Retirement planning can seem daunting enough for individuals. For small business owners, the pressure to choose a plan may seem even more overwhelming.
In reality, though, entrepreneurs are well-equipped to evaluate business needs, engage in long-term planning and carefully compare options – all the skills necessary to successfully select and set up a retirement plan for a small business. Setting up a retirement plan for a small business needn’t be daunting.
Moreover, there are a variety of benefits that make the task worthwhile. First and foremost, a well-structured retirement plan can help employers and their employees to effectively save for the future. A good retirement plan is also a valuable recruiting and retention tool, allowing business owners to attract and keep first-rate talent. And, depending on the type of plan employers choose, their businesses may even realize some substantial tax benefits.
The first choice employers need to make in selecting a retirement plan is whether they prefer a qualified or a nonqualified plan. Qualified plans receive tax benefits that nonqualified plans do not. Employer contributions and asset growth are generally tax deferred, meaning funds are subject to tax only when they are distributed to employees. Employers can also deduct plan contributions. In addition, qualified plans can offer features that employees find appealing: Some plans permit loans, which do not trigger tax consequences if paid back in accordance with the plan rules, and federal law protects qualified plans from creditors. Contribution limits are also higher than for individual retirement accounts, giving employees greater opportunities for tax-deferred savings.
Nonqualified plans lack some of these benefits – though some do allow a certain degree of tax deferral for the employee – but are also much less complicated. These plans are not subject to the same complex compliance issues as their counterparts. Therefore, while the employer does not get an immediate deduction for contributions, the administrative cost of the plan typically is less. Employers using nonqualified plans do need to take care to avoid “constructive receipt” for employees in order to preserve tax deferral. Doing so typically exposes employees to a level of credit risk if the business fails before paying out deferred compensation.
While nonqualified plans have their place, the four most common retirement plan choices for small businesses are all qualified plans: Simplified Employee Pension Plans (SEP IRAs), Savings Incentive Match Plans for Employees (SIMPLE IRAs), profit sharing plans (PSPs) and 401(k) plans. No one choice is necessarily better or worse than the others. Each involves benefits and drawbacks.
The SEP IRA principally offers simplicity. The plan is easy to set up, requiring only a basic form, usually provided by the custodian that will oversee the plan. After setting up the plan, the employer has no more filing requirements beyond notifying employees when contributions are made. The fees are also generally low. SEP IRAs are also available to self-employed individuals, which is especially useful for sole proprietors who intend to expand their businesses in the future.
SEP IRAs are completely funded by the employer, and employers can deduct plan contributions as a business expense. Employers make contributions for all eligible employees; eligibility is often determined by a combination of age, length of time with the business and annual compensation. An employer exercises some control over how to determine eligibility, but must contribute an equal percentage of each employee’s income in a given year, including the owner’s own. As of 2018, these annual contributions may be up to 25 percent of eligible employee compensation or up to $55,000, whichever is less. (Special rules apply for self-employed individuals when calculating the maximum deductible contribution.) An employer with a SEP IRA plan need not contribute every year, allowing some built-in flexibility. This feature may be especially attractive to businesses with inconsistent cash flow.
Despite the acronym, a SIMPLE IRA is a step more complex than the SEP IRA, though it is still relatively straightforward. Like a SEP, a SIMPLE plan has no ongoing filing requirements once established. It is available to businesses with fewer than 100 employees as long as the business has no other retirement plan in place. All employees who have earned income of at least $5,000 in any prior two years and are reasonably expected to earn at least $5,000 in the current year must be eligible to participate in a business’s SIMPLE IRA, regardless of other employer-specific requirements.
Both employer and employees can contribute to a SIMPLE plan. Employer contributions are still tax deductible, as in a SEP plan, and employee deductions are pretax salary deferrals. In 2018, employees can make contributions of up $12,500 per year, regardless of their salary level; participants age 50 or older can also make additional catch-up contributions up to $3,000. Employers may either match employee contributions dollar-for-dollar, up to 3 percent of compensation, or contribute 2 percent of each employee’s compensation directly. If employers opt for the 2 percent contribution, they must contribute each year and take into account up to $275,000 of compensation per employee as of 2018. While employers who elect to match employee contributions must still contribute every year, they can adjust the match amount to as little as 1 percent for the year, though they cannot do so more than two out of five consecutive years.
