Starting a business is a busy endeavor, but it’s also a great opportunity to set up a tax-favored retirement plan for you and your employees. Benefits include:

• A current deduction from income to the employer for contributions to the plan
• Tax-free buildup of the value of plan investments 
• The deferral of income (augmented by investment earnings) to employees until funds are distributed

Here are the two basic types of plans.

Pension plans with defined benefits

This plan provides a fixed benefit in retirement. Typically, these plans are based on years of service and compensation. 

These plans pay benefits as an annuity over the life of the participant or over the joint lives of the participant and their spouse, but some defined benefit plans provide a lump sum payment of benefits. In “cash balance plans,” the benefit typically comes as a cash lump sum.

Choosing a defined benefit plan as an employer requires a commitment to fund it. If the business owners are nearing retirement, these plans often provide the greatest current deduction from income and the greatest retirement benefit. The administrative expenses associated with defined benefit plans, however, can make them less attractive than defined contribution plans.

Plans with defined contributions

This plan provides an individual account for each participant, and benefits are based solely on the amount contributed to the participant’s account and investment income, expenses, gains, losses and forfeitures that may be allocated to the account. Profit-sharing plans and 401(k)s are both defined contribution plans.

The common 401(k) plan provides for employer contributions made at the direction of an employee under a salary reduction agreement—the employee elects to have a percentage of pay withheld and contributed by the employer on his or her behalf to the plan. These contributions can be made either:

1. On a pre-tax basis, saving employees current income tax on the amount contributed, or
2. On an after-tax basis. This includes Roth 401(k) contributions (if permitted), which will allow distributions (including earnings) to be made to the employee tax-free in retirement, if conditions are satisfied.

Employers can also adopt automatic-deferral provisions, which require employees to opt out of participation.

Employers may or may not provide matching contributions on behalf of employees. These contributions can also be subject to a vesting schedule. 401(k) plans are subject to testing requirements to prevent “highly compensated” employees from contributing too much more than non-highly compensated employees, but these tests can be avoided if employees adopt a “safe harbor” 401(k) plan. A highly compensated employee in 2020 is defined as one who earned more than $130,000 in the preceding year.

Other types of tax-favored retirement plans within these general categories include employee stock ownership plans (ESOPs).

Other plans

Simplified Employee Pensions (SEP) are another option for small businesses. These receive similar tax advantages to “qualified” plans and also make contributions on behalf of employees. A business with 100 or fewer employees can establish a Savings Incentive Match Plan for Employees (SIMPLE). Under a SIMPLE, the employer makes matching contributions to an IRA for each employee based on contributions elected by employees.

There may be other options for your business. Contact your trusted Smolin advisor to discuss the retirement plans available to you.