Small business owners need to understand the risks and rewards of starting a pension for employees.
If you own a business, and want an easy tax deduction, many so-called investment professionals want you to open a pension plan, so you can deduct the contributions to the plan.
While tax deductibility is one of the benefits, there are a number of duties and issues which come with the plan setup. This article is designed as a starting point so the business owner understands the risks and rewards of starting a pension for your employees.
The Type of Plan
Most advisors suggest a 401K plan, which is an arrangement where employees can redirect part of their paycheck to fund their own retirement, and the employee can pick among a variety of investment choices .
Small business owners like that idea, because the majority of the funding comes from the employee, not from the business.
However, there are limits on how much the highly compensated company leaders can allocate for themselves, based upon the amount the lower –paid rank and file employees put in to the plan. In order to induce employees to contribute, employers may set up an automatic withdrawal for employees, so they don’t actually feel the cash coming out of that paycheck.
Employers may also lure the employees to contribute by offering a matching company contribution, which isn’t immediately owned by the employee. Those matching contributions don’t become irrevocable, or “vest”, until 3 to 6 years of employment.
There are other types of plans including defined benefit plans or an employee stock ownership plans.
Those types of arrangements are seldom started by small businesses because they cost too much to maintain, require significant contributions from the company and often have undesired consequences for the company and its stockholders.
Fiduciary Duty of the Sponsor and Trustee
The owner of the company which sponsors the plan may have significant responsibilities to assure that the plan is operating in the best interest of the employees.
Seven of those duties include:
1. Allowing the employees a variety of investment choices from low-risk/guaranteed return investments to high-risk high potential reward funds.
2. Ascertaining that the investment choices are not burdened with excessive fees or expenses which reduce the investment returns.
3. Computing the correct amount to be withdrawn from employees who opt in to the withholding arrangement.
4. Depositing employee money on a timely basis, which is usually 3 to 5 days after the payroll is computed and paid to the employees.
5. Filing an annual form called a 5500 with the IRS and Department of Labor in a manner that is accurate and on time.
6. Updating the plan as laws change to be assured that the plan operations comply with the updated law.
7. Assuring that persons hired to handle the pension compliance rules, including the third party administrator, the plan’s attorney and CPA, the asset custodian and investment advisor are all competent.
These are only a sample of the duties the employer-sponsor must accept.
The Department of Labor and the IRS have increased their oversight on 401K plans, and are imposing stiff fines on those plans that do not meet their legal duty. However, the fines are never paid from employee investments, so the likely responsibility will rest with the sponsoring company or its officers , or the plan trustee .
Investment advisors often forget to explain these risks and obligations since it defeats their opportunity to earn the advisory fees they could obtain if the owner knew how much effort is really involved.
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