I am amused at how often business owners refer to all types of retirement plans as 401(k) plans. There are actually many types and varieties of retirement plans; and ironically, I seldom recommend a 401(k) plan to a business owner client who is starting a retirement plan for his or her company.
The conversation usually begins something like this:
“Jason, I think I am ready to start a 401(k) for the business. How much will it cost me, and how much do I have to put in for my employees?”
Before we delve into my perspective on the best starter retirement plan for businesses (which I will cover in my next article), I’m going to provide a top line overview of the basic plan types. There are two basic qualified retirement plan types available to businesses today: 1) defined benefit and 2) defined contribution.
A defined benefit retirement plan requires the employer to pay a certain level of benefit to each retired employee. This plan type is similar to a pension. Upon retirement, the company contributes a specific benefit amount to each retired employee. The amount paid is usually determined by a formula that incorporates a variety of key factors, like the employee’s salary history and longevity. The company is typically required to pay the benefit for the lifetime of the retiree.
A defined contribution plan requires the employer to pay a certain level of contribution to employees while they are still working. In simple terms, think of a 401(k) company match. The employer is required to contribute a certain amount into an account for each employee. Upon retirement, the employer is no longer required to make contributions. It’s easy to understand why the private sector in America has all but stopped using pensions in favor of plans that have no ongoing, post-retirement financial obligation. It’s also easy to see that a newer business would favor this method since they aren’t typically financially stable and secure enough to promise an employee a lifetime of retirement benefits.
Within the defined contribution category, there are several specific types of plans to consider. Here is a brief list:
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