Hafnia Financial

Comprehensive Overview of Retirement Plans for Small Businesses

Please bear in mind while we are following the laws, regulations, and taxation of each plan like all other investment advisory firms, we believe that we often have some advantages on plan cost, investment cost, and selection compared to other Investment Advisory firms. These advantages are typically found in reducing what we believe are unnecessary costs in the investments themselves, such as using Exchange-Trade Funds vs traditional mutual funds. See our article on EFTs vs mutual funds cost comparison. Also, we do our money management in-house, so you would only be paying one advisory fee. If the money management is outsourced you would typically pay an additional cost of the outside money management. We have cut out the middle-man so to speak. As always this is meant as educational information. Further, we do not give legal or tax advice. Please consult with a lawyer or a tax professional regarding legal and taxation matters.

Let’s dive in. What type of Retirement Plan should you consider for your Small Business?

Here are the different types:

  • SEP IRA (Simplified Employee Pension)
  • SIMPLE IRA (Savings Incentive Match Plan for Employees)
  • Individual 401(k)
  • Individual Roth 401(k)
  • Traditional 401(k)
  • Roth 401(k)
  • Profit Sharing Plan
  • Money Purchase Plan
  • Defined Benefit Plan
  • Deferred Compensation Plan

This guide includes key features, costs, fees, and taxation details, along with illustrations to clarify the differences.

 

  1. SEP IRA (Simplified Employee Pension)

Overview: A SEP IRA is designed for self-employed individuals and small business owners. Employers make all contributions on behalf of employees.

Key Features:

  • Contribution Limits: Up to 25% of each employee’s compensation, with a maximum of $66,000 for 2024.
  • Flexibility: Employers can vary contributions each year.
  • Eligibility: Employees must be at least 21 years old, have worked for the employer in 3 of the last 5 years, and have received at least $750 in compensation in the current year.

Costs and Fees:

  • Setup Fees: Generally low or $0
  • Annual Fees: Minimal or $0, usually lower than other plans.
  • Investment Fees: usually lower than other plans as we use Stocks, bonds and ETFs
  • Investment Advisory Fees: Defends on Asset Level

Taxation:

Tax Advantages for Employers:

  1. Tax-Deductible Contributions:
    • Employers can make tax-deductible contributions to their employees’ SEP IRAs. These contributions are considered a business expense and can be deducted from the employer’s taxable income, reducing the overall tax liability.
  2. Flexibility in Contributions:
    • Employers have the flexibility to decide how much to contribute to SEP IRAs each year. They can choose to contribute up to 25% of each employee’s compensation, up to a maximum contribution limit set by the IRS. This flexibility allows employers to adjust contributions based on business profits and cash flow.
  3. No Ongoing Contribution Requirement:
    • Unlike some retirement plans that require annual contributions, SEP IRAs do not require ongoing contributions. Employers can choose whether or not to make contributions each year, depending on their financial circumstances.

Tax Advantages for Employees:

  1. Tax-Deferred Growth:
    • Contributions made to a SEP IRA grow tax-deferred until withdrawn. This means that investment earnings within the SEP IRA are not subject to annual taxation, allowing the account balance to grow more quickly over time.
  2. No Taxes on Contributions:
    • Employees do not pay taxes on contributions made by their employer to their SEP IRA. These contributions are made with pre-tax dollars, reducing the employee’s current taxable income.

Taxation:

  1. Tax Control in Retirement:
    • During retirement, when withdrawals are made from the SEP IRA, the distributions are taxed as ordinary income. However, retirees may have more control over their tax situation, such as withdrawing funds during years with lower tax rates.
  2. Potential Lower Tax Bracket in Retirement:
    • In retirement, individuals may find themselves in a lower tax bracket compared to their working years. This can result in paying less tax on SEP IRA withdrawals than they would have paid on contributions during their working years.
  3. Penalties
    • Early withdrawal penalties apply before age 59½ (10% penalty).

Pros and Cons:

Pros Cons
High contribution limits Employees cannot contribute directly
Simple administration Only employers can contribute
Flexible annual contributions The same contribution percentage for all

 

  1. SIMPLE IRA (Savings Incentive Match Plan for Employees)

Overview: A SIMPLE IRA is suitable for businesses with 100 or fewer employees. Both employer and employee contributions are allowed.

