Question

Jim, age 52, just started a consulting company.

He currently employs seven people, who range in age from 22 to 31.

Jim estimates that the average employment period for his employees will be about three years.

He would like to start a retirement plan that will favor older participants and contain an appropriate vesting schedule to maximize Jim's benefits.

In addition, he would like the employees to bear the investment risk of the plan. He is considering a SEP plan, SIMPLE-IRA, target benefit plan, defined benefit pension plan, and cash-balance pension plan.

Indicate which of these five plans would be best for Jim and discuss why it is the best choice.

Also, for each of the other plans, briefly describe why each particular plan would not be a good choice.

Answer 1

I would recommend Jim simplified employee pension plan (SEP). This is the plan that would be suitable because the employer is allowed tax deductions for the contributions made by him. This is also a plan that is favored by many small organizations because of its eligibility requirements. The following are the eligibility requirements:

• The minimum age is 21.
• At least three years of employment (matches with what Jim has mentioned).
• Minimum compensation would be $600.

The other important benefit of this plan which is not available in any of the other plans is that SEP would allow the employers to skip contributions when the business is down. Being a small business of seven employees, we can’t expect the business to be always in good position.

Why other plans are not suitable:

• Simple IRA: the drawback here is that the owner can’t save as much as much for retirement as with other small business plans like SEP. also this can’t be rolled into traditional IRA without 2 year waiting period.
• Target benefit plan: this is a plan that involves fixed contributions. Being a small business, we can’t assure on the profitability & it would be difficult for Jim to make it when the business experiences losses.
• Defined benefit pension plan: this is mainly suitable for larger corporations with stable work force. This being small business we can’t expect all the seven people would continue forever. And also the benefit depends on the employee’s salary. Higher the salary, higher the benefits.
• Cash balance pension plan: this is considered to be costly because Cash balance pension plans can be more costly to employers than 401(k) plans, in part because an actuary must certify each year that the plan is properly funded. Typical costs include $2,000 to $5,000 in setup fees, $2,000 to $10,000 in annual administration fees, and investment-management fees ranging from 0.25 to 1 percent of assets.