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Help Your Clients Select the Best Retirement Plan for Their Business by Using Tax Planning Software – Part II

In our last article, we explored the ins and outs of 401(k)s – how they are taxed, how they are administered, and how expensive they would be for your clients to sponsor. But there are so many other types of plans your clients can choose from.

As you explore other retirement plan options with your clients, think about how you can use your tax planning software to help them make the right selection. With the right software, you can help them compare costs and tax outcomes of each plan, which can make the selection process much more straightforward.

SIMPLE IRA Plans

Savings Incentive Match Plans for Employees – or SIMPLE IRA plans – are like 401(k)s in a few ways: (1) they allow both employers and employees to make contributions; (2) contributions are made with pre-tax dollars; and (3) the growth within the plan accumulates tax-free until retirement. But there are a few key differences.

While traditional 401(k) plans are available to all businesses, SIMPLE IRAs are only available to businesses with 100 or fewer employees that do not offer any other retirement plan. They are also easier to establish and cheaper to administer than 401(k)s, in part because they do not require annual testing or annual filings. But in exchange for their simplicity, the plan requires employers to match employee contributions. Employer matches must either be a match of (1) the employee’s contributions, at a rate between 1%-3% a percentage of employees’ salary, or (2) a flat 2% of the employee’s salary regardless of how much the employee contributes to their plan (if at all). Employer matches in SIMPLE IRAs are always immediately vested.

SEP Plans

Simplified Employee Pension (SEP) plans are great options for many types of employers because there is no requirement on number of employees. Even self-employed individuals can open an SEP plan. SEP plans are like 401(k)s in that contributions are made with pre-tax dollars and plan growth is tax deferred until retirement, but that is where most of the similarities end. In SEP plans:

  • Only the employer can make contributions.
  • Employees are immediately vested in SEP funds.
  • Annual testing is generally not required.

And most importantly, the contributions must be uniform for all employees. If the business chooses to contribute 2% of each employee’s salary, they must contribute 2% of everyone’s salary, from the lowest to the highest paid employee.

Profit-Sharing Plans

Profit-sharing plans allow employers to contribute a share of the company’s profits to employees as a retirement benefit. They are often offered alongside another plan (like a 401(k) plan) so that employees are also given the opportunity to contribute to their retirement.

In profit-sharing plans, employer contributions:

  • Are deductible to the employer.
  • Grow tax-deferred while in the plan.
  • Vest according to a predetermined schedule. Common vesting schedules are gradual over time (called “graded vesting”) or 100% vested after a predetermined number of years (called “cliff vesting”).

Business owners like profit-sharing plans because of their flexibility. Each year, the business can choose what percentage of their profits it wants to contribute to the plan, but they are never required to contribute, even in years their company returns high profits.

Employee Stock Ownership Plans

Employee Stock Ownership Plans (ESOPs) are a form of profit-sharing plan. They are qualified retirement plans, but they are quite different from other plans. While most retirement plans invest in external products – stocks, bonds, mutual funds, etc. – ESOP investments are held in a trust comprised almost solely of company stock. This means that an employee’s return on investment is directly correlated with how well their employer’s business performs. Aligning the company’s interests with that of its employees can help boost productivity and job satisfaction.

ESOPs are often used in closely held businesses to provide a market for shares that would be difficult to sell otherwise. When employees depart or retire, the employer promises to repurchase their vested shares of stock. The employer can either redistribute those shares to current employees or can retire them altogether. This provides employees with cash at retirement and simultaneously keeps stock ownership close to the company.

Most employees are happy when their employer offers an ESOP because it’s free money to the employees. All contributions come from the employer.

ESOPs can be a bit more administratively burdensome, but there are a few tax benefits not available in other retirement plans. Consider the following benefit to corporations: dividends paid on corporation ESOP shares that are reinvested back into the plan are deductible. This deviates from the standard treatment of stock dividends. Dividends paid to corporation shareholders are not deductible to the business because they are not business expenses; they represent a share of the business’s net income. But when those stock shares are held in a separate trust for the ESOP, dividends reinvested into the plan are deductible.

S corporations receive another benefit that has to do with their status as a flow-through entity. As a flow-through entity, the S corporation passes its tax liability through to its owners: the shareholders. Because the ESOP trust holds company shares, the trust is considered the company’s owners. When income is reported to the ESOP trust, the ESOP’s portion of company earnings is nontaxable at the federal level. Some states may still tax the income, though

Defined Benefit Plan

All the plans we have discussed thus far have been defined contribution plans. In defined contribution plans, the business does not promise a certain payout at retirement; the plan instead focuses on the contributions. Defined benefit plans are the opposite. In defined benefit plans, the business promises to pay their employees a certain benefit at retirement and must raise the funds necessary to fulfill those promises.

Defined benefit plans – also known as pensions – have certainly fallen out of favor in the last few decades. In general, they are more costly (and riskier) to employers. The burden of the end payout falls solely on the employer.

The costs of running a defined benefit plan and contributions made to the plan are deductible to the business, which can help the business justify the cost of funding the plan. They are also fairly flexible. The business can promise almost any payout. Generally, payout at retirement is based on a combination of the employee’s tenure with the company, their age, and their salary. But the exact combination of these factors is up to the business. This means that businesses can offer plans only to long-standing employees, something that defined contribution plans are not as easily able to do.

How to Choose the Right Plan

Your clients have a lot of factors to consider when selecting their retirement plan. To help them decide, you can do a few things.

First, ask them what their goals are. Are their goals simply to provide a benefit to their employees? Do they want their jobs to be more marketable? Do they want to encourage employees to stick around for longer? Do they want to incentivize employees to care more about the company’s success? These questions alone can help you narrow the selection down to just a few plans.

Next, ask them how much time, money, and effort they are willing to spend on plan sponsorship. Some plans are simple to administer, while others are time consuming. Some plans require annual filings and rigorous testing, while others do not.

Then, ask them what their employees want. The age and lifestyle of their employee population will make certain plans better than others. For example, a pension that rewards employees who remain at the company for 10+ years will not entice employees who have a more varied work history. You want the plan to be good for your clients and valuable to their employees.

And lastly, walk them through how each plan will be taxed. This is where your tax planning software can help. With a good tax planning software, you can see how your client’s taxes would change under each plan. A good software will look at the deductions available under each plan and will also consider the additional costs of plan sponsorship. Corvee Tax Planning software is especially good in this arena. You can adjust multiple assumptions in the program and get detailed, multi-year reports that show your clients the long-term cost and tax outlook of each selection. This information will help them make a good decision, and when your clients see how powerful your knowledge can be, it can help you sell tax planning services. 

Here is a quick comparison table your client’s business might consider for retirement plans:

Ideal BusinessesEmployer ContributionsVestingMust Pass ERISA Nondiscrimination Testing
Traditional 401(k) Employers of all sizesOptionalImmediate, cliff, or gradedYes
Automatic Enrollment 401(k) Employers of all sizesOptionalImmediate, cliff, or gradedYes
Safe Harbor 401(k) Employers of all sizesRequiredImmediateNo
SIMPLE 401(k) Employers with 100 or fewer employeesRequiredImmediateNo
SEP Plans Employers of all sizes and self-employed personsRequiredImmediateNo
Profit-Sharing Plan Employers of all sizesRequiredImmediate, cliff, or gradedYes
ESOPsEmployers of all sizesRequiredImmediate, cliff, or gradedYes
Defined Benefit Plans Employers of all sizesN/AN/AYes

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