Key Features:

  • Contribution Limits: Employees can contribute up to $15,500 annually ($19,000 if 50+). Employers must either match up to 3% of salary or make a 2% non-elective contribution.
  • Eligibility: Employees who earned at least $5,000 in any two preceding years and are expected to earn at least $5,000 in the current year.

Costs and Fees:

  • Setup Fees: Generally low.
  • Annual Fees: Typically minimal.
  • Investment Fees: usually lower than other plans as we use Stocks, bonds and ETFs
  • Investment Advisory Fees: Defends on Asset Level

Taxation:

Tax Advantages for Employers:

  1. Tax-Deductible Contributions:
    • Employer contributions to employees’ SIMPLE IRAs are tax-deductible as a business expense. This deduction reduces the employer’s taxable income, resulting in lower tax liability.
  2. Tax Credit for Small Employers:
    • Small employers may be eligible for a tax credit of up to $500 per year for the first three years after establishing a SIMPLE IRA plan. This credit helps offset the costs of setting up the plan.
  3. No Employer FICA Taxes:
    • Employer contributions to SIMPLE IRAs are not subject to FICA (Federal Insurance Contributions Act) taxes, including Social Security and Medicare taxes.

Tax Advantages for Employees:

  1. Pre-Tax Contributions:
    • Employee contributions to a SIMPLE IRA are made with pre-tax dollars, reducing the employee’s current taxable income. This lowers the amount of income subject to federal income tax, resulting in immediate tax savings.
  2. Tax-Deferred Growth:
    • Contributions and investment earnings within a SIMPLE IRA grow tax-deferred until withdrawn. This allows the account balance to grow more quickly over time, as taxes are not owed on investment gains each year.
  3. Lower Tax Bracket in Retirement:
    • In retirement, individuals may be in a lower tax bracket compared to their working years. Withdrawals from a SIMPLE IRA during retirement are taxed as ordinary income, but retirees may pay less tax on these withdrawals than they would have paid on contributions during their working years.
  4. No Taxes on Employer Contributions:
    • Employees do not pay taxes on employer contributions to their SIMPLE IRA. These contributions are made with pre-tax dollars, reducing the employee’s current taxable income.
  5. Penalties: Early withdrawal penalties apply before age 59½ (10% penalty); additional penalties within the first two years of participation (25% penalty).

Pros and Cons:

Pros Cons
Simple setup and maintenance Lower contribution limits
Both employer and employee contributions Less flexibility in employer contributions
Required employer contributions Higher early withdrawal penalties initially

 

  1. Individual 401(k) (Solo 401(k))

Overview: An Individual 401(k) is for self-employed individuals or small business owners with no employees other than a spouse.

Key Features:

  • Contribution Limits: Up to $66,000 ($73,500 if 50+), combining employee salary deferrals and employer profit-sharing contributions.
  • Flexibility: Allows both salary deferrals and profit-sharing contributions.
  • Eligibility: Business owners with no employees other than a spouse.

Costs and Fees:

  • Setup Fees: Typically low or free.
  • Annual Fees: Usually low but can vary by provider.
  • Investment Fees: Depends on the investment options chosen.

 Taxation:

Tax Advantages for Contributions:

  1. Pre-Tax Contributions:
  • Contributions to a Solo 401(k) are made with pre-tax dollars, reducing the individual’s current taxable income. This means that the amount contributed to the Solo 401(k) is deducted from the individual’s gross income, resulting in immediate tax savings.
  1. High Contribution Limits:
  • Self-employed individuals can contribute to their Solo 401(k) as both employer and employee, allowing for potentially higher contribution limits compared to other retirement plans. For 2024, the total contribution limit is $66,000 ($73,500 if age 50 or older), including both employee salary deferrals and employer profit-sharing contributions.
  • Catch-Up Contributions:
    • Individuals aged 50 or older can make additional catch-up contributions to their Solo 401(k), up to $6,500 for 2024. These catch-up contributions provide older individuals with the opportunity to save more for retirement and reduce their taxable income further.

Tax Advantages for Investment Growth:

  1. Tax-Deferred Growth:
    • Contributions and investment earnings within a Solo 401(k) grow tax-deferred until withdrawn. This allows investments to compound over time without being subject to annual taxation, resulting in potentially faster growth of retirement savings.
  2. No Capital Gains or Dividend Taxes:
    • Within the Solo 401(k), investments can be bought and sold without triggering capital gains or dividend taxes. This allows for more flexibility in investment choices and enables individuals to reallocate assets within the plan without tax consequences.

