One fundamental consideration for every business is determining whether to offer a retirement plan for employees, and that decision is quickly followed by a follow-up: What type of retirement plan should be offered? This article will provide a broad overview of retirement plans and hopefully can be used as a basis for further discussion.

First, a quick discussion of why we consider this to be a fundamental consideration. There are several reasons, and we see these as the critical ones:

• Attracting and retaining employees – particularly in a challenging job market, businesses that do not offer a retirement plan are at a distinct disadvantage when it comes to hiring.
• Tax advantages – a business’ contributions to retirement plans are typically tax-deductible benefits that the business can offer to its employees.
• Owner’s financial benefit – because contributions (to a certain extent) to employees are based on the compensation levels of the individuals, higher-paid employees will be able to maximize their benefits. Business owners are almost always the highest-compensated individuals in the business.

Nonqualified versus Qualified Plans - There are nonqualified retirement plans and qualified retirement plans. We’ll only discuss qualified plans in this article. A qualified retirement plan offers tax advantages, which include a current deduction from income to the employer for contributions to the plan, the tax-free buildup of the value of plan investments, and the deferral of income to the employees until the funds are ultimately distributed. 

Defined Benefit Pension Plans and Defined Contribution Plans - There are two basic types of qualified retirement plans —defined benefit pension plans and defined contribution plans.

Defined Benefit Plan - A defined benefit plan provides for a fixed benefit at retirement, based generally upon years of service and compensation according to a selected formula. While defined benefit plans generally pay benefits in the form of an annuity (e.g., over the life of the participant, or joint lives of the participant and his or her spouse), some defined benefit plans provide for payment of benefits in a lump sum. In certain defined benefit plans, called “cash balance plans,” the benefit, in fact, is typically paid and expressed as a cash lump sum.

Adoption of a defined benefit plan requires a commitment to fund the plan. These plans will often provide the greatest current deduction from income, and the greatest retirement benefit, where the owners of the business are older and nearing retirement. However, the large retirement benefits of defined benefit plans must cover all eligible employees, so these plans are typically seen in business with few employees (often 1 to 10 employees). In addition, the added administrative expenses associated with defined benefit plans (the key expense being actuarial costs) can make them less attractive.

Defined benefit plans are often referred to as “pension plans”.

Defined Contribution Plan - A defined contribution plan provides for an individual account for each participant, with benefits based solely on the amount contributed to the participant's account and any investment income, expenses, gains and losses, and any forfeitures (usually from departing employees) that may be allocated to the participant's account.  There are limits on the amounts that an employee can contribute annually, and there are limits on the amounts that an employer can contribute annually on behalf of an employee.

Examples of Defined Contribution Plans are as follows:

1. Profit-sharing plans – Each year, the employer sets a percentage of an employee’s compensation that the employer will contribute to the employee’s profit sharing plan. An employer is not required to contribute in a given year. 
2. 401(k) Plans – In common usage, this is often the default retirement plan that is mentioned when someone talks about a retirement plan. A 401(k) plan allows employees to set aside funds from their compensation, which are allocated to an account in their name. An employer may, or may not, contribute funds to the employee’s account. See more information below.
3. Employee Stock Ownership Plans (ESOPs)- Shares of stock in the employer are purchased to fund the plan and are gradually allocated to employee accounts.
4. Simplified Employee Pension Plans (SEPs) - Small businesses may adopt a SEP plan, and make contributions to SEP-IRAs on behalf of employees.
5. Savings Incentive Match Plan for Employees (SIMPLE) - A business with 100 or fewer employees may establish a SIMPLE. Under a SIMPLE plan, an IRA is established for each employee, and the employer makes matching contributions based on contributions elected by participating employees under a qualified salary reduction arrangement.
6. SIMPLE 401(k) plan  - Has features similar to a SIMPLE plan, with automatic passage of the otherwise complex nondiscrimination test for 401(k) plans.

Additional information about 401(k) plans – Because these plans are typically the default plan that is mentioned most often in the media, it’s worthwhile to spend a little more time on this topic. As mentioned above, a 401(k) plan is a defined contribution plan providing for employer contributions made at the direction of the employee under a salary reduction agreement. Specifically, the employee elects to have a certain amount of pay deferred and contributed by the employer on his or her behalf to the plan. Employee contributions can be made either (1) on a pre-tax basis, saving employees current income taxation on the amount contributed, or (2) on an after-tax basis, which includes Roth 401(k) contributions (if permitted by the plan), which will allow distributions (including earnings) to be distributed to the employee tax-free in retirement, if conditions are satisfied.

The employer may, or may not, provide matching contributions on behalf of those employees who make elective deferrals to the plan. Matching contributions may be subject to a vesting schedule (which requires complete vesting in three years, or 20% vesting of employer contributions to the employee's account each a year, starting after the employee completes two years of service). While 401(k) plans are subject to testing requirements, so that highly compensated employees (in general, for 2024 plan years, employees who earned more than $155,000 in the preceding year, i.e., in 2023; for 2023 plan years, highly compensated employees are those who earned more than $150,000 in 2022) do not contribute too much more than non-highly compensated employees, these tests can be avoided if you adopt one of the “safe harbor” 401(k) plan designs. For example, in one safe harbor design, your 401(k) plan will automatically match a non-highly compensated employee's 401(k) contribution dollar-for-dollar up to the first 3% of the employee's compensation, and 50-cents for each additional dollar that the employee contributes, up to 5% of the employee's compensation. Immediate or accelerated vesting will apply.

While a SIMPLE IRA and a SIMPLE 401(k) can operate similar to a 401(k) plan, neither of those plans maintain the flexibility and the level of potential benefits that can be found in a 401(k) plan. With those advantages comes additional cost; it will almost always cost more to have a 401(k) plan than to maintain a SIMPLE IRA or a SIMPLE 401(k), due to the added complexities and the annual reporting requirement. 

Summary

The initial steps in determining which type of retirement plan is right for a business is a complex matter that will typically involve a CPA at the outset, and then will involve an investment advisor and possible an attorney as the decision-making process progresses.