Plan Sponsor Considerations

As a Business Owner selecting and implementing right Employer Retirement Plan can be a challenge. Let Prosperity Advisors help you evaluate and decide options best fits your company and your employees.

Simplified Employee Pension (SEP) plans

SEPs can be used by businesses regardless of tax structure and number of employees. Contributions to the Plan are made by the employer only (i.e., Employer Contributions only), up to the lesser of 25% of each qualified employee's compensation or $69,000 for 2024. These contributions are tax-deductible as a business expense. Simplicity is what is key for these types of Plans. After the initial set up, there are no annual IRS forms, required compliance testing, or major IRS oversight, and the administrative time and costs are minimal.

Simply by executing a written agreement that outlines the benefits offered to all eligible employees, supplying employees' information about the provisions offered to them, and setting up an IRA account for each employee is basically all that is needed to get this Employer Retirement Plan up and running. The IRS has a model SEP plan document, Form 5305-SEP, Simplified Employee Pension — Individual Retirement Accounts Contribution Agreement or employers can use what is called a prototype document.

So, what is the downside? SEPs do not allow employees to defer income. This is sometimes frustrating to employees that cannot further enhance their retirement goals deferring part of their own salary into a Plan. Also, with these types of plans, what you do for one, you must do for all eligible employees. Meaning, if the owners give themselves a 25% employer contribution to themselves, guess what? They must do the same for each eligible employee of the Plan. Or, if considering a dollar amount to themselves, the same dollar amount must be given to each eligible employee. This could be very costly or limiting to the owner. Lastly, employees are always 100% vested in employer contributions to their SEPs. Therefore, they may not be the best choice for companies in industries with many employees or even high employee turnover. If the owner wishes to max out as much as they can for themselves, and cash flow is a concern, this type of Plan might not be the best option, because to do for themselves requires a “like” contribution to all eligible.

Savings Incentive Match Plan for Employees (SIMPLE) IRA Plans

The first type of plan that limits setup due to the number of employees for the company is referred to as a SIMPLE IRA Plan. This type of Plan is generally available to businesses with 100 or fewer employees who received $5,000 or more in compensation in the preceding year. These plans are funded by tax-deductible employer contributions and pre-tax employee contributions. SECURE Act 2.0 has allowed Roth contributions to be made to these Plans which have been a welcomed upgrade for those that want to save after-tax dollars.

As the name implies, SIMPLE IRAs are simple to establish and administer. To implement this plan, the employer can use IRS Form 5304-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) — Not for Use with a Designated Financial Institution, or Form 5305-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) — for Use with a Designated Financial Institution. As with Form 5305-SEP, the employer is required to keep the form in its records but does not file it with the IRS.

This type of Plan may be more attractive to a small employer (compared to a SEP Plan previously discussed) because it allows employees to defer a portion of their own salary to their SIMPLE IRAs. Another potential advantage to an employer of a SIMPLE IRA plan over a SEP is that it generally requires a smaller contribution on the employer's part. For example, an employer must match each employee's salary reduction contribution dollar-for-dollar up to 3% of the employee' compensation or make a nonelective contribution of 2% of an eligible employee's compensation, regardless of whether the employee makes a salary reduction contribution.

As with SEPs, though, employees are always 100% vested in employer contributions to SIMPLE IRAs, so they may not be the best choice for companies in industries with high turnover. But may be a good option if cash flow is of concern (lower employer contribution requirement when compared to the SEP).

Qualified Plans

Moving into a bit more complex arena, Qualified Plans (explained further below), have more reporting requirements and restrictions but might be more appropriate for larger or growing businesses. Additional flexibility, such as a loan feature, hardship withdrawal allowances, and in-service withdrawals, are desired features among employees who are considering enrolling into these types of Plans. There are several types of Qualified Plans, which can be broken down into two broad categories: Defined Benefit and Defined Contribution Plans.

A high-level description of a Defined Benefit Plan is commonly associated with a “Pension Plan.” Based on the employee's compensation, length of service with the company, and their age, these types of Plans promise to pay a calculated monthly amount (at some point in the future). Employers must contribute enough to the defined benefit plan each year to satisfy what is known as a minimum funding requirement. As we all have the potential to live longer along with the requirement for a possible minimum funding calculation, these plans have become less favorable due to the overall expense and administration that is required; not to mention, the need for an actuary. For that reason, very few small businesses use them.