Tax Advantages for Withdrawals:

  1. Controlled Taxation in Retirement:
    • During retirement, distributions from a Solo 401(k) are taxed as ordinary income. However, retirees may have more control over their tax situation, such as managing withdrawals to minimize tax liability by timing distributions strategically and potentially being in a lower tax bracket than during their working years.
  2. Roth Option for Tax-Free Withdrawals:
    • Some Solo 401(k) plans offer a Roth sub-account, allowing individuals to make after-tax contributions. Qualified distributions from the Roth sub-account, including contributions and earnings, are tax-free in retirement, providing tax diversification and flexibility in managing retirement income.

Pros and Cons:

Pros Cons
High contribution limits Only for businesses with no employees
Combines employee and employer contributions More administrative work than SEP IRA
Tax benefits Early withdrawal penalties

 

  1. Individual Roth 401(k)

Overview: An Individual Roth 401(k) is similar to an Individual 401(k) but contributions are made with after-tax dollars. Suitable for self-employed individuals or small business owners with no employees other than a spouse.

Key Features:

  • Contribution Limits: Up to $23,000 annually ($30,500 if 50+).
  • Flexibility: Combines employee salary deferrals (after-tax) and employer profit-sharing contributions (pre-tax).
  • Eligibility: Business owners with no employees other than a spouse.

Costs and Fees:

  • Setup Fees: Typically low or free.
  • Annual Fees: Usually low but can vary by provider.
  • Investment Fees: Depends on the investment options chosen.

Taxation:

Tax Advantages for Contributions:

  1. After-Tax Contributions:
    • Contributions to an Individual Roth 401(k) are made with after-tax dollars, meaning contributions do not provide an immediate tax deduction. However, because contributions are made with after-tax dollars, qualified distributions, including both contributions and earnings, are tax-free in retirement.
  2. Tax-Free Growth:
    • Similar to a traditional Roth IRA, contributions and investment earnings within an Individual Roth 401(k) grow tax-free until withdrawn. This tax-free growth allows retirement savings to compound over time without being subject to annual taxation, potentially resulting in significant growth of retirement assets.

Tax Advantages for Withdrawals:

  1. Tax-Free Distributions:
    • Qualified distributions from an Individual Roth 401(k), including both contributions and earnings, are tax-free in retirement. This tax-free treatment provides retirees with a source of tax-free income during retirement, reducing their overall tax burden.
  2. No Required Minimum Distributions (RMDs):
    • Unlike traditional 401(k) plans, which require individuals to start taking required minimum distributions (RMDs) after reaching age 72, Roth 401(k) accounts are not subject to RMDs during the account owner’s lifetime. This allows individuals to maintain control over their retirement assets and potentially pass on tax-free assets to heirs.

Additional Benefits:

  1. Diversification of Tax Treatment:
    • By contributing to both a traditional pre-tax 401(k) and an Individual Roth 401(k), individuals can diversify their tax treatment in retirement. Having a mix of tax-deferred and tax-free retirement accounts allows retirees to manage their tax liabilities more effectively by controlling the source of their retirement income.
  2. Flexible Withdrawal Options:
    • Roth 401(k) contributions can be withdrawn at any time without penalty, providing individuals with flexibility in accessing their contributions in case of emergencies or financial needs. While earnings may be subject to taxes and penalties if withdrawn before age 59½, the ability to access contributions penalty-free adds flexibility to the retirement savings strategy.
  3. Estate Planning Benefits:
    • Roth 401(k) assets can be passed on to heirs tax-free, providing potential estate planning benefits. Inherited Roth 401(k) accounts are subject to required minimum distributions (RMDs) for non-spouse beneficiaries but continue to grow tax-free, potentially providing a valuable inheritance for heirs.

Overall Benefits:

  • Tax Diversification in Retirement:
    • By contributing to both traditional pre-tax and Roth after-tax retirement accounts, individuals can achieve tax diversification in retirement, providing flexibility in managing their tax liabilities and optimizing their retirement income strategy.
  • Long-Term Tax Savings:
    • Roth 401(k) contributions offer the potential for significant long-term tax savings, as qualified distributions in retirement are tax-free. Individuals who expect to be in a higher tax bracket in retirement or who anticipate changes in tax laws may benefit from contributing to an Individual Roth 401(k).
  • Control Over Retirement Assets:
    • Individual Roth 401(k) accounts provide individuals with control over their retirement assets, allowing them to make investment decisions and manage their retirement savings according to their individual goals and risk tolerance.

