Adding a company retirement plan is an exciting milestone for any small business, but proceed with caution. Increased compliance measures have added complexity and costs to managing these plans, and jumping to offer this benefit prematurely can drain both the coffers and the essential energy required to lift a small business from survival to profitability. Here are three questions that every small business owner should answer before establishing a new retirement plan.
1. Is your business ready?
Despite what a commission-based retirement plan salesperson will tell you, reducing your personal tax burden is not enough of an incentive to institute a company-wide retirement plan. A successful plan will also promote employee satisfaction and will enhance productivity.
Don’t even think of adding a retirement plan before your business can afford regular contributions to all employees. Plans that are poorly funded or lack a matching contribution receive very little support from the employees, and the costs quickly outweigh the perceived benefits.
I recommend considering 3% of all wages to be a minimum employer contribution before embarking on a retirement plan. Any less will lose you more credibility than not having a plan at all. In addition to a fixed contribution, these plans also allow a business to offer tax-sheltered profit sharing (bonuses) during the financially healthy years.
A good gauge of company health is to calculate your total employee payroll and benefits as a percentage of business revenue. These ratios will differ based on the type of business that you are in. Low-overhead professional businesses (accounting, financial planning, law practices) can sustainably target a 50% ratio but any more is likely unsustainable over long periods. You should research successful businesses in your industry to find the right targets.
It will be helpful to begin this process of starting a new company retirement plan with a budgeted amount in mind of how much you can afford.
2. What type of plan is best?
Most businesses implement 401(k) plans, but for small to mid-sized businesses, Savings Incentive Match Plans for Employees (SIMPLEs) and Simplified Employee Pension (SEP) IRAs are cost-effective alternatives. Regardless of the plan, employer contributions are deductible and avoid payroll taxes. These tax savings allow you to stretch your compensation dollars more than they otherwise would as a part of wages.
The 401(k) plans are the most common because they offer the most flexibility. You can create a plan that emphasizes contributions to those who have served the longest. You can set vesting schedules as long as six years, which will encourage employees to stick around. These 401(k) plans also offer the ability to save in a Roth option without income limitations. I don’t recommend offering loans in your plan, but this is another option.
For most companies, their first 401(k) should be a Safe Harbor 401(k) plan. This will mandate either a 3% contribution to all eligible participants or a matching program. The benefits for this plan include reduced compliance costs because the safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.
Other companies may choose a SEP or SIMPLE IRA plan to avoid the need to hire a third-party administrator (TPA) and other burdens of a 401(k) plan. SEP plans work best for those companies that do not want to take on the administration of allowing employee contributions. A helpful comparison of the basic retirement plans can be found here.
Your CPA likely can offer helpful advice on the tax savings available to your firm by implementing these different types of plans and will be an important resource in the selection process.
3. What types of investments will you include?
Too many start-up retirement funds perform poorly because they invest in high-cost funds offered by a commissioned salesperson. It’s best to avoid starting a retirement plan with anyone that is new to the industry or anyone who sells insurance and annuities. Avoid dealing with a go-between to oversee the plan until you have enough assets in the plan to justify high-quality service.
Many cost-conscious employers start their first retirement plan with prepackaged plans offered by large mutual fund companies such as Vanguard and T. Rowe Price. These companies offer target date retirement funds that make diversification easy. Employee Fiduciary of Mobile, Alabama, combines several different fund company options inside their EF Smart Plan, which is an excellent lineup of low-cost mutual funds. These companies all have a retirement specialist division that will help you set up these plans, but you will have to take care of much of the employee communication.
With the right timing, right plan and right investments, your company retirement plan will be a huge success.