Like the Defined Benefit Plan, a high-level description of a Defined Contribution Plan is that employers contribute into individual accounts for each employee. Employees generally have the authority to invest the money as they see fit among the investment options provided by the plan.

Types of defined contribution plans include Profit-sharing Plans and Money Purchase Plans. Under a Profit-sharing Plan, an employer's contributions are discretionary, so the employer is not required to make contributions to the plan each year. Under a Money Purchase Plan, contributions are mandatory, so the employer must contribute to the plan each year, and the contribution percentage used to determine the contribution amount for each year cannot vary. Both types of Plans still have a place within the Employer Retirement Plan space but less common than the next arrangement we will discuss.

401(k) Plans

By far the most common terminology for an Employer Retirement Plan is considered a 401(k) Plan. Many of the Profit-sharing Plans of the past include a 401(k) feature (also known as a cash or deferred arrangement, or CODA) under which the employees participating in the plan can choose to have a portion of their pre-tax or after-tax compensation contributed to an individual account rather than receive the compensation in cash. Referred to as "elective deferrals" because the employee elects to defer from their paycheck has allowed many companies to adopt this type of plan. On the flipside of a Defined Benefit Plan, the employee chooses to contribute. This has led to many being unhappy upon reaching their desired retirement age because without participating in the plan (electing to defer from their own salary), many have experienced a shortfall of what they need to sustain a healthy (financial) retirement goal. Another type of a 401(k) Plan is a "Solo 401(k) Plan" which is a 401(k) plan that covers only a business owner and his or her spouse.

For 2024, participants in a 401(k) plan can make elective deferrals of up to $23,000 ($30,500 for participants who are age 50 or over at the end of the calendar year). If the plan permits, employers have an option to contribute a percentage of each employee's compensation to the employee's account (a nonelective contribution) or can, within certain limits, match the number of employees' elective deferrals or do both. Total employer and employee contributions to a 401(k) plan for 2024 are limited to the lesser of: 100% of the employee's compensation or $69,000 ($76,500 for those age 50 or over utilizing the catch-up allowance).

Vesting within a 401(k) plan can be flexible from immediate to a gradual 6-year overall schedule (partially vesting over a period of years). Once an employee meets or exceeds the vesting schedule (outlined within the plan document), the dollars held within that source are 100% theirs and they have a nonforfeitable right to the full amount of the contributions in his or her account. It is important for business owners to consider what type of vesting schedule might make the most sense for their culture and business and can be a way to help an employer retain valued employees. Another option for vesting is referred to as "cliff vesting." With cliff vesting, the employee vests in all employer contributions subject to vesting after the employee meets a specific minimum number of years of service. This method might be an innovative idea for employers who experience high turnover and is a way to utilize these forfeitures (unvested contributions that are captured when a terminated participant withdrawals their balance from the Plan) for future employer contributions or plan expenses.

For business owners that have a goal of maxing out their deferrals and do not want to worry about failing a non-discrimination test (this is a topic for another day, but basically the owners and highly compensated employees cannot dominate the Plan with their salary deferrals), you may want to consider utilizing a Safe Harbor 401(k) Plan. Non-discrimination tests are performed on 401(k) plans to ensure there is a level playing field for salary deferrals. However, a special provision referred to as an Employer Safe Harbor Match or an Employer Safe Harbor Non-elective contribution can be made that will avoid certain non-discrimination tests, thus allowing owners and highly compensated employees to defer the max allowed by law without fear of failing a test and receiving refund. We touch on this during our initial conversation with business owners to assist them with their decisions. As a teaser, there are a few different iterations of Employer Safe Harbor contributions; however, the basic Safe Harbor match formula is 100% on the 1^st 3% of compensation deferred plus 50% on the next 2% of compensation deferred. The Employer Safe Harbor non-elective formula is 3% of eligible wages (regardless if the employee is deferring from their own salary).

Flexibility is key with a 401(k) setup, but many more restrictions and requirements are also imbedded in the overall design. Additionally, if you commit to making an employer match or a non-elective type of profit-sharing contribution, a strong cashflow is also key. Main flexibility points stem around eligibility and entry requirements, higher employee salary deferral allowances, less restrictive employer contributions, vesting allowances, as well as a loan option, in-service withdrawal options, and hardship withdrawal options. On the flipside, 401(k)s are much more heavily governed by the IRS, with strict non-discriminatory rules, fiduciary responsibilities, and investment oversight. These plans generally require the expertise of a third-party administrator (TPA) to maintain compliance with the operations of the Plan and the annual requirement of a Form 5500, (Annual Return/Report of Employee Benefit Plan). An advisor coupled with a TPA helps to minimize the operational and administrative burden of these plans and helps to avoid excise taxes and penalties if the plan is not administered correctly.