Overall, the Individual Roth 401(k) offers significant tax advantages for retirement savings, including tax-free growth and tax-free distributions in retirement. However, it’s essential to consult with a financial advisor or tax professional to understand the specific tax implications based on individual circumstances.

 Pros and Cons:

Pros Cons
Tax-free withdrawals in retirement Contributions are not tax-deductible
High contribution limits Only for businesses with no employees
Combines after-tax and pre-tax contributions More administrative work than SEP IRA

 

  1. Traditional 401(k)

Overview: A traditional 401(k) plan can be adopted by any size business and allows both employer and employee contributions.

Key Features:

  • Contribution Limits: Employees can contribute up to $23,000 annually ($30,500 if 50+). Total contributions (employee + employer) cannot exceed $66,000 ($73,500 if 50+).
  • Flexibility: Employers can choose to match contributions or make profit-sharing contributions.
  • Eligibility: Typically set by the employer, often including age and service requirements.

Costs and Fees:

  • Setup Fees: Can be significant.
  • Administrative Fees: Ongoing fees for plan management.
  • Investment Fees: Vary based on investment choices.

Taxation:

Tax Advantages for Investment Growth:

  1. Tax-Deferred Growth:
    • Contributions and investment earnings within a Traditional 401(k) grow tax-deferred until withdrawn. This tax-deferred growth allows retirement savings to compound over time without being subject to annual taxation, potentially resulting in significant growth of retirement assets.
  2. No Taxes on Capital Gains or Dividends:
    • Investments held within a Traditional 401(k) plan can be bought and sold without triggering capital gains or dividend taxes. This allows for more flexibility in investment choices and enables individuals to reallocate assets within the plan without tax consequences.

Tax Advantages for Withdrawals:

  1. Controlled Taxation in Retirement:
    • During retirement, distributions from a Traditional 401(k) are taxed as ordinary income. However, retirees may have more control over their tax situation, such as managing withdrawals to minimize tax liability by timing distributions strategically and potentially being in a lower tax bracket than during their working years.
  1. Potentially Lower Tax Rate in Retirement:
    • Individuals may be in a lower tax bracket during retirement compared to their working years, leading to potentially lower taxes on withdrawals from a Traditional 401(k). This can result in overall tax savings and maximize retirement income.
  • Required Minimum Distributions (RMDs):
    • Traditional 401(k) accounts are subject to required minimum distributions (RMDs) starting at age 72. RMDs ensure that individuals withdraw a minimum amount from their retirement accounts each year, helping to distribute retirement savings over the individual’s lifetime.

Overall Benefits:

  • Immediate Tax Savings:
    • Contributions to a Traditional 401(k) provide immediate tax savings by reducing taxable income in the year contributions are made. This allows individuals to lower their current tax liability while saving for retirement.
  • Tax-Deferred Growth:
    • Tax-deferred growth within a Traditional 401(k) allows retirement savings to grow more quickly over time, as investment earnings are not subject to annual taxation. This compounding effect can lead to significant growth of retirement assets over the long term.
  • Employer Contributions:
    • Many employers offer matching contributions to employees’ Traditional 401(k) accounts, providing additional retirement savings at no cost to the employee. Employer matches effectively increase the individual’s retirement savings without requiring additional contributions.

Overall, the Traditional 401(k) offers significant tax advantages for retirement savings, including immediate tax savings on contributions, tax-deferred growth, and potential tax savings in retirement. However, it’s essential to consult with a financial advisor or tax professional to understand the specific tax implications based on individual circumstances.

Pros and Cons:

Pros Cons
High contribution limits Higher administrative costs
Employer match and profit-sharing options Complex administration
A variety of investment options Compliance testing required

 

  1. Roth 401(k)

Overview: A Roth 401(k) is similar to a traditional 401(k), but contributions are made with after-tax dollars, and qualified withdrawals are tax-free.

