called "elective deferrals") for any employee can't exceed $12,000 for 2003, $13,000 for 2004, $14,000 for 2005 and $15,000 in 2006 and after. Elective deferrals don't count in figuring the employer's deduction limits. Thus, the employer's contribution up to the profit-sharing deduction limit, plus the elective deferral, are tax-sheltered.

An employer's discretionary matching contribution can provide incentive for employee participation as well as serve as an employee benefit. Employer contributions can be capped, to limit costs, and a vesting schedule can be applied to employer deposits (employees are always 100% vested in their own contributions).

For employees, the opportunity to reduce federal — and often state and local — taxes through participation in a 401(k) plan offers significant benefits. While savings are intended for retirement, certain types of loans can provide employees with access to their funds — employees repay borrowed principal plus interest to their own account. 

CAUTION: Special non-discrimination tests apply to 401(k) plans, which may limit the amount of deferrals that highly compensated employees are allowed to make. To avoid these limits, some employer contribution on behalf of lower-paid employees may be required. 
5. Stock Bonus Plans. This is similar to a profit-sharing plan. The plan invests in employer stock, which is generally distributed to participants at retirement. 

6. Employee Stock Ownership Plans. A special breed of qualified plan, an employee stock ownership plan (ESOP), provides retirement benefits for employees. In addition, an ESOP can be used as a market for company stock, for financing the company's growth, to increase the company's cash flow or as an estate planning tool. 

ESOP funds must be primarily invested in employer securities. ESOPs are stock bonus plans or stock bonus combined with money purchase plans. Tax deductible contributions to the plan are used to buy stock for eligible employees. On retirement, the employee may take the shares or redeem them for cash. Complicated rules must be adhered to in the establishment and maintenance of an ESOP plan. Expert advice should be sought. 

7. SIMPLE Plans. Employers with 100 or fewer employees can establish "Simple" retirement plans. The Simple combines  the features of an IRA and a 401(k). Employees can contribute to the Simple, pre-tax, and the employer must make a matching contribution (usually less than the employee's). The limit on the employee's contribution is $8,000 in 2003, $9,000 in 2004, and $10,000 in 2005 and after. The penalties for withdrawing money from the Simple before age 59-1/2 can be higher than with other plans. 

Plans Available to Non-Corporate Employers 

Non-corporate employers can adopt any of the plans listed above that corporate employers can, except, of course, those based on stock in the employer corporation (stock bonus and ESOP plans). Defined benefit, profit-sharing, money purchase and 401(k) plans sponsored by noncorporate employers — that is, self-employed persons — who participate in the plans are often called "Keogh plans. 

Contribution limits for unincorporated businesses are the same as for corporate plans of the same type, except for contributions on behalf of the self-employed owner — sole proprietor, partner or LLC member, who for this purpose is treated as an employee. Contributions for a self-employed owner are based on the owner's self-employment net earnings. The contribution ceiling for money purchase, profit-sharing and SEP plans are the same: in effect, 20% of earnings (technically, 25% of earnings reduced by the contribution) up to a maximum contribution of $40,000 (indexed; the 2004 amount is $41,000). For defined benefit plans, a self-employed owner's benefit is based on self-employment net earnings less deductible contributions. 

In plans such as 401(k)s or SIMPLEs where employees defer part of their salary, self-employed owners are deferring part of their self-employment earnings. For employees, deferred salary is excluded from taxable pay; for self-employed owners, deferred self-employment earnings are deducted. 

Keogh plans, like comparable corporate plans, must be established by the end of the year (December 31) for which you are making the contribution. Once established, you have until your tax return filing date - including extensions - to make the contribution. 

SIMPLEs generally must be established by October 1 of the year they go into effect. 

A SEP may be established by the tax return due date, including extensions, for the year it goes into effect. Thus, a plan effective for 2004 can be created in 2005; contributions to that plan in 2005 will be deductible on the 2004 return if designated as for 2004 and made by the 2004 return due date including extensions.

Employee contributions. These are important elements of many employer plans, allowing employees to make their own tax-sheltered investments within the company plan. 

In many cases such contributions are "pre-tax"—that is, from salary (reducing taxable pay), as in the case of 401(k)s, SIMPLEs, and certain SEPs, called SARSEPs, formed before 1997. Pre-tax "employee" contributions can also be made by self-employed owners, in which case they reduce taxable self-employment earnings. The ceilings on such contributions are discussed above (SARSEP and 401(k) ceilings are the same). 

