Having a financially secure retirement is the goal of all Americans, but what’s the best way to achieve it?
While there are many paths to achieving financial security, they all depend on a few simple, straightforward concepts. When followed, these concepts provide the basis for funding tax-efficient retirement accounts that can produce solid returns in the future.
Planning for retirement is a long process. But if you start out with the right tools, this decades-long journey can be made much easier and hopefully end with more money in your portfolio.
Here are the key concepts and elements you need to understand in order to select a tax-deferred plan that can lead to a financially secure retirement.
1. Choose an Appropriate Plan
Small business owners can choose from a variety of tax-deferred plans that offer a range of benefits and features. Given this variety, owners can choose the appropriate plan offered by the IRS that matches their business and financial structure.
For instance, a business with high employee turnover can choose a plan that has a vesting schedule for employer contributions. This increases employee tenure, so employees have to meet eligibility requirements in order to take their contributions with them to their next job.
If your business income is not financially stable, or if it fluctuates because your business has just started, you may consider a profit-sharing plan or an SEP IRA, where contributions are discretionary. This gives you more flexibility when funding the plan while a more stable income stream develops.
Other options to consider when setting up a retirement plan include the desired amount of contribution, the complexity of plan administration and who assumes any funding responsibility. SEP IRAs and profit-sharing plans are funded only with employer contributions. SIMPLE IRAs and 401(k) plans are often funded with employer contributions and supplemented by employees’ salary-deferred contributions that may offer a tax benefit.
At the individual-plan level, here are some factors to consider:
- IRA-based plans, in general, are very popular among newly established employers.
- Simplified Employee Pensions (SEPs) are IRA-based employer plans in which your business is solely responsible for funding the plan. Since contributions are discretionary in SEPs, small business owners should consider this structure if you cannot gauge profit margins from year to year.
- Simple IRAs are commonly funded with employer and employee contributions. Employee contributions—also known as salary-deferral contributions—are made on a pre-tax basis from the employee’s salary. This reduces the employee’s taxable income. Contributions to SIMPLE IRAs, like SEP-IRA contributions, are immediately 100% vested.
2. Understand Basic Retirement Investment Concepts
Investing for retirement is a long-term process, often extending over 30 years into the future. Since most of today’s small businesses use 401(k)-type, SEPs or other tax-deferred plans to create investment portfolios, people are assuming all the market risk for their investment decisions.
This is in stark contrast to the 1980s, when employer-sponsored, defined-benefit pension funds were managed by professional investment managers. But since then, employers have phased in defined contribution (DC) or 401(k) plans that have effectively put the responsibility for managing retirement investments into the hands of individuals, many of whom are not equipped to handle the task.
This seemingly subtle shift in the way retirement has changed means that small business owners and employees have to be aware of market risk.
While risk is an ever-present element in long-term investing, it can be managed—and often reduced—by portfolio diversification, choosing active vs. passive investment strategies, choosing the appropriate investment vehicles (i.e. mutual funds and low-cost ETFs versus individual stocks), including both fixed income and equities, and plain-old discipline (i.e. avoiding frequent buying and selling of portfolio investments).
Risk management is important because if you lose 50% of an investment, you have to make a 100% gain to get back to even. That is difficult to do in real-world investing.
Investing over time also has another great benefit: compound interest. This is considered one of the financial world’s most powerful mathematical tools. It is a mathematical force that astounded Albert Einstein. It also impressed Ben Franklin, who left £1,000 each to the cities of Boston and Philadelphia, and stipulated that they could not withdraw this money for 100 years. After that time period, they could withdraw $500,000. After 100 years, the money allocated to Boston had compounded at 8% and in 1990 was worth $5 million.
Compounding is available to anyone who starts saving or investing early and leaves it there for many years.
3. Implement the Strategy
Using these concepts, entrepreneurs can begin to implement their retirement program for themselves and employees. There are a variety of appropriate tax-deferred vehicles listed by the IRS available to small business owners that have different requirements and benefits.
The good news is that these are established plans that are readily available from investment firms and independent advisors. These plans (e.g. SEP, payroll deduction IRA, SIMPLE IRA, Roth and 401(k)) are offered with advice about evaluating appropriate investment options and any requirements to open an account.
Selecting a plan also means it should be evaluated using important criteria, including whether the plan will be open to employees or just owner-managers, the plan’s flexibility, eligibility requirements, contribution limits and evaluations of the benefits to both employees and employers.
4. Implement the Plan
Choosing a retirement plan today is much easier than it was only five years ago. That’s because a number of online resources have popped up that can help small businesses set up a plan. These sites are often cheaper, faster and simpler than working with brokers. Additionally, online sites appeal to younger workers and are typically more convenient, allowing plan participants to make any needed changes to their accounts whenever necessary.
Once a qualified retirement plan is established, the next step is choosing the appropriate menu of investments that ideally will begin to generate an investment return that is above market averages over time. This is a challenge, but there are some important things to consider that you can control, which can greatly improve your odds of beating the indexes.
The most important is controlling the fees and expenses of any investment. In fact, a recent study of the S&P and Dow Jones Indices found that 86% of active large-cap fund managers failed to beat their benchmarks in 2014, while almost 89% of those fund managers underperformed their benchmarks over the past five years. For further context, 82% underperformed over the last decade.
These poor results for active fund management raise the question about fees. Why do investors pay fees to active managers who often fail to outperform an index fund? Especially when index funds have proven to be much cheaper.
No matter what the investment return to anyone’s portfolio, fees are always charged. High fees have a very corrosive effect on any investor’s net return. For example, an investor with a $100,000 401(k) portfolio can pay a 1.5% management fee to an advisor and a 1.4% annual fund expense charge, handing over almost 3% of a portfolio in total expenses annually. Nobel Prize-winning finance professor Burton Malkiel estimated that, over time, fees of just 3% can devour up to 50% of an investor’s returns, as cited in the book How 401(k) Fees Destroy Wealth and What Investors Can Do to Protect Themselves.
The importance of fees was again illustrated in a May 2015 New York Times article that cited an audit of New York City pension accounts. The audit found that, over the past 10 years, five pension funds paid out over $2 billion in fees to money managers and “have received virtually nothing in return,” according to New York City Comptroller Scott M. Stringer. The audit covered funds with assets of almost $160 billion covering 715,000 city employees, including teachers, police officers and firefighters.
5. Monitor the Plan
Once a retirement plan is in place, business owners have a responsibility to monitor and manage the plan over time. This is because investment conditions are fluid. People age, tax regulations change, and investment firms may alter their fee and expense structures. All of these have a material effect on the retirement plan and investment strategy.
Another key area to monitor is employee financial education. Ongoing education about the markets and investments should be part of any employee orientation and education program.
Small businesses that offer benefits—especially any type of retirement plan or 401(k) match—also have a distinctive advantage in attracting and retaining motivated and qualified employees. Retention is also improved when benefits are offered, accompanied by good working conditions and comfortable living wages.
Taken as a package, building and offering a well-structured and equitable retirement plan will benefit employers and employees alike. Small business owners can reap significant tax benefits while also saving for their working and retirement years.
Retirement is just one aspect of a solid benefit plan that can attract high-performing workers. To create a full-spectrum benefit package, see our guide to employee benefits for small business.