Key Features:

  • Contribution Limits: Up to $23,000 annually ($30,500 if 50+). Total contributions (employee + employer) cannot exceed $66,000 ($73,500 if 50+).
  • Flexibility: Employers can match contributions on a pre-tax basis.
  • Eligibility: Typically set by the employer, often including age and service requirements.

Costs and Fees:

  • Setup Fees: Can be significant.
  • Administrative Fees: Ongoing fees for plan management.
  • Investment Fees: Vary based on investment choices.

Taxation:

Tax Advantages for Contributions:

  1. After-Tax Contributions:
    • Contributions to a Roth 401(k) are made with after-tax dollars, meaning contributions do not provide an immediate tax deduction. While contributions do not lower the individual’s taxable income in the year contributions are made, they allow for tax-free withdrawals in retirement.
  2. Tax-Free Growth:
    • Similar to a Roth IRA, contributions and investment earnings within a Roth 401(k) grow tax-free until withdrawn. This tax-free growth allows retirement savings to compound over time without being subject to annual taxation, potentially resulting in significant growth of retirement assets.

 

Tax Advantages for Withdrawals:

  1. Tax-Free Distributions:
    • Qualified distributions from a Roth 401(k), including both contributions and earnings, are tax-free in retirement. This tax-free treatment provides retirees with a source of tax-free income during retirement, reducing their overall tax burden.
  2. No Required Minimum Distributions (RMDs):
    • Unlike traditional 401(k) plans, which require individuals to start taking required minimum distributions (RMDs) after reaching age 72, Roth 401(k) accounts are not subject to RMDs during the account owner’s lifetime. This allows individuals to maintain control over their retirement assets and potentially pass on tax-free assets to heirs.

Additional Benefits:

  1. Diversification of Tax Treatment:
    • By contributing to both a traditional pre-tax 401(k) and a Roth after-tax 401(k), individuals can diversify their tax treatment in retirement. Having a mix of tax-deferred and tax-free retirement accounts allows retirees to manage their tax liabilities more effectively by controlling the source of their retirement income.
  2. Flexible Withdrawal Options:
    • Roth 401(k) contributions can be withdrawn at any time without penalty, providing individuals with flexibility in accessing their contributions in case of emergencies or financial needs. While earnings may be subject to taxes and penalties if withdrawn before age 59½, the ability to access contributions penalty-free adds flexibility to the retirement savings strategy.
  3. Estate Planning Benefits:
    • Roth 401(k) assets can be passed on to heirs tax-free, providing potential estate planning benefits. Inherited Roth 401(k) accounts are subject to required minimum distributions (RMDs) for non-spouse beneficiaries but continue to grow tax-free, potentially providing a valuable inheritance for heirs.

Overall Benefits:

  • Tax-Free Retirement Income:
    • Roth 401(k) contributions provide a source of tax-free income in retirement, offering significant tax advantages for individuals who anticipate being in a similar or higher tax bracket in retirement.

 

  • Long-Term Tax Savings:
    • Roth 401(k) contributions offer the potential for significant long-term tax savings, as qualified distributions in retirement are tax-free. Individuals who expect their tax rate to increase in retirement or who anticipate changes in tax laws may benefit from contributing to a Roth 401(k).
  • Control Over Retirement Assets:
    • Roth 401(k) accounts provide individuals with control over their retirement assets, allowing them to make investment decisions and manage their retirement savings according to their individual goals and risk tolerance.

Overall, the Roth 401(k) offers significant tax advantages for retirement savings, including tax-free growth and tax-free distributions in retirement. However, it’s essential to consult with a financial advisor or tax professional to understand the specific tax implications based on individual circumstances.

Pros and Cons:

Pros Cons
Tax-free withdrawals in retirement Contributions are not tax-deductible
High contribution limits Higher administrative costs
A variety of investment options Compliance testing required

 

  1. Defined Benefit Plan

Overview: A defined benefit plan, often referred to as a pension plan, promises a specified monthly benefit at retirement, which can be based on salary and years of service.

Key Features:

  • Contribution Limits: Contributions are actuarially determined to fund the promised benefits.
  • Benefits: Provides a predictable retirement benefit based on a formula.
  • Eligibility: Varies based on plan design.

Costs and Fees:

  • Setup Fees: High.
  • Administrative Fees: Significant ongoing fees for actuarial and management services.
  • Investment Fees: Depends on the investment options chosen.

