First, I want to be clear that these small business retirement plans are available to all types of business structures, whether you have a sole-proprietorship, S or C Corporation, LLC taxed as a corporation or partnership, or a partnership. However, just because these plans are available to all businesses doesn’t mean they’re right for yours. To determine which option is best for your business, you’ll need to identify your goals and determine your cash flow.
There are 6 major types of small business retirement plans: Payroll Deduction IRA, SEP IRA, SIMPLE IRA, 401(k), Safe Harbor 401(k) and Defined Benefit Plan. Similar to the old fashioned “baker’s dozen” that provided a bonus 13th donut, in the small business retirement account world, there is a bonus of two other types of small company retirement plans: the Profit Sharing Plan and Automatic Enrollment 401(k). However, these last two “bonus” plans are often used as features in a Traditional or Safe Harbor 401(k), not as stand alone plans.
The types of small business retirement plans vary from the simple, employee-only Payroll Deduction IRAwith no employer contributions, to the most complex, employer-sponsored Defined Benefit Plans.
Continue reading for an introductory exploration of small business retirement plans and to learn more about which plan might be right for your company.
IRA Based Plans
An IRA, or Individual Retirement Account, is one of the simplest retirement plans available to small businesses. These plans can include minimal employer involvement or employer contributions, depending on the business owner’s preference.
Payroll Deduction IRA
Under this plan, employees set up a Traditional or Roth IRA. The employee then informs the employer the payroll deduction amount that they want to contribute to their IRA. The employer then transfers the employee’s IRA payroll deduction to their IRA account.
Like with other IRAs, contributions are not subject to taxes until the time of withdrawal.
SEP IRA
For most small businesses with employees, a SEP (Simplified Employee Pension) does not make sense. It can be very costly where all contributions are made by the employer. In addition it does not promote or educate employees on saving for their retirement.
However, SEP IRAs can be a good fit for self-employed individuals with no employees. Annual contributions can vary in amount from year to year, allowing business owners to adapt to leaner times and take advantage of profitable years. Plus, contribution limits are very high, amounting to $57,000 or 25% of earnings (whichever is lower).
SIMPLE IRA
SIMPLE (Savings Incentive Match Plan for Employees) IRAs are available to businesses with fewer than 100 employees. A SIMPLE IRA plan works like a 401(k) plan and offers many of the same benefits as traditional retirement plans, but with lower administrative costs. If you don’t have a lot of excess cash flow, this plan can be a good starting point.
However, this plan, like any other plan, has its pros and cons. Although SIMPLE IRAs are easier and less costly to administer, employee contribution limits are lower than with a 401(k) (generally $6,000/year less if under age 50 and $9,000/year less if over age 50). Additionally, employers sacrifice flexibility with the employer contribution or match (either 2% of all eligible employees’ compensation or a 3% matching contribution).
Small businesses who have some cash flow flexibility tend to start with a Safe Harbor 401(k) or they graduate to it from a SIMPLE IRA plan. The Safe Harbor 401(k) allows for simplified discrimination testing if the employer contributes 3% of all employees compensation or a 4% matching contribution.
Defined Contribution Plans
Under a Defined Contribution Plan, employees make tax-deferred contributions to capital market investments with or without additional employer contributions. The most common types of defined contribution plans are 401(k)s.
401(k) plans give employees the option to have a portion of their earnings redirected by their employer to an individual retirement account. These elective deferrals are usually exempt from federal income tax at the time of contribution. Instead, employees pay taxes when they begin to withdraw funds after retirement age. The exception is when employees flag some of their deferrals as “Roth elective deferrals.” These deferrals follow the same taxation rules as Roth IRAs and are taxed as income during the contribution year.
Employer contributions to 401(k) are tax deductible when they are within 401(k) contribution limits.
Traditional 401(k)
With a Traditional 401(k), an employer can match contributions to employee elective deferrals or contribute on behalf of every employee, regardless of whether that employee has contributed. All contributions must meet nondiscrimination criteria and employers must pass annual tests, proving that contributions do not inappropriately benefit highly compensated individuals.
Safe Harbor 401(k)
Safe Harbor 401(k) plans offer many of the same features as a Traditional 401(k), with the primary difference that employer contributions must be fully vested. Furthermore, Safe Harbor plans are not assessed with complex annual non-discrimination tests. Even still, without a profit sharing feature, employers cannot allocate more money to highly compensated employees.
Automatic Enrollment and Profit Sharing
Automatic enrollment and profit sharing are features that can be added to a 401(k) to tailor the plan you select to the specific needs or desires of your business.
The profit sharing retirement plan feature enables 401(k)s to function similarly to Defined Benefit plans. Using this feature, employers can more heavily weigh their contributions to highly compensated and longest tenured employees. However, they can do so at a much lower cost than a Defined Benefit Plan. Plus, employer contributions are discretionary, so small business owners can adjust their annual contributions according to cash flow.
To learn more about profit sharing plans, download our eBook Profit Sharing: The Small Business 401(k) Tax Saving Secret.
The automatic enrollment feature enables business owners to automatically redirect a fixed amount or percentage of employees’ wages to a 401(k) plan. Employees must take action to opt out of this arrangement. Some businesses choose to add this feature to encourage their employees to save for retirement.
Defined Benefit Plans
The most complex small business retirement plan is the defined benefit plan. This plan allows for the highest contributions to employees. It is funded by the employer. It is by far the most expensive plan based on level of contributions and cost to administer. It works like a pension plan – the older you are and closer to retirement, the larger the employer contribution. These plans work best for small businesses with no employees beyond the principal owner or a very small number of employees, especially if they are much younger than the owner and years from retirement.
Which small business retirement plan is right for your business?
Choosing the right small business retirement plan comes down to your goals and cash flow.
Working with a fee-only, fiduciary financial planner like Bartley Financial can mean the difference between choosing a small business retirement plan that saves your company money and retains top talent, and choosing a plan that swamps your business in expenses and administrative headaches.
Reach out to us today to find out more about how we can help you choose, implement, and maintain a retirement plan for your small business.