Executive Summary:
If you're like many small business owners, running your own business can feel like an all-consuming endeavor. And the idea of establishing a retirement plan, in addition to everything else you already have to do, might feel overwhelming and evoke worries about complicated reporting and administration. All of this can cause you to put off choosing a retirement plan for your business. But, if you plan to retire in your lifetime, you will need cash flow to buy groceries, pay property taxes, go to your doctor, etc. In the United States, there is some help in the form of Social Security, which provides the most basic retirement plan. However, if you want to sustain your current lifestyle or live even better in retirement, Social Security will not be enough. A retirement plan can help you bridge the gap between your ambitions and the money you will need for everyday living.
Essentially, retirement planning is about efficiently handling taxation during both the time you are employed and when you stop working--and it begins with choosing the correct plan for your situation. The major plans available to everyone are traditional IRAs and Roth IRAs. And if you are an employer, you have the ability to create other qualified retirement plans--for example, 401(k), 403(b), profit-sharing plans, and cash balance plans. Advisors can help you choose the best plan to accommodate your company’s unique needs.
While the difference between traditional IRAs and Roth IRAs may seem confusing, the main difference is the time at which you pay taxes on your money. In a traditional IRA, you take a tax deduction now, but you pay taxes when you retire. Money grows in your account in a tax-deferred manner during your working years, and it is taxed at normal income level--ideally in a lower tax bracket--when withdrawn in retirement. You can control how much income you want to receive in the future by controlling withdrawal levels, which allows for the right tax planning strategies. A Roth IRA works in precisely the opposite manner: you pay taxes now so you don't have to pay taxes in retirement. Deciding which plan is best for you depends on your personal situation, and financial planning advisors can help determine the right balance.
Most retirement plans are built to be employer-sponsored, and they benefit employees as well as business owners. Contributions to SIMPLE IRA(Savings Incentive Match Plan for Employees Individual Retirement Account) and SEP IRA(Simplified Employee Pension Individual Retirement Account) are based on a percentage of income-- company owners make contributions and are required to proportionately put in the same percentage of income for all eligible employees. The next level of complexity is to use plans that require employee contributions, such as 401(k)s or 403(b)s. These plans are generally made available to all qualified employees. Participation is not mandatory, and the sponsoring company is not required to provide matching contributions to employees who do not contribute to the plan. Companies can go even one step further by providing profit sharing and even building defined benefit plans like cash balance plans to allow for larger tax-deferred contributions.
Employers who include their employees in retirement plans receive considerable benefits including increased employee retention, company tax benefits, and overall happier employees. While business owners may worry that employees will take the money and leave, in reality, companies can attach strings to the money they contribute, which strengthens the bond between employees and employer. Plans can be set up in multiple ways, and vesting schedules, matching contributions, investment choices, and employee access are all considerations to be reviewed with an advisor to ensure they fit the plan’s goals.
This article by Mahym Gulova, Administrative Associate, is an excerpt from an interview with Colin Kelty, President and Senior Financial Advisor, and Michael Goldenberg, CEO and Co-Founder, at AFIN Family Wealth Management.*
*Securities and insurance products are offered through Cetera Investment Services LLC (doing insurance business in CA as CFGIS Insurance Agency), member FINRA/SIPC. Advisory services are offered through Cetera Investment Advisers LLC. Cetera is under separate ownership from any other named entity.
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Interview Transcript
Q1: Why do I need a retirement plan?
Michael Goldenberg: This is the third country that I have lived in, and while the basic retirement plans are different from country to country, one thing is consistent in all countries--the need for cash flow when I retire. Retirement happens in some countries at a specific age, and in some countries--including the United States--when you can't continue working or when you choose to stop working. When it comes time to retire, for whatever the reason and in whichever country you retire, you have to face serious questions: How are you going to buy bread? How will you pay your property taxes? How will you pay your doctor? The simple answer is that to do all of those things, you will need cash flow.
In the United States, you have some security in the form of the most basic retirement plan, Social Security. But relying on Social Security income alone will place you below the poverty line, so you need a plan to bridge the gap between guaranteed Social Security pensions and the actual amount of money you need for daily living. A retirement plan can ensure that your bridge is built effectively and efficiently.
You can stash money under your mattress, invest in government bonds, open Roth IRAs, or contribute to your 401(k) plans. All of these options have benefits, and we prefer customizing your retirement plan so that you feel comfortable with it and that it works for you. Whatever your plan, the goal is to ensure that you will be able to maintain your pre-retirement lifestyle--or better-- after you retire.
Q2: How should I approach the process of choosing a retirement plan?
Colin Kelty: Retirement planning is basically a function of efficiently handling taxation during the time you are working and the time you are not working. This planning is a complex matter of determining how much taxes should be pushed forward in time to a point when you are no longer drawing a paycheck; how much tax should be paid now so you have tax free money in retirement; and how much money we can officially get into retirement accounts. We determine those numbers based on rules the IRS gives us, and we are governed by how much money you make; what kind of business you run, which determines what kind of options we can build for you; and your working and retirement goals. Taking all of that into account, we can determine how much you need to get into retirement accounts, how quickly and efficiently you can do that, and which type of account will be the best for your needs.
Q3: What are the major plans available to me?
