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Posts Tagged ‘retirement plan’

Small Employers Consider A Defined Benefit Plan

You may be familiar with the dire state of many pension funds in the recent past and currently. In fact, an Examiner review of federal actuarial reports shows almost half of the nation’s 20 largest unions have pension funds that federal law classifies as “endangered” or in “critical” condition due to being underfunded. Nevertheless, if you are a small business owner, there are good reasons to consider a pension plan as a component of your overall plan for retirement. Consider the following…

What Is A Defined Benefit Plan?

Unlike Defined Contribution (DC) Plans (IRAs, 401Ks, etc.), in which the amount of the contributions is predetermined annually, but the final benefit amount is unknown; Defined Benefit (DB) plans define the monthly benefit to be received by the plan participant while the amount necessary to be contributed by the company to meet the set goal of the plan would have to be redetermined each year.

The benefit is determined according to a formula based on the recipient’s salary and years of service. For instance, a plan formula that provides a monthly pension at age 65 equal to 1.5 percent for each year of service multiplied by the monthly average of a participant’s highest three years of compensation would provide a participant with 10 years of service, a monthly pension equal to 15 percent of the monthly average of the participant’s highest three years of compensation.

Benefits to Employee

  • Benefits may not be reduced as a result of investment performance.
  • Older employees may not be discriminated against but may receive favored treatment. Their accrued benefit must be equal to or greater than that of any other similarly situated employee.
  • Benefits are usually higher than those from a defined contribution plan.
  • Contributions are made by employer.

Advantages and Disadvantages to Employer

  • A substantially greater deduction to taxable income is possible since contributions up to $195,000 per employee may be made, whereas DC plan limits are $49,000 or 100 percent of income.
  • Unlike DC plans forfeited benefits are not distributed among the plan participants but may be used to reduce future contributions by the employer.
  • DB plans are more complicated to administer than DC plans, requiring an actuary and advisor.
  • Benefits of DB plans are guaranteed (to a limit) by the government through the Pension Benefit Guaranty Corporation (PBGC).
  • Although more complex, due to their efficiency, they actually provide “the same retirement income at nearly half the cost”, according to the National Institute for Retirement Security.

Types Of Pension Plans (DB Plans)

Two basic types of defined benefit plans are the Traditional Pension Plan and the Cash Balance Pension Plan. Traditional Pension Plans define the employee’s promised benefit in terms of an amount to be paid monthly from retirement through the life of the employee. Cash Balance Pension Plans however, present the benefits as a stated account balance similar to that of a 401(k).

Who Should Have A DB Plan?

Defined Benefit Plans are especially appealing to self-employed or small business owners, age 45 or older, whose companies are well established, with consistently high taxable income, and few employees who are significantly younger or lower paid.

Considerations

As many have learned during this recession, no retirement plan is completely “fullproof”. There is always risk involved, whether it is risk of loss from the market, or from the failure of commercial or government institutions. No one can completely guarantee, that a particular bank, or insurance company, or even that federal government safeguards such as Social Security, will be able to provide the funds sufficient to care for you comfortably in retirement.

This does not mean however, that you should abandon all hope of saving for retirement. Those who do prepare and save for retirement are far more likely to be better off than if they had not saved. Instead minimize your risk and consider the suggestions below when putting together a retirement plan.

  • Spread your risk over different investments.
  • If possible, make use of both a defined contribution and defined benefit plan guaranteed by different institutions.
  • Examine your tax obligation and consider the benefits of triple-compounding through qualified plans.
  • Consult with a financial advisor.
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Profit Sharing Plans

There are two basic types of Profit Sharing Plans:

  1. Cash or Bonus Plans, whereby the employee receives cash at the end of the year and is taxed on the amount at the same time, and
  2. Qualified Deferred Profit Sharing Plans which deposit funds into separate employee accounts to be distributed and taxed at a future date.

Profit Sharing Plans are often used in conjunction with 401(k) plans.