Taxation:

Taxation Advantages of Defined Benefit Plans:

  1. Tax-Deferred Growth:
    • Contributions and investment earnings within a Defined Benefit Plan grow tax-deferred until withdrawn. This means that participants do not pay taxes on investment gains or income generated within the plan, allowing retirement savings to compound over time without being subject to annual taxation.
  2. Employer Contributions:
    • Employer contributions to a Defined Benefit Plan are tax-deductible as a business expense. Employers can contribute a substantial amount to the plan, potentially reducing their taxable income and lowering their overall tax liability.
  3. Lifetime Income Stream:
    • Defined Benefit Plans typically provide participants with a guaranteed lifetime income stream in retirement, often in the form of monthly pension payments. These payments are generally taxable as ordinary income when received, allowing retirees to spread out their tax liability over the course of their retirement.
  4. Rollover to IRA:
  • Possible to rollover your balance in your employee account to your IRA account.

In summary, while Defined Benefit Plans provide a guaranteed income stream in retirement and tax-deferred growth, it’s essential to consult with a financial advisor or tax professional to understand the specific tax implications of each plan based on individual circumstances.

Pros and Cons:

Pros Cons
Provides predictable retirement income High setup and administrative costs
Higher potential contributions for older business owners Complex administration
Tax benefits Employer bears the investment risk

 

  1. Profit Sharing Plan

Overview: A Profit Sharing Plan allows employers to contribute a portion of their profits to their employees’ retirement accounts.

Key Features:

  • Employer Contributions: Contributions are discretionary and can vary from year to year based on the company’s profits.
  • Employee Eligibility: Often available to all employees who meet certain eligibility requirements, such as age and years of service.
  • Vesting: Employers can choose a vesting schedule determining when employees have full ownership of employer-contributed funds.

Costs and Fees:

  • Setup Fees: Initial setup costs can vary depending on the plan provider and complexity.
  • Administrative Fees: Ongoing administrative costs may include recordkeeping, compliance, and consulting fees.
  • Investment Fees: Depending on the investment options offered, there may be associated fees.

Taxation:

Taxation Advantages for Employers:

  1. Tax-Deductible Contributions:
    • Employer contributions to a Profit Sharing Plan are tax-deductible as a business expense. This deduction reduces the employer’s taxable income, resulting in lower tax liability for the business.
  2. Flexible Contribution Amounts:
    • Employers have the flexibility to determine the amount of contributions made to the Profit Sharing Plan each year. Contributions can vary based on the company’s profits, allowing for adjustments to be made in accordance with business performance.
  3. Tax-Deferred Growth:
    • Investment earnings within the Profit Sharing Plan grow tax-deferred until withdrawn. This allows the plan’s assets to compound over time without being subject to annual taxation, potentially resulting in significant growth of retirement savings.

Taxation Advantages for Employees:

  1. Pre-Tax Employee Contributions:
    • Employees can make pre-tax contributions to the 401(k) portion of the plan, reducing their current taxable income. This immediate tax savings lowers the employee’s tax liability for the year in which contributions are made, providing a tax benefit.
  2. Tax-Deferred Growth:
    • Similar to employer contributions, investment earnings on employee contributions within the 401(k) portion of the plan grow tax-deferred until withdrawn. This tax-deferred growth allows retirement savings to grow more quickly over time, as taxes are not owed on investment gains each year.
  3. Controlled Taxation in Retirement:
    • Distributions from the Profit Sharing Plan and 401(k) portion are taxed as ordinary income when withdrawn in retirement. However, retirees may have more control over their tax situation, such as managing withdrawals to minimize tax liability by timing distributions strategically and potentially being in a lower tax bracket than during their working years.

Overall Benefits:

  • Tax-Advantaged Retirement Savings:
    • Profit Sharing Plans combined with 401(k) plans offer tax advantages for both employers and employees, allowing for tax-deductible contributions, tax-deferred growth, and potential tax savings in retirement.
  • Employer Flexibility:
    • Employers have the flexibility to tailor their contributions to the Profit Sharing Plan based on business performance, allowing for adjustments to be made in accordance with profitability.
  • Employee Retirement Savings:
    • Employees benefit from pre-tax contributions, tax-deferred growth, and the opportunity to save for retirement through employer-sponsored retirement plans, helping them build wealth for their future.

