Retirement Plan Choices

April 13, 2006

In recent years, there has been a lot of talk in Washington about the need to “fix” social security so that it remains fiscally solvent for many years to come. While that’s certainly a worthy goal, even if the effort is successful, people will most likely need to supplement their social security benefits. There has also been recent talk about the bankruptcy of the social security system.

Social security was never intended to provide more than a minimal safety net. Thus, assuming people want a financially comfortable retirement, they need to have other sources of income to draw upon during what could be a 20 to 30+ year period of their life.

One of the best sources of additional income is a practice retirement plan. Not only does it generally offer tax deductions to the sponsoring employer, it also allows employees covered by the plan to build retirement benefits without currently paying taxes on the increasing value of those benefits.

Unfortunately, dealing with retirement plans can often leave employers confused about the choices available or concerned about the costs of each of the options. Perhaps they’d like to help their employees (and themselves) save more for retirement, but they don’t know where to start. The following is a table that describes the key characteristics of the most common retirement planning options. It moves from the simplest option (a payroll deduction IRA which is really nothing more than a way to assist employees in setting up their own IRAs) to the most complex choice (the traditional defined benefit plan that guarantees employees a certain specified benefit at retirement).

If you haven’t started your own personal retirement planning, NOW is the time to start doing so.

Summary of Retirement Plan Options

Issues Payroll Deduction IRA (or Roth IRA) SEP-IRA SIMPLE-IRA Defined Contribution Defined Benefit Plan
Profit Sharing 401(k)
Key Advantage Easy to set up and maintain.

Funded by employees—no employer contributions are allowed.

Easy to set up and maintain. Salary reduction plan with little administrative paperwork.

Funded mainly by employees— employer can limit contributions to employees who contribute.

Permits employer to create relatively large account balances for employees. Permits employee to contribute more than in other options. May be combined with employer profit sharing.

Plan can allow deferrals to Roth 401(k) accounts, qualified distributions from which are tax-free.

Permits employers to contribute more than other plans and provides a fixed, pre-established benefit for employees.
Employers Who Can Provide This Option Any business. Any business. Any business with 100 or fewer employees that does not currentlymaintain another retirement plan. Any business. Any business. Any business.
Employer’s Responsibilities Transmit employee contributions to employees’ IRA. No employer tax filing required. Set up plan (generally by completing IRS Form 5305-SEP). No employer tax filing required. Set up plan (generally by completing IRS Form 5304-SIMPLE or 5305-SIMPLE). No employer tax filing required. Bank or financial institution does most of the paperwork. There is no IRS model form to establish a plan. Professional advice is generally necessary. Annual filing of IRS Form 5500 series return is generally required. There is no IRS model form to establish a plan. Professional advice is typically necessary. Annual filing of IRS Form 5500 series return is generally required. May require special testing to ensure plan does not discriminate in favor of highly compensated employees. Special record keeping required for Roth 401(k) accounts. There is no IRS model form to establish a plan. Professional advice is necessary. Annual filing of IRS Form 5500 series return is required. Actuary must determine funding obligations.
Funding Responsibility Employee contributions remitted through payroll deduction. Employer contributions are not allowed. Employer contributions only. Employee salary reduction contributions and employer contributions (but can be limited to employees who contribute). Employer contribution only. Employee salary reduction contributions and employer contributions. Primarily employer; may require or permit employee contributions.
Funding Vehicle IRA set up by employee. IRA set up by employee. IRA set up by employee. Trust set up by employer. Trust set up by employer. Trust set up by employer.
Contributor’s Options Employee can decide how much to contribute at any time. Employer makes contributions as set by plan terms. Contributions can be from 0%–25% and redetermined each year. Employee can decide how much to contribute. Employer must make matching contributions or contribute 2% of each employee’s salary up to the set maximum. Employer makes contributions as set by plan terms. Contributions can be from 0%-–5% and redetermined each year. Employee makes contributions as set by plan option. The employer may match.

 

Employer makes contributions as set by plan terms. Contributions are usually required each year.
Maximum Annual Contribution per Participant for 2004 Employee: Lesser of employee’s salary or $4,000 ($5,000 if age 50 or older).

Employer:Contributions not allowed.

Note: Contributions reduce the amount the employee can contribute to other IRAs.

Roth IRA contributions are not allowed if the employee’s income exceeds $110,000 ($160,000 for married couples filing a joint return).

Employee:Contributions not allowed.

Employer: Lesser of (1) 25% of employee’s compensation or (2) $44,000.

Note: Contributions do not reduce the amount the employee can contribute to other IRAs.

Employee: Deferrals limited to lesser of 100% of compensation or $10,000 ($12,500 if age 50 or older).

Employer: 100% match of deferrals up to 3% of compensation or 2% nonelective contribution on up to $220,000 of compensation.

Note: Contributions do not reduce the amount the employee can contribute to other IRAs.

Employee:Contributions not allowed.

Employer: Lesser of (1) 100% of employee’s compensation or (2) $44,000.

Employee: Deferral limited to $15,000 ($20,000 if age 50 or older).

Employer/Employee combined: Lesser of (1) 100% of employee’s compensation or (2) $44,000 (increased to $49,000 if age 50 or older and to the extent an employee catch-up deferral is made).

Employee: Per plan terms, employer may permit or require employee contribution.

Employer: Set by plan terms.

Minimum Employee Coverage Requirements No requirement. This is merely a convenience that can be offered to any or all employees. Must be offered to all employees who are at least 21 years of age, employed by the business for three of last five years, and who earn at least $450 during 2006. Must be offered to all employees who have earned at least $5,000 in any previous two years and are reasonably expected to earn this amount in the current year. Generally must be offered to all employees at least 21 years of age who have completed at least two years of service. Generally must be offered to all employees at least 21 years of age who have completed at least two years of service (one year of service for employee elective deferrals). Generally must be offered to all employees at least 21 years of age who have completed at least two years of service.
Withdrawals, Loans, & Payments Withdrawals at any time; subject to current federal income taxes and a possible 10% penalty if the participant is under age 59½. Withdrawals at any time; subject to current federal income taxes and a possible 10% penalty if the participant is under age 59½. Withdrawals at any time; subject to current federal income tax and, if employee is under age 59½, may be subject to a 25% penalty if taken within the first two years of participation and a 10% penalty if taken afterwards. May permit loans and hardship withdrawals. Withdrawals subject to current federal income tax and possibly a 10% penalty if participant is under age 59½. Benefits generally paid at retirement. Cannot withdraw employee elective contributions until a specified event, such as reaching 59½, death, separation from service, or other event as identified in plan. May permit loans and hardship withdrawals. Withdrawals subject to current federal income tax and possibly a 10% penalty if participant is under age 59½. Payment of benefits generally at retirement.
In-service withdrawals are not permitted.
Vesting Immediate 100%. Immediate 100%. Immediate 100%. Within specified limits, may vest over time according to plan terms. Employee contributions vested immediately. Within specified limits, employer contributions may vest over time according to plan terms. Within specified limits, may vest over time according to plan terms.

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