Benefits to The Employer:

  1. The employer is not obligated every year, to contribute a set amount or any amount, as long as the contributions are generally significant and recurring.
  2. The employer can limit which employees are eligible to receive benefits, based on months in service, age, or coverage in a union plan.
  3. The employer can limit how much certain employees may receive based upon rank or salary level.
  4. Investment risks lie completely with the employee.
  5. Contributions are tax deductible by the company, up to 25 percent of covered payroll. (Although an employer is limited to contributing only up to 15 percent of covered payroll, if in a prior year the employer only contributed 5 percent, the employer would be allowed to contribute an additional 10 percent to the current year’s 15 percent).
  6. Vesting allows the employer to reward employees who devote years to the company while penalizing those who terminate early, enabling the employer to retain the most experienced workers.
  7. If an employee leaves before completing a vesting schedule, the employer has the option of using the forfeited funds to reduce future allocations of profit or may divide the amount among the accounts of the remaining employees.

Benefits to the Employees:

  1. All contributions are made by the employer.
  2. Employees do not presently pay taxes on the contributions.
  3. Generally, the employee may have an IRA in addition to the profit sharing plan.
  4. Participants may borrow from the plan if the plan permits.

Allocation of Benefits

Four common plans for allocation of benefits are:

  • Non-Integrated Plans – All employees’ benefits are in direct proportion to participant compensation. For instance, all employees receive x percent of their compensation.
  • Integrated Plans – participants with compensation in excess of the plan"s wage base can receive proportionally higher contributions than participants with lower annual compensation.
  • Age Weighted Plans – Provides higher benefits to older employees according to how many years remain until retirement.
  • New Comparability Plans – Allows the employer to allocate different percentages of benefits based on classifications, i.e., executive, administration, skilled laborer, unskilled laborer, etc.

As you can see Profit Sharing Plans provide great flexibility to employers. These plans are especially popular with companies having few owners or one, employers whose owners or key employees are significantly older than the rest of the workers, or where the objective is to provide the maximum benefits to executives and higher compensated employees while minimizing benefit costs to rank and file workers.

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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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There are numerous areas that a financial plan needs to cover to provide financial security for you and your family. A few of the major areas are:

  • Emergency funds
  • Life insurance
  • Health insurance
  • Disability income insurance
  • Saving for retirement, etc.

There are two rules of thought regarding financial planning and how much insurance and what type of insurance you should purchase:

1. “decide which goals will take priority and work toward the lesser goals only after the really important ones are well provided for“, and

2. Spread your funds to provide at least some protection to each of the major areas of need, or expressed another way “don’t put all your eggs in one basket”.

I was surprised to read the first opinion expressed by a CNN Money Advisor as if it was the one and only answer to the financial security conundrum. I believe the answer depends largely on you and your situation, and in fact for the most part I subscribe to the second rule of thought. Here’s why:

It is rare that someone just beginning the process of financial planning is able to immediately meet even one of their major goals right away, such as having an emergency fund to meet six months of family expenses or purchasing the maximum amount of life insurance truly needed. But, if one is able to, let’s say, purchase a sufficient amount of life insurance, or purchase an adequate disability policy, but cannot do both, then Murphy’s law is bound to apply; in the case that you purchased the life insurance, you will become disabled, and in the case that you purchased the disability policy, a meteor will fall from the sky landing on you, and only you.

On the other hand, if you are employed with a company that offers a wide array of benefits, it may be worthwhile to sign up for the lowest amount of disability insurance and life insurance, even if it means you cannot put as much into a retirement plan. Remember, regardless of your health or employment situation you can put away into a retirement plan. It does not require you to qualify. However, if any factor such as your health, age, or employment changes, you may not be able to purchase life or disability insurance no matter how much money you have in your emergency fund or in your retirement plan.

This is not meant to question the wisdom of contributing as much as possible to a retirement plan (something you definitely want to do), especially when your employer is matching the contribution amount, but it just illustrates why I believe you shouldn’t necessarily feel that you need to complete one goal before starting another.

Again, I believe that each situation is different and that it is the job of the advisor to inform and explain to the client about the options available and the benefits and drawbacks of each, while it is the client’s job to decide which option best fits his/her circumstance.

Anyway, as always, we are interested in your comments. Do you agree? Disagree? Or is there something else on your mind?

Let us know. We are listening.

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