In both SEP and SIMPLE plans, employees are completely vested as soon as an employer makes a contribution. If employers wish to use the plan to encourage retention, they may wish to look into options that allow for vesting, such as a profit sharing plan. This plan offers more features at the tradeoff of a greater administrative load than the two options above.
A profit sharing plan is funded only by the employer. Like a SEP, these plans allow employers to make discretionary contributions, which can provide flexibility for businesses with inconsistent cash flow. In most PSPs, employees receive either a fixed or a formula-determined percentage of their compensation for the plan’s fiscal year. An employer is not required to make a contribution every year, although employers must use a set formula for allocating profits in years they do contribute. The business may set up this formula in a variety of ways but must respect annual contribution limits of 100 percent of the employee’s income or $55,000, whichever is less. Employers may deduct amounts up to 25 percent of aggregate participant compensation. PSPs are available to businesses of any size, and may even be used in conjunction with another retirement plan if desired.
The plan with the heaviest administrative load also offers the widest variety of features: the traditional 401(k) plan.
Sole proprietors with no employees, or whose only employee is their spouse, can take advantage of a Solo 401(k) (also called a Self-Employed 401(k) or an Individual 401(k)). This plan allows the business owner to contribute up to 25 percent of eligible compensation up to a maximum amount, which is $55,000 in 2018. This allows for a larger annual contribution amount than either a SEP or SIMPLE plan. While the Solo 401(k) is less complicated than a regular 401(k), once the plan’s assets exceed $250,000, business owners will need to remember to file Form 5500 annually.
For the most part, however, the larger a company grows, the more attractive a traditional 401(k) becomes. These plans allow for employee and employer contributions, gradual vesting of employer contributions, and other features such as loans. They are also relatively customizable, and employers can choose to make them more or less complicated depending on the business’s needs.
While it offers a variety of attractive benefits, however, a 401(k) also requires complex administration and substantial set-up costs. Employers must generally offer the plan to all employees age 21 and older who have worked at least 1,000 hours in the previous year. Plans must also undergo annual testing to ensure employer contributions do not favor owners and managers over rank-and-file employees.
A 401(k) may be funded by both employee deferrals and employer contributions, up to $18,500 a year; this ceiling rises to $24,500 for employees age 50 or above. One of the more attractive 401(k) features for employers is the plan’s flexibility where contributions are concerned. Employers have the option to match employee contributions, to make a contribution up to 25 percent of compensation, both or neither. Combined employer and employee contributions are capped at $55,000 or 100 percent of compensation, whichever is less. Employers can deduct contributions up to 25 percent of aggregate compensation for participants and all salary reduction contributions.
Employers may also choose to offer a Roth option in their 401(k) plan. Roth 401(k)s are funded with after-tax dollars and, unlike Roth IRAs, there are no income limits on employee participation. Employees may still contribute up to $18,500 annually, much higher than a Roth IRA’s $5,500 limit, and qualified distributions are not taxed. Offering a Roth option may add complexity to the plan’s administration, but may be an enticing benefit for employees. (Solo 401(k) plans may also be set up as Roth accounts. Just as employee deferrals into Roth 401(k) plans are made with after-tax dollars, contributions to a Roth Solo 401(k) account are nondeductible for the business owner.)
Even for the smallest business, taking the time to set up a retirement plan can offer real benefits. In order to maximize them, employers should ask themselves: How much time and money are they willing to spend on setting up and administering the plan? Is it important to allow employee contributions? Does a vesting schedule matter? Will cash flow be an issue if the plan requires annual contributions? By thoughtfully assessing what they hope to accomplish, employers should be able to determine which plan is the most logical match.
As with many aspects of a small business, the worst plan is generally no plan at all. And many small business owners may find themselves pleasantly surprised at how straightforward – and rewarding – selecting a retirement plan can be.