Colin Kelty: In the United States, a few basic retirement plans are available to everyone. Today, I’ll discuss traditional and Roth IRAs, as I explain those quite frequently. If you work for an employer or you are an employer, you have the ability to create a 401(k) or a 403(b), which are qualified retirement plans owned by a company or institution. In addition, profit-sharing plans and cash balance plans also exist. Each different plan has different functions and different nuances, but those are the basics.
Michael Goldenberg: And I will add to that. Historically there were more pension plans around. Now, pension plans are disappearing, especially in the private sector. For those working in some organizations (government, healthcare, etc.), pensions are still available, but for the rest of us, pensions are no longer an option.
Q4: What are the differences between traditional and Roth IRAs?
Michael Goldenberg: For money contributed to a traditional IRA, you take a tax deduction right now, and you pay the taxes when you retire. Some of the main benefits of this plan are that you get a tax deduction now, money grows in a tax-free (tax-deferred) form over the years, and then, in retirement, you can control the amount of income that you want to receive, which allows for effective tax planning. One major negative possibility to consider is that if you contribute too much, you can end up with a massive 401(k) or traditional IRA account, and that can push you into a higher tax bracket in retirement.
The Roth portion of an IRA or the Roth portion of 401(k) or 403(b) plans works exactly the opposite in terms of taxation. When the money goes into your account, you pay taxes on this money now. Then, it grows in a tax-deferred manner until you retire. When you take the money out in retirement, you do not have to pay taxes on it because you already paid the taxes when you earned the original money you put away into the account. Because you didn’t take tax deductions earlier, you get to take them now. This can be a great benefit.
But deciding which one is better for you is personal and depends on your unique situation. Because of this, you need a financial plan to determine the best choice. But, in the end, the main difference between these two approaches is that in the Roth, you pay taxes now and you don’t have to pay in the future, but in the traditional, you don't pay now, but you will have to pay in the future. I often consider both approaches for our clients because, at the end of the day, we don't know what taxes rates will be in the future, so a combination of both of these plans works quite well for many clients.
Q5: Do I have to include my employees in my retirement plan?
Colin Kelty: Usually, yes. Most retirement plans are built to be employer-sponsored, but to benefit the ownership structure and the employees--although that is not entirely true for all retirement plans. Generally, the more money your business makes, the more money you can direct into plan structures that allow for more ownership benefits. There are simple plans like SIMPLE IRA or SEP IRA. Contributions are based on the percentage of income you want to put in for the ownership, which means you have to proportionately put in the same percentage of income for everyone.
You can go to the next level and offer 401(k)s to everyone, but there is no requirement for you to provide a matching portion of 401(k). But everyone has to be offered the opportunity to participate in a plan and some restrictions could be added. And those restrictions are based on the time at the company, hours worked, and, to a certain extent, employee age. The next level is profit sharing, which doesn't necessarily have to be given proportionately to any person involved in the plan, but rules and regulations govern all of that. Cash balance planning can also be built, which is driven more by the company's ownership and doesn’t necessarily have to benefit employees. A lot of planning must be done before we make any recommendations regarding cash balance planning.
Q6: What are the benefits of including employees in my retirement plan?
Colin Kelty: Employee retention is the greatest benefit, because employees are generally happier if they can imagine they will be able to retire at some point. As Michael said, people used to have pensions. For example, my grandfather used to be a steelworker. Did he love his job? No, but he knew he could retire with a pension, so he knew he would be taken care of, and he stayed with the company his whole life. But the American retirement dream has changed considerably since then, and these days, retirement planning is more an individual responsibility rather than the responsibility of a company.
Offering retirement plans is a good thing to do for employees--and not just from an altruistic standpoint, because employers also receive considerable benefits. Companies that provide their employees with 401(k)s, profit-sharing, 401(k) matches, and those types of benefits have much higher employee satisfaction levels, and thus, a higher rate of employee retention. And, as icing on the cake, the government offers incentivizing tax benefits to employers who set up plans to help their employees plan for retirement. Not only can employers write off 401(k) set up and operating fees, but the contributions they give to employees don't pass through as taxable income. This can be a win-win situation: employees benefit by planning for retirement, and employers benefit by retaining good employees and receiving tax benefits.
Q7: Can employees take the money when they leave?
Michael Goldenberg: It depends on how the plan is structured. Generally, as an employee, your money will be divided into two categories: money you contributed and money the company contributed. You can usually take the money that you contributed with you when you leave the firm. The money the company contributes to employees usually comes with some strings attached--in the form of vesting. Vesting schedules can be set up in multiple ways, depending on the plan--usually somewhere between three to seven years. If an employee works for a company for fewer than three years, usually most of the money is not vested. But if they work somewhere for more than seven years, usually all of the money is vested. Again, it depends on how the plan is structured, but if an employee works somewhere for three to seven years, they are entitled to a portion of the employers' contributions.
Colin Kelty: The simple answer to this question is that employees can generally leave with whatever they put into the plan by taking it out taxably, rolling it over to other plans, or rolling it over into an IRA. But, employers can attach strings to the money they contribute. There is, however, a maximum time frame employees can set for vesting, and, as Michael stated, seven years is the current maximum. The average time frame across industries is three years.