Overall, a Profit Sharing Plan combined with a 401(k) plan offers significant taxation advantages for retirement savings, benefiting both employers and employees. However, it’s essential to consult with a financial advisor or tax professional to understand the specific tax implications based on individual circumstances.

Illustration: Imagine a small business, ABC Inc., that decides to implement a Profit Sharing Plan. They contribute 10% of their annual profits to their employees’ retirement accounts. If ABC Inc. earns $500,000 in profits for the year, they would contribute $50,000 to the plan, divided among eligible employees based on a predetermined formula.

 

  1. Money Purchase Plan

Overview: A Money Purchase Plan requires employers to make fixed annual contributions to employees’ retirement accounts, regardless of company profits.

Key Features:

  • Mandatory Contributions: Employers must contribute a fixed percentage of each employee’s salary each year.
  • Employee Eligibility: Generally available to all eligible employees, similar to other retirement plans.
  • Fixed Contributions: Employers are obligated to make contributions annually, providing employees with a predictable retirement benefit.

 

Costs and Fees:

  • Setup Fees: Initial setup costs may vary depending on plan complexity and provider.
  • Administrative Fees: Ongoing administrative costs include recordkeeping, compliance, and trustee fees.
  • Investment Fees: Fees may apply based on the investment options selected within the plan.

 

Taxation:

Taxation Advantages for Employers:

  1. Tax-Deductible Contributions:
    • Employer contributions to a Money Purchase Plan are tax-deductible as a business expense. This deduction reduces the employer’s taxable income, resulting in lower tax liability for the business.
  2. Fixed Contribution Amounts:
    • Money Purchase Plans typically require employers to make fixed contributions each year, providing predictability in retirement savings funding. These fixed contributions can be based on a percentage of employee compensation or a set dollar amount.
  3. Tax-Deferred Growth:
    • Investment earnings within the Money Purchase Plan grow tax-deferred until withdrawn. This allows the plan’s assets to compound over time without being subject to annual taxation, potentially resulting in significant growth of retirement savings.

Taxation Advantages for Employees:

  1. Tax-Deferred Growth:
    • Similar to employer contributions, investment earnings on employee contributions within the Money Purchase Plan grow tax-deferred until withdrawn. This tax-deferred growth allows retirement savings to grow more quickly over time, as taxes are not owed on investment gains each year.
  2. Controlled Taxation in Retirement:
    • Distributions from the Money Purchase Plan are taxed as ordinary income when withdrawn in retirement. However, retirees may have more control over their tax situation, such as managing withdrawals to minimize tax liability by timing distributions strategically and potentially being in a lower tax bracket than during their working years.

 

Overall Benefits:

  • Tax-Advantaged Retirement Savings:
    • Money Purchase Plans offer tax advantages for both employers and employees, allowing for tax-deductible contributions and tax-deferred growth, which can lead to significant retirement savings over time.
  • Employer Contributions:
    • Employers have the flexibility to determine the contribution amount to the Money Purchase Plan, providing an opportunity to maximize retirement savings for employees while also benefiting from tax deductions.
  • Employee Retirement Savings:
    • Employees benefit from tax-deferred growth on contributions made to the Money Purchase Plan, helping them build wealth for their future retirement needs.

Overall, a Money Purchase Plan offers significant taxation advantages for retirement savings, benefiting both employers and employees. However, it’s essential to consult with a financial advisor or tax professional to understand the specific tax implications based on individual circumstances.

  • Contributions: Employer contributions are tax-deductible as a business expense.
  • Withdrawals: Withdrawals during retirement are taxed as ordinary income.
  • Penalties: Early withdrawals before age 59½ may incur a 10% penalty unless an exception applies.

Illustration: Suppose XYZ Corp. establishes a Money Purchase Plan with a contribution rate of 5% of each employee’s annual salary. If an employee earns $50,000 per year, XYZ Corp. would contribute $2,500 annually to the employee’s retirement account. This contribution is made regardless of the company’s profitability.

Conclusion:  Profit Sharing Plans and Money Purchase Plans offer small businesses flexibility and predictability in providing retirement benefits to employees. While Profit Sharing Plans allow employers to make discretionary contributions based on profits, Money Purchase Plans mandate fixed contributions regardless of profitability. Both plans offer tax advantages for employers and employees, with contributions being tax-deductible for the business and taxed as income upon withdrawal for employees. Understanding the features, costs, and taxation of each plan can help small businesses make informed decisions when selecting retirement options for their employees.

