As a small business owner, it's up to you to make smart decisions that help you and your employees. Retirement planning is a big concern for many entrepreneurs. They want to save for the future, and help their employees do the same, but they also don't want to overload their balance sheet with commitments they can't afford. Is a traditional 401(k) really the best way to get the most bang for your buck?
For very small business with just a handful of employees, there's a better option. Let me show you one good alternative to the traditional 401(k) program.
What Is a 412(e)(3)?
One of the main drawbacks of a 401(k) is the way it limits tax-deductible contributions to your employees' accounts. It can also be expensive and complicated to administer because of the need for actuarial analysis. Because of these complex reporting requirements and calculations, many solopreneurs and partnerships are looking for alternatives. One such alternative is a 412(e)(3) plan.
A 412(e)(3) plan is a defined benefit plan, whereas a traditional 401(k) is a defined contribution plan. The difference is that 412(e)(3)s are funded by an insurance company, through fixed life insurance or annuity products. Contrast this with a traditional 401(k) plan, which is funded by you, the employer. The only products that can be used to fund a 412(e)(3) are guaranteed, making this a much more conservative choice than retirement plans that invest employee funds in the stock market or mutual funds.
The biggest benefit of a 412(e)(3) is the amount it allows you and your employees to contribute. For example, in 2014, the maximum yearly contribution amount for a 401(k) is $52,000. For a 412(e)(3), employees in their 50s can contribute about $255,000.* The much higher contribution limit allows employees who can afford it to sock away money quickly, financing their retirement in as little as 10 years. Then, when you retire, you receive the equivalent of a pension: a monthly check.
A second benefit of 412(e)(3) plans is that they don't need an actuary's certification. According to Paul Sullivan of the New York Times, this can cost $6,000 to $7,000 per year. Because 412(e)(3) plans are funded with life insurance or annuities, your insurer handles the calculations an actuary would normally handle. Also, you don't have any required quarterly contributions, you don't have to deal with the funding limitations that can affect non-insurance-funded plans, and 412(e)(3) plans generally cost less to administer than 401(k) plans.
A third benefit is the life insurance coverage the plan provides (if funded with life insurance rather than an annuity). Should you or a covered employee die suddenly, the family members have a guaranteed income-tax-free death benefit to help see them through.
Now that you've heard the benefits, you're probably also wondering about the limitations. There is one main limitation you need to be aware of. This kind of plan works best at a very small company, with just you or you and a handful of employees. Why? Because you are obligated to offer the plan to every eligible employee. If you have hundreds of employees, you may not want to do this. If you have only a few, it's a lot more feasible.