Solo 401(k) or Solo Roth 401(k) Plans

A type of Employer Retirement Plan that has become extremely popular over the last 5 years is referred to as an Individual(k)/Solo 401(k) Plan. This is where if an owner and his or her spouse are the business's only employees, they may implement a plan for their business and not have to worry about the heavy testing requirements that traditional 401(k) plans have. They allow the same benefits as the plans offered by much larger companies, but basically all of the bells and whistles can be offered without fear of discrimination.

One advantage of a Solo 401(k) is that it allows self-employed individuals to obtain enhanced benefits through income deferral. Possible tax savings can be achieved if the company matches 25% of the employee's compensation. For example, let us assume an owner/employee, age 55, operates an S corporation and received a Form W-2, Wage and Tax Statement, with $100,000 of wages. The employee deferred the maximum allowed employee contribution of $30,500 in 2024. His or her business contributes 25% of the gross wages, or $25,000, on their behalf (in the form of a non-elective or profit-sharing contribution). The total amount of contributions would be $55,500, which would be the maximum amount allowed.

Compare plans

How to choose

In choosing the right retirement plan, business owners need to weigh a variety of factors, one of the most crucial being their own personal goals, as well as what might work best for their employees. The first step that we take is to have a detailed conversation with the business owner to uncover their goals as well as uncovering what they would like to offer to their employees. As a business owner, do they have desire to try and maximize contributions for themselves and their executive staff? If so, a 401(k) with a Safe Harbor provision might be a consideration. Do they only have a desire to provide incentives to their employees (in an effort to attract or retain employees)? Maybe a SIMPLE IRA Employer Retirement Plan would work best. It is important to take a deep dive into the goals, the “why’s,” company cashflow, employee turnover, and many other questions to land on the best type of Plan for all. Business owners with a strong cashflow who wants to continue enhanced incentives could also consider a Defined Benefit Plan.

It is important for advisors to help business owners evaluate all known factors that would impact the operation, administration, funding, reporting requirements, and expenses associated with a retirement plan. Some of the most crucial factors include:

• Types of contributions/eligibility: Who will contribute? The employer, employees, or both? Do you want to exclude a group of employees? Do you want to target a group to receive additional incentives?
• The number of employees: Some Plans limit the number of employees, and some allow for max allowance of provisions based on the number of employees of a company.
• Employee turnover and vesting period: This is an important decision for choosing a retirement plan. Should the business experience a good deal of employee turnover, the company should give special consideration to the plan's vesting period.
• Contribution limits: The minimum and maximum contribution limits available to employers and employees need to be considered. Retirement goals play a huge role here.
• Affordability: Depending on the structure, the employer contributions that might be offered, as well as the operational expenses, is the cashflow for the business strong enough to sustain the overall expense? Tax credits and corporate tax deductions aside, the plan must be affordable for the company to administer and fund.
• Administrative requirements: As previously mentioned, some plans are easier than others to administer. If it is determined that the employer does not have the time or does not have a staff member devoted to the duties of the Plan, many companies may select a SIMPLE IRA rather than a 401(k) because it takes less time to administer.
• Need for a TPA: This is also an important consideration because this is an additional expense. A 401(k) plan or defined benefit plan requires a TPA that provides valuable compliance services. These more sophisticated plans must meet certain IRS regulations to maintain their tax-favored status. Should a plan fail to meet the required regulations, the plan may be subject to excise taxes and penalties.
• Operational aspects: How can contributions be made, assets managed, and information be provided to participating employees? This is where an advisor can assist as well and share duties as a co-fiduciary on the operational side of the Plan.
• Withdrawals and Loans: How and when can assets be accessed? What are the penalties for early withdrawal? Does the business owner have the time to administer and keep track of loans?

Having knowledge about the diverse types of Plans offered, as well as knowledge on Plan operations and administrations, advisors can be valuable consultants to small business owners in setting their retirement goals. They can play a significant role in assisting business owners in choosing a retirement plan that fits their personal goals as well as their business goals. We are happy to have a discussion with you to help navigate these questions for you.