Additional pre-tax contributions are allowed for participants age 50 or over. The ceiling amount of such contributions, called "catch up" contributions (misleadingly, since the amount or lack of prior contributions is irrelevant), for 401(k)s and SARSEPs is $2,000 for 2003, $3,000 (2004), $4,000 (2005) and $5,000 (2006 and after). For SIMPLEs, these amounts are halved ($1,000 for 2003, etc.). 

Employee contributions may also be after-tax. That is, they are not excludable (where made by employees) or deductible (where by self-employed owners) but still grow tax-free once invested, until withdrawn. The contributions come back tax-free; only the earnings are taxed. 

Employee after-tax contributions may be attached to a plan, such as a 401(k), or be to a standalone plan (maybe called a savings plan) for employees' contributions alone, or with some employer match. 

Credit for low-income participants. "Lower-bracket" taxpayers age 18 and over are allowed a tax credit for their contributions to a plan or IRA. Credit is allowed on joint returns of couples with (modified) adjusted gross income (AGI) below $50,000, heads-of-household below $37,500 and others (singles, married filing separately) below $25,000. Credit is a percentage (10%, 20%, 50%) of the contribution, up to a contribution total (considering all contributions to all plans and IRAs) of $2,000. The lower the AGI, the higher the credit percentage: the maximum credit is $1,000 (50% of $2,000). 

Credit is allowed whether the contribution is pre-tax (credit is in addition to a deduction or exclusion) or after-tax. 

Review plan decisions. Law changes in the recent past, and changes described above that are scheduled to become effective in 2004 and after, suggest that business owners should reconsider the type of plan they provide. Plans most affected are: 

• Money purchase plans. Profit-sharing plans can now shelter as much as money purchase plans, without having to make the commitment (required by money purchase plans) of regular, determinable contributions each year.
• 401(k) plans can be made richer than regular profit-sharing plans, where the employee contributes (defers) the maximum (up to $12,000 in 2003, higher later) and the employer contributes the maximum (up to 25% of employee pay).
• Defined benefit plans can be funded faster with tax-deductible contributions, and funded more richly, up to a higher  annual pension. In specific cases this can make them preferable to other plans.
• Contributions or benefits for higher income participants, including owners, can be increased since rules against plan  discrimination in their favor have been eased.

Those lacking tax-favored retirement plans should give plan adoption a new look. Those with such plans already should review the options, and what's required to take advantage of them. Professional guidance is essential and, as pointed out above, encouraged by the law. 

Individual Retirement Accounts. An employer may establish IRAs for its employees to which the employees contribute,  though this is not usual. Effective starting in 2003, an employer will be able to establish IRAs for employees within an employer plan. But virtually all IRAs are set up by the individual worker, employed or self-employed (occasionally for the worker's spouse) without involvement of any employer. 

An IRA is a tax-favored savings plan that allows workers to make contributions with pre-tax dollars (where deduction is allowed, see below) and defer taxation on earnings until retirement. 

There are several limitations to IRAs: 

• Contributions for 2003 and 2004 cannot exceed the lesser of $3,000 per year or 100% of compensation ($6,000 for a couple), rising to $4,000 for 2005-7 (couples $8,000), and $5,000 (couples $10,000) for 2008 and after. Additional "catch-up" contributions are allowed persons age 50 or over, of $500 (2003-5) and $1,000 (2006 and after).
• Contributions may be made only up to age 70 1/2.
• The account holder may not use funds to purchase life insurance or collectibles (except gold or silver coins issued by the U.S. Government).
• IRA contributions up to the ceiling are deductible if neither the taxpayer nor his or her spouse is covered by a corporate or unincorporated retirement plan. Deduction is limited (phases out) at prescribed income levels (which increase each year) where the taxpayer is covered by a plan or where (using higher levels) the taxpayer's spouse is covered though taxpayer is not. Nondeductible contribution is allowed in other cases, including contribution to Roth IRAs. Also, low-income taxpayers are allowed the up-to-$1,000 tax credit described above (under Employee Contributions) for IRA contributions. For details on Roth IRAs and how they compare to other retirement IRAs (called traditional IRAs), see the Financial Guide: ROTH IRAS: How They Work And How To Use Them.

Where To Get Pension Information The variety of plans and related regulations are numerous. You should consult with your professional advisors regarding which options are available to you and which one best first your company’s needs.

Questions To Ask Before Finalizing a Pension Plan

1. Does the plan require a given level of contribution each year?
2. Do the plan provisions (eligibility, hours of service and vesting of employer contributions) meet current and future needs?
3. What are the costs of establishing and administering a plan and trust, including providing annual employee reports?
4. What are the investment options offered?
5. Are there any loads (charges) associated with deposits (front-end charges) or surrenders (rear-end charges) from the plan?
6. Can — and should — employees make individual investment selections? What types of reports do participants receive?

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