Money purchase pension plans
Money purchase pension plans are similar to profit-sharing plans, but employers are required to make an annual contribution. Participants receive their respective share according to the plan document’s formula.
As with profit-sharing plans, money purchase pension plans cap individual contributions at 100% of earnings or $57,000 annually in 2020 (up from $56,000 in 2019), while employers are allowed to make deductible contributions up to 25% of the total compensation of all plan participants.
Like profit-sharing plans, money purchase pension plans are relatively straightforward and inexpensive to maintain. However, they are less popular than profit-sharing or 401(k) plans because of the annual contribution requirement.
Defined benefit plans
By far the most sophisticated type of retirement plan, a defined benefit program sets out a formula that defines how much each participant will receive annually after retirement if he or she works until retirement age. This is generally stated as a percentage of pay, and can be as much as 100% of final average pay at retirement.
An actuary certifies how much will be required each year to fund the projected retirement payments for all employees. The employer then must make the contribution based on the actuarial determination. In 2020, the maximum annual retirement benefit an individual may receive is $230,000 ($225,000 in 2019) or 100% of final average pay at retirement.
Unlike defined contribution plans, there is no limit on the contribution. The employer’s total contribution is based on the projected benefits. Therefore, defined benefit plans potentially offer the largest contribution deduction and the highest retirement benefits to business owners.
SIMPLE IRA retirement plans
Actually a sophisticated type of individual retirement account (IRA), the SIMPLE (Savings Incentive Match Plan for Employees) IRA plan allows employees to defer up to $13,500 for 2020 (up from $13,000 2019) of annual compensation by contributing it to an IRA. In addition, employees age 50 and over may make an extra “catch-up” contribution of $3,000 for 2020 (same limit as 2019). Employers are required to match deferrals, up to 3% of the contributing employee’s wages (or make a fixed contribution of 2% to the accounts of all participating employees whether or not they defer to the SIMPLE plan).
SIMPLE plans work much like 401(k) plans, but do not have all the testing requirements. So, they’re cheaper to maintain. There are several drawbacks, however. First, all contributions are immediately vested, meaning any money contributed by the employer immediately belongs to the employee (employer contributions are usually “earned” over a period of years in other retirement plans). Second, the amount of contributions the highly paid employees (usually the owners) can receive is severely limited compared to other plans. Finally, the employer cannot maintain any other retirement plans. SIMPLE plans cannot be utilized by employers with more than 100 employees.
The above sections are not exhaustive, but represent the most popular plans in use today. Current tax laws give retirement plan professionals new and creative ways to write plan formulas and combine different types of plans, in order to maximize contributions and benefits for higher paid employees.
Finding a plan that’s right for you
If you are considering a retirement plan for your business, ask a plan professional to help you determine what works best for you and your business needs. The rules regarding employer-sponsored retirement plans are very complex and easy to misinterpret. In addition, even after you’ve decided on a specific type of plan, you will often have a number of options in terms of how the plan is designed and operated. These options can have a significant and direct impact on the number of employees that have to be covered, the amount of contributions that have to be made, and the way those contributions are allocated (for example, the amount that is allocated to you, as an owner).