With unemployment at its lowest level in decades, many businesses are struggling to retain employees and fill vacancies. An attractive retirement or profit-sharing plan can help meet this challenge while also reducing a company’s tax liability. It can also help company owners accumulate wealth for their own retirement.
Qualified plans—those that meet the requirements of the Employee Retirement Income Security Act (ERISA) of 1974—allow companies to deduct their contributions and administrative costs, while their employees’ retirement accounts grow on a tax-deferred basis. If your company is ready to upgrade its retirement benefits to appeal to today’s tax-savvy workers, here are some of the most widely used qualified alternatives.
401(k) Plans
A 401(k) plan lets employees defer a portion of their salary on a pre-tax basis and invest in a menu of investment alternatives the plan offers. The employer may match some or all of the employee’s contribution, but is not required to.
Employee contributions are limited to $20,500 annually for the 2022 tax year ($27,000 for those ages 50 and older). In addition, a 401(k) plan can offer employees the option of making after-tax contributions that function like a Roth IRA, allowing tax-free withdrawals during retirement. Traditional 401(k) plans must pass several nondiscrimination tests to ensure they do not unduly benefit highly compensated employees.
Any business can establish a 401(k) plan, but the administrative costs can make it impractical for some small- to medium-sized businesses. To address this, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 introduced tax credits to help companies with 100 or fewer employees offset some of the startup costs. New rules also made it easier for smaller employers to pool their plans into a single, larger program and share the costs.
Another alternative for companies with 100 or fewer employees is a SIMPLE 401(k) plan. (SIMPLE stands for Savings Incentive Match Plan for Employees.) A SIMPLE plan can be easier to operate, but unlike a regular 401(k) plan it requires the employer to contribute annually and offers lower employee contribution limits. It also imposes other requirements that can add administrative burden.
Individual Retirement Accounts (IRAs)
Like SIMPLE 401(k) plans, SIMPLE IRAs are available only to businesses with 100 or fewer employees. Employees can make their own tax-deductible contributions, just as they do with conventional 401(k) plans or IRAs, but with a SIMPLE IRA the employer is required to contribute annually—either a matching contribution (up to 3 percent of the employee’s salary) or a nonelective contribution equal to 2 percent of the employee’s pay. This can be problematic for companies with fluctuating cash flows.
Employees’ annual contributions are limited to $14,000 for 2022 ($17,000 for employees ages 50 and over). These limits can diminish a SIMPLE IRA’s appeal as a recruiting tool or as a retirement vehicle for company owners.
Another variation, a Simplified Employee Pension (SEP) IRA, offers higher contribution limits and does not require the company to contribute every year. When the company does contribute, however, it must contribute equally to all eligible employees based on a percentage of each employee’s pay. For 2022, an employer can contribute as much as 25 percent of each eligible employee’s pay, up to a maximum of $61,000.
With a SEP IRA, only the company contributes—employees cannot make direct contributions, but they do maintain ownership and control of their individual accounts. Although they are available for any size business, SEP IRAs can be particularly advantageous for smaller companies that need flexibility in their annual contributions.
Profit-Sharing Plans
In addition to helping employees save for retirement, a qualified profit-sharing plan also gives workers a stake in the company’s success. Employees do not contribute, and the company has full discretion in choosing whether it contributes each year—even in years when there is no profit.
Employers can allocate their contributions proportionally based on salaries or choose among several formulas such as weighting their contributions to give older participants a larger allocation. Employer contributions are limited to an inflation-adjusted maximum of $61,000 per employee in 2022.
Defined Benefit Plans
Unlike defined contribution plans such as IRAs, profit sharing, and 401(k) plans, a defined benefit plan guarantees a specific payment upon retirement. This shifts the investment management choices—and the associated risks—to the employer, which is one reason why traditional pension plans are much less common today. Defined benefit plans are also more expensive to fund and administer, but they can offer older owners higher contribution limits to build retirement savings and shelter current income.
There are many variables to consider when establishing or updating a retirement program, and the tax deferment rules can be complex. Nevertheless, a qualified plan can attract and retain talented personnel by helping both employers and employees accumulate wealth for retirement.
Contact us to discuss the tax benefits a retirement plan can provide to your business.