Retirement savings plans are designed to help employees save money to enable a comfortable, secure lifestyle during retirement. From the business sector to NGO organizations many different retirement plans exist. Most commonly people are familiar with 401(k) typically offered by corporations to its employees and IRA’s (both roth and traditional) which are more widely accessible. For nonprofit organizations there are unique plans available in creating retirement savings plans. Options like 403(b) and 457(b) are specific to nonprofit organizations. In today’s post, we will review the benefits and drawbacks of each of these options for nonprofit organizations and their employees.
What’s a 403(b)?
A 403(b) plan, also known as a tax-sheltered annuity (TSA) plan, is constructed specifically for employees of public schools, colleges, universities, certain tax-exempt organizations like 501(c)(3) non-profit, government agencies, hospital service organizations, and certain religious ministers. Many of these organizations use 403(b) plans as either stand-alone retirement vehicles or as supplements to typically beefier defined benefit plans. Enrolled participants are allowed to contribute up to a specified percentage of their salary into 403(b) plans. Specific benefits from these plans include:
- Tax-deferred earnings. In other words contributions and interest earned in the account are not taxed until withdrawal, typically when retirees have lower taxable incomes, contributions and earnings will then be taxed.
- Contributions decrease the amount of taxable income for the year. Similar to other retirement plans, 403(b) plan contributions can be excluded from reportable income meaning your taxable income for the year will be less.
- Certain contributions may be eligible for tax deduction credits lowering taxable income.
- Similarly to 401(k) and IRA plans, eligibility to begin withdrawing from retirement is at age 59½.
The downside to 403(b) plans is that the plans themselves can often be confusing to start and maintain; something organizations like not-for-profit organizations may not have the time and resources to handle efficiently. In 2007, new fiduciary regulations were passed in an attempt to make the plans more transparent for employees. These regulations require yearly reporting. The Plan Council Sponsor of America (PCSA) offers a 19-page guide of the regulatory filings.
Understanding 457(b) Plans
Another retirement option for nonprofit organizations is the 457(b) plan. This is a voluntary, deferred compensation retirement plan available to certain governmental and tax-exempt entities under section 501(c)(3) of the IRS code These plans also allow users to contribute a portion of their paycheck monthly to an account. Employers have the option of matching contributions. However, it’s important to note that employee-matching is most commonly found in 401(k) plans, and then in sequence in 457(b) plans, followed by the least likely to match in 403(b) plans.
Similarly to 403(b) plans, most 457(b) plans are used in conjunction with more robust defined benefit plans. The benefit to 457(b) plans is they act like a second layer of retirement savings for users. For example once defined benefit plan contributions are maxed, employees can contribute up to the limits -$18,000 yearly – in a 457 plan. Doing so, employees at governmental and other tax-exempt agencies have opportunities to invest more money in retirement than typical corporate plans allow.
Once an employee leaves an employer, withdrawals from 457(b) plans can begin. However, a downside to 457(b) plans for employees still working is the increased withdrawal age of 70½ .
Do 401(k) Plans work for nonprofit organizations?
Nonprofit organizations have the choice whether or not to use 401(k) or 403(b) plans, most corporations can only choose to use 401(k) plans. While most go the route of 403(b) or 457(b) plans, certain tax-exempt organizations are eligible to offer 401(k) plans for their employees. Like setting up 401(k) plans for any organization, these types of plans are often the most expensive plan to set up and maintain as they require annual report filings with the IRS. To discuss specific 401(k) options that might work for your nonprofit, contact your financial representative.
1. Defined Benefit Plans Reward You for Years of Service.
Defined benefit plans are pension plans that reward employees based on years of service and associated salary earned. These retirement schemes pay out a set annuity amount upon retirement for the remaining life of an employee and/or their spouse. Alternately, defined contribution plans are retirement plans that establish investment opportunities for employees based on employee and employer contributions.
The set amount is determined from a formula using the number of years of service, earnings history, and age. Typically, years vested is multiplied by pensionable earnings and divided by the set accrual rate. For example, for someone vested in a pension plan for 20 years, retiring at an average salary of $100,000, and a set accrual rate of 1/60th can expect $33,333 in pension yearly.
2. Defined Benefit Plans May Be a Good Option for Business Owners
For small business owners, defined benefit plans may be a particularly attractive retirement scheme. The IRS allows business owners to contribute up to 100% of average salary based on the highest three consecutive years or up to $210,000, whichever figure is the lesser amount. For small business owners making large salaries, near the $210,000 mark, defined benefit plans are a great tool to stockpile or quickly make up ground in retirement savings.
This type of plan may also be attractive to small business owners because the contributions are fully deductible as a common business expense. For small businesses that face issues with high turnover, defined benefit plans can also add incentives for employee retention. When setting up these schemes, business owners effectively reward employees who stay with a company for a tenured amount of time. For employees who only stay short stints, the scheme is less beneficial.
However, it is important to note that defined benefit plans are relatively expensive to manage compared to alternate retirement schemes. Therefore it’s recommended that business owners have steady, strong cash flows and a relatively small number of employees before considering this plan.
3. You Have Options In How You Draw Your Pension
There are several options when considering how to utilize pension funds. The most standard way is to withdraw once an employee has met vesting requirements. Once fully vested, an employee can begin drawing pension benefits, whether or not the employee is retired. This typically happens at the age of 65, when employers stop contributing to plans. However, depending on verbiage in the scheme employees may have access as early as age 62. The pensions drawn from a defined benefit plan are taxed at the time of withdrawal, similarly to how traditional IRA’s are taxed.
Alternately, employees may be able to withdraw pensions as a lump sum. Employees facing financial distress due to illness, job loss, or family emergencies may consider this option. Many times there is verbiage in the plan that restricts this sort of access, however. For example, a plan may only allow a lump sum withdrawal up to $30,000 dollars in funds or in $10,000 installments. Regardless, lump sums are subject to taxation as well.
4. You May Be Able to Borrow Against Your Pension Plan
Some pension plans include provisions that allow participants to borrow loans against their pension plans. The IRS regulates that up to 50% of the vested pension plan balance can be used to borrow against in the form of a loan. If your balance is less than $10,000 then the full amount may be borrowed against. The maximum limit is set at $50,000 and loan terms cannot exceed five years (except for the purchase of a home). Your plan administrator will set up regular payments of roughly equal proportion. Each payment will include principal and interest, with interest rates configured based on current market prime rates. Effectively, you’re borrowing money from yourself and paying yourself back on the loan plus additional interest.
At TrueNorth Retirement Services, we can help make your journey easier. We believe in honesty, reliability, and hard-work. As fee-only fiduciary advisors, we sit on the same side of the legal table as plan sponsors providing sound investment advice. We listen to plan sponsors and understand your challenges. Our goal is to understand your needs and then try to create a plan to address those needs. We appreciate the opportunity to assist you, your company’s retirement plan, and your participants. For a free financial consultation, please call: (801) 274-1768 or email info@truenorthwealth.com.
