Rebuilding Your Nest Egg – Part 2

Part one of this series addressed a type of Defined Contribution Plan (DCP) created particularly for individuals and small business owners – IRAs or Individual Retirement Accounts. Now we’ll discuss another Defined Contribution Plan which is probably the most widely known, 401(k) plans.

A 401(k) Plan is a plan set up by an employer which allows employees to defer a portion of their salary, before taxes, to a retirement account. As with IRAs, the funds and interest on the funds, accrue untaxed until distributed upon retirement.

There are some major differences however, some of which are listed below:

• With an IRA all contributions are 100 percent vested, however some 401(k) plans may use a vesting schedule, meaning that employer contributions belong to the employee only after a specified number of years.
• A 401(k) allows greater access to funds by permitting the employee to take loans from the funds which must be paid back.
• In 2009 and 2010, employee contributions are limited to $16,500 annually with an additional $5,000 allowed if participant is over 50, while IRAs are limited to $11,500 with an allowed catch-up contribution of $2,500.
• 401(k) plans may be subject to annual nondiscrimination testing to ensure that the amount of contributions made on behalf of rank-and-file employees is proportional to contributions made on behalf of owners and managers.
• IRAs are easier to set up and operate and do not require filing an annual return.

Our next segment will discuss the different types of 401(k) plans.

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Rebuilding Your Nest Egg – For Small Business Owners

As the economy improves (think positive) small businesses should be looking again to provide employees with benefits that will ensure their best workers are with them for a long time to come. Health insurance aside the benefits most workers are anxious for are retirement benefits. However, for small business owners choosing and implementing the best retirement plan for the business can be a complicated and time consuming project, so for the next few blogs I will address some of the options available for retirement, the basics you need to know, as a small business owner, and advantages and disadvantages you may want to consider.

First we’ll discuss qualified plans, that is, plans which by definition qualify for tax-preferred treatment by the federal government, usually in the way of tax deductions or credits. When comparing the way in which benefits are determined, there are basically two groups, Defined Contribution Plans and Defined Benefit Plans.

With Defined Contribution Plans the benefit received by the participant depends upon the account balance of the participant when the funds are distributed and the plan itself defines the how contributions are made to the participant’s account.

One class of Defined Contribution Plans is Individual Retirement Accounts or IRAs. IRAs enjoy the following features:

• Easy to set up and operate,
• No annual return required,
• Annual nondiscrimination testing not required, and
• Immediate vesting of all contributions.

Discrimination testing ensures that the amount of contributions made on behalf of rank-and-file employees is proportional to contributions made on behalf of owners and managers, while vesting refers to employee ownership of the contributions. If contributions are 100% vested, the full amount is accessible to the employee (minus of course taxes due and a 10% penalty if withdrawn before retirement age). If employer contributions are vested according to a vesting schedule then if the employee terminates employment before completing a set number of years (according to the vesting schedule) the employee forfeits a portion of the employer’s contributions to the account. The forfeited amounts are then divided up among the remaining accounts.

A Simplified Employee Pension Plan (SEP) is an IRA that allows employers the option from year to year to make contributions on a tax-favored basis to IRAs of their employees. The employee must set up the IRA to accept the employer’s contributions and all eligible employees must participate in the plan, including part-time employees, seasonal employees, and employees who die or terminate employment during the year.
Sole proprietors, partnerships, and corporations, including S corporations, can set up SEPs. Administrative costs are low and employer may be eligible for a tax credit of up to $500 per year for each of the first 3 years for the cost of starting the plan.

The SIMPLE SEP has the same features as the SEP IRA except the employer must make either matching contributions or contribute 2% of each employee’s compensation. Also the plan must be offered to all employees who have earned income of at least $5,000 in any prior 2 years, and are reasonably expected to earn at least $5,000 in the current year.

In my next blog, we’ll discuss 401(k)s.

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