 

  1. Deferred Compensation Plan

Overview: A Deferred Compensation Plan allows employees to defer a portion of their salary or bonuses until a later date, typically retirement, offering tax-deferred growth on contributions.

Key Features:

  • Employee Contributions: Employees can defer a portion of their salary, bonuses, or other compensation until a future date, such as retirement.
  • Employer Contributions: Employers may offer matching contributions or other incentives to encourage participation.
  • Vesting: Vesting schedules determine when employees have full ownership of deferred contributions and any associated earnings.
  • Distribution Options: Participants can choose from various distribution options upon reaching retirement age, including lump-sum payments or periodic installments.

Costs and Fees:

  • Setup Fees: Initial setup costs vary depending on the plan structure and provider.
  • Administrative Fees: Ongoing administrative expenses include recordkeeping, compliance, and trustee fees.
  • Investment Fees: Fees may apply based on the investment options chosen within the plan.

Taxation:

Taxation Advantages for Employers:

  1. Tax Deductions:
    • Employer contributions to a Deferred Compensation Plan are tax-deductible as a business expense. This deduction reduces the employer’s taxable income, resulting in lower tax liability for the business.
  2. Deferred Tax Liability:
    • Employers can defer the recognition of compensation expenses associated with the plan until the deferred amounts are paid out to employees. This allows for the deferral of tax payments on compensation expenses until future years.
  • Employee Retention Incentives:
    • Deferred Compensation Plans can serve as valuable employee retention tools by providing additional compensation in the form of deferred benefits. This can help attract and retain top talent within the organization.

 

Taxation Advantages for Employees:

  1. Tax Deferral:
    • Contributions to a Deferred Compensation Plan are not included in the employee’s taxable income until they are paid out in the future. This allows employees to defer income tax on the compensation they defer into the plan, potentially resulting in tax savings.
  2. Tax-Deferred Growth:
    • Investment earnings on contributions within the Deferred Compensation Plan grow tax-deferred until withdrawn. This allows for potentially higher returns on investments over time, as taxes are not owed on investment gains each year.
  3. Flexible Distribution Options:
    • Employees have flexibility in determining the timing and structure of distributions from the Deferred Compensation Plan, allowing them to manage their tax liability strategically. They can choose to receive distributions in retirement when they may be in a lower tax bracket, potentially reducing their overall tax burden.

Overall Benefits:

  • Tax-Advantaged Retirement Savings:
    • Deferred Compensation Plans offer tax advantages for both employers and employees, allowing for tax deductions on contributions and tax-deferred growth on investment earnings.
  • Employee Financial Planning:
    • Deferred Compensation Plans provide employees with additional tools for retirement planning and income deferral, allowing them to customize their financial strategy based on their individual needs and goals.
  • Employer Flexibility:
    • Employers have the flexibility to design Deferred Compensation Plans to meet the specific needs of their workforce, providing tailored benefits and incentives to employees.

Overall, a Deferred Compensation Plan offers significant taxation advantages for retirement savings and employee compensation, benefiting both employers and employees. However, it’s essential to consult with a financial advisor or tax professional to understand the specific tax implications based on individual circumstances.

 

Illustration:  Consider an employee, Sarah, who earns an annual salary of $100,000 and elects to defer 10% of her salary into a Deferred Compensation Plan. Assuming a 30% marginal tax rate, Sarah’s deferred contributions would reduce her taxable income by $10,000, resulting in a tax savings of $3,000. Over time, the deferred contributions and any investment earnings grow tax-deferred until Sarah begins receiving distributions in retirement.

Conclusion:  Deferred Compensation Plans offer employees the opportunity to defer a portion of their compensation until retirement, providing tax benefits and flexibility in retirement planning. Employers can use these plans to attract and retain talent by offering additional retirement savings options. Understanding the features, costs, and taxation of Deferred Compensation Plans can help both employers and employees make informed decisions when implementing and participating in these plans.

 

Hafnia Financial, Inc. is a registered investment adviser. Registration does not imply a certain level of skill or training. The information presented is for educational purposes only and is not intended to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance. Insurance products and services are offered and sold through Jan Gleisner an individually licensed and appointed insurance agent. CA Ins Lic # 0D77385.

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