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Defined-contribution plans
If you choose to set up a retirement plan for your employees that is funded by their contributions, your retirement plan is called a defined-contribution plan. As plan sponsor, you have the choice to make matching contributions. Depending on the type of defined-contribution plan, your contributions may be fixed or variable.
A defined-contribution plan qualifies as a tax-deferred retirement plan if the plan is set up in accordance with ERISA standards. Among other requirements, the Employee Retirement Income Security Act of 1974 requires the plan sponsor to comply with certain reporting and disclosure requirements for the benefit of plan participants.
The most common type of defined-contribution retirement plan is a 401(k) plan. However, most of the plans for small businesses discussed in this educator are defined-contribution plans. These plan types include SARSEPs,
SIMPLE-IRAs and
SIMPLE-401(k)s, money-purchase pension plans, and profit-sharing plans.
Generally, a plan sponsor and plan participant can contribute up to the lesser combined amount of $45,000 or 100% of the participant's compensation in 2007.
According to a 2006 (reporting on the 2005 plan year) survey of profit-sharing and 401(k) plans by the Profit Sharing 401k Council of America (PSCA), employees (those not considered highly compensated) contributed 5.4% of their gross salary, on average, to their 401(k)s, up from 4.5% in 1993. Employers contributed 2.8% of payroll to 401(k) plans in the form of matching contributions.
The PSCA survey found that the most common type of matching contribution to 401(k) plans was a 50% matching contribution -- 50 cents for each dollar contributed by an employee -- for up to the first 6% of compensation. This 50% match was used by 33.6% of plans that made fixed amounts of matching contributions.
Some guidelines you may wish to consider in setting up a defined-contribution plan include:
- Identify importance of a defined-contribution retirement plan to recruit and retain employees. A first step in setting up a retirement plan is deciding on whether or not to use a defined-contribution plan. A key step is to align your company's goals for financial success with the desires and needs of your workforce. Since they often offer employer-matching and tax-deferred savings benefits, defined-contribution plans may be a substantial employee benefit.
- Evaluate costs of setting up a plan. As plan sponsor, you may decide to administer your retirement plan yourself or you may elect to hire a plan administrator. A plan administrator is a fiduciary agent that specializes in managing retirement plans. The cost to hire a plan administrator varies with the number of plan participants. You may be able to deduct some or all of any contributions that you make to the plan. For more information on deductions, see IRS Pub. 560.
- Consider using an investment policy statement. As plan sponsor, you want to ensure that you meet your fiduciary responsibilities. While not mandatory, you may wish to complete an investment policy statement. This document describes the investment guidelines and objectives that you intend to adhere to with your retirement plan. The Profit Sharing 401k Council of America (PSCA) offers a model of an investment policy statement. (Registration with the non-profit association of employers offering defined-contribution retirement plans is required to view the document.)
- Negotiate a reasonable number of plan investment options. You may want to negotiate with the plan administrator to ensure an adequate number of investment choices for plan participants to adequately
diversify their plan assets. Negotiations may include having the plan administrator offer mutual funds that aren't managed by a single investment-management company. The 2006 PSCA survey found that, on average, plan sponsors used 17 funds to make company contributions and offered 19 funds for employee contributions. More than 69% of the surveyed plan sponsors offered 10 or more mutual fund investment choices.
- Do a fund screening. A fund screening reduces the universe of mutual funds to just a few mutual funds or fund management companies that you, the plan sponsor, may be interested in offering to plan participants. You may want to consider hiring an investment-management consultant, which specializes in screening fund companies whose investment styles likely fit your investment policy statement.
The Economic Growth and Tax Relief and Reconciliation Act of 2001 authorized increased contributions, beginning in 2002, to 401(k) and other defined-contribution plans. A catch-up provision allows workers who turn age 50 to make even larger contributions.
For 2007, the employee contribution limit for a 401(k) plan is $15,500 for those under 50 and $20,500 for those who will be age 50 or older during 2007.. Limits for years after 2006 are indexed to inflation in increments of $500.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next Topic: Defined-benefit plans
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