One of the big challenges facing small businesses is providing competitive benefits for employees while also allowing themselves (the business owner) to save for retirement. For example, an employee is likely to have access to employer-provided health and retirement benefits at a large employer; a benefit that may be cost-prohibitive at a smaller firm. Saving for retirement as a small business owner can also be challenging without a larger employer-provided retirement plan. However, there are accounts that small business owners can use to both lower their tax burden and save for retirement, while also making themselves more competitive for potential employees. Here are three such small business retirement plans along with who should use them.
SIMPLE IRA
Overview
A SIMPLE (Savings Incentive Match Plan for Employees) IRA minimizes the administrative burden of maintaining a retirement plan. No annual paperwork is filed with the IRS to maintain a SIMPLE IRA. These accounts are most often seen with small businesses that may have a handful of employees. Like many small business retirement plans, a SIMPLE IRA offers the employee the ability to defer a percentage of their income that the employer then matches. The benefit for a small business owner is a reduction in their tax burden and the attraction of good employees.
Eligibility
Employees who have earned $5,000 for the previous 2 years and are expected to earn $5,000 in the current year are considered eligible for a SIMPLE IRA and cannot be excluded.
Contributions
Typically the employee can defer a maximum of $13,500, which the employer then matches dollar for dollar up to 3% of the employee’s compensation. The employer only makes matching contributions up to 3%; so if an employee chooses not to participate or defers less than 3%, the employer is only obligated to match what the employee contributes.
The employer can reduce the 3% match provided it is not reduced below 1% and provided it is not reduced for more than 2 years out of a 5-year rolling period.
The employer can instead choose to make “non-elective” contributions of 2% to all employees regardless of whether they participate. All contributions are immediately vested.
Pros and Cons
Pros:
Administrative ease
Employee shares contribution burden
Income taxes deferred on contributions
Employer avoids FICA taxes on employer contributions
Cons:
Lower contribution limit than other plans
Cannot have any other retirement plan in place
25% withdrawal penalty in the first two years of account
Best For:
Small firms or solo entrepreneurs earning a low or medium amount of income.
SEP IRA
Overview
A SEP (Simplified Employee Pension) IRA is a small business retirement plan that combines the administrative ease of the SIMPLE IRA with the higher contribution limits of the 401k. A SEP IRA is “non-contributory” which means that the employees don’t make contributions to their accounts, only the employer does. Like the SIMPLE IRA, a small business owner can save substantially on taxes, by deferring income taxes on the amount of their contributions.
Eligibility
All employees who are at least 21 and have earned at least $600 in 3 out of the last 5 years are eligible for a SEP IRA.
Contributions
Contributions are limited to the lesser of 25% of compensation or $57,000. If you are a self-employed small business owner, your effective contribution limit is 20% of net self-employment income minus one-half of self-employment taxes. Contributions are not mandatory and are only made by the employer. Like the SIMPLE IRA, all contributions are immediately vested.
Pros and Cons
Pros:
Contribution flexibility
Administrative east
High contribution limits
Income taxes deferred on contributions
Cons:
Most employees will be eligible
Employees do not share contribution burden
Best For:
Solo entrepreneurs and small firms.
401(k)
Overview
The 401(k) is a very common retirement plan that used to be exclusively used by larger companies. Today, even solo entrepreneurs can take advantage of 401(k)s in their small business retirement plan. 401(k)s allow for more flexible employer contributions than does the SIMPLE IRA but also allows for up to $57,000 in combined employer and employee contributions per year. Just like both the SIMPLE IRA and SEP IRA, a small business owner can save substantial income tax dollars on the amount of contributions. A small business owner can also save FICA tax dollars on contributions to their employees.
Eligibility
Employees who are at least 21 and have worked for at least 1,000 hours over the last 1 year are eligible
Contributions
Contributions come from the employer and the employee. The employee can contribute up to the lesser of 100% of compensation or $19,500/yr. The employer can make matching contributions, flat non-elective contributions, and profit-sharing contributions. The profit-sharing contributions are limited to 25% of gross aggregate employee compensation. Contributions generally vest over a period of 2 to 6 years.
Pros and Cons
Pros:
Flexible employer contributions
Higher contribution limits
Employer avoids FICA taxes on employer contributions
Income taxes may be deferred on contributions
Loans available from accounts
Cons:
Administrative burden
Best for:
Medium to large firms and/or high earning solo entrepreneurs.
For more information about these plans please visit this link for SIMPLE IRAs, this link for SEP IRAs, or this link for 401(k)s.