As a small business owner, you understand that long-term planning is critical to your success as a business owner. One of the more significant long-term planning issues is planning for your retirement. Luckily, one of the advantages of being a small business owner is that there are more retirement plan options available to you than are available to most taxpayers. The downside is that unlike an employee that may have access to a 401(k), you’re on your own to save for retirement.
A common feature of all small business retirement plans is that they help you save a significant amount of money toward retirement and provide tax advantages at the same time. The plans available to you have varying degrees of complexity and a wide range of contribution limits. With those ideas in mind, here are some questions you should consider before deciding on a retirement plan:
- Is the plan affordable for the company to administer and fund?
- Who can contribute? Is it important that employees be able to contribute to a retirement plan?
- Is your priority higher contribution limits or ease of administration?
- Would you like plan contributions to be deductible as a business expense?
To assist you with choosing the right retirement plan for your business we have put together summaries of some of the most popular retirement plans for small businesses. These summaries include the basic features of each plan, tax advantages, and the pros and cons.
SEP IRA
The Simplified Employee Pension Individual Retirement Account (SEP IRA) is a simple, tax-deferred retirement plan for self-employed individuals or small business owners. A SEP IRA is a traditional IRA that follows the same investment, distribution, and rollover rules as traditional IRAs. Any business owner with one or more employees, or freelance income, can open a SEP IRA.
One key aspect of the SEP IRA that is important to note is that only you, the employer, make contributions to a SEP IRA plan. Employees cannot make contributions.
A SEP IRA is ideal for self-employed individuals or small business owners with few or no employees. Because to use a SEP IRA; employers must make proportional contributions to all full-time employees.
Contribution Limits
Where a SEP IRA differs significantly from the traditional IRA is in the contribution limits. A traditional IRA allows you to put away $5,500 in 2018 ($6,500 if your 50 or older). A SEP IRA allows a much higher contribution limit.
The contributions you make to a SEP IRA each year cannot exceed the lesser of:
- 25% of compensation (or net self-employment earnings), or
- $55,000 for 2018
The amount of compensation you can use to calculate the 25% limit is limited to $275,000 in 2018. SEP IRAs do not allow for catch-up contributions.
Employer Contributions
SEP IRA plans require proportional contributions for each eligible employee if you contribute for yourself. Which means that if you have employees and you choose to contribute 10% of your compensation to the SEP IRA, you must also contribute 10% of each eligible employees compensation to the SEP IRA. Additionally, contributions by the employer for each eligible employee are immediately 100% vested for each employee.
An eligible employee/participant is defined by the IRS as employees who are 21 years or older, have worked for you for three of the past five years and have earned at least $600 from your business in the past year.
Tax Advantages
Your contributions to a SEP IRA are tax-deductible, including those made to employee accounts. You can deduct the lesser or your contributions or 25% of compensation, subject to the $275,000 compensation limit. If you’re self-employed, your deduction is 25% of net self-employment income.
Pros and Cons of SEP IRA
How to Open a SEP IRA
In order to open a SEP IRA, you will first want to identify an account provider. Most IRA account providers also offer SEP IRAs, and the account can be opened online. Opening a SEP IRA is similar to opening a traditional or Roth IRA, but there may be additional paperwork and reporting requirements, especially if you have employees.
The IRS outlines three steps for setting up a SEP IRA:
- Create a formal written agreement. You can do this through your account provider.
- Give each eligible employee (if any) certain information about the SEP. Your account provider can get you the information you need to give your employees.
- Set up separate SEP IRAs for each eligible employee with the account provider.
A SEP IRA can be formed up until the due date of the employer’s tax return. Deductible contributions for the 2018 tax year can be made up until the due date of the tax return.
SIMPLE IRA
A SIMPLE IRA plan (Savings Incentive Match Plan for Employees) allows employees and employers to contribute to traditional IRAs set up for employees. As the name suggests, a SIMPLE IRA is an easy retirement plan to set up with requirements similar to a SEP IRA.
The SIMPLE IRA plan is ideal for businesses with less than 15 employees who want to contribute between $6,000-$25,000 per year. If you think you’ll contribute less than $6,000 per year, a traditional IRA may be a better option. Businesses with more than 15 employees or business owners that want to contribute more than $25,000 per year should consider a 401(k) plan.
Contribution Limits
SIMPLE IRA contributions are limited to $25,000 for 2018. Employees can contribute up to $12,500, and the employer can match up to $12,500. Employees age 50 and over are allowed to contribute an additional $3,000.
Employer and Employee Contributions
SIMPLE IRA contributions come from both the employer and employee. The employee can elect salary deferrals to fund their account and employers choose from two different contribution plans.
The employer contribution options are:
- Elective contributions - Employers match employee contributions dollar for dollar up to 3% of their annual salary. Employers can temporarily reduce the match to 1%, but not match less than 3% for more than 2 of the preceding 5 years.
- Non-elective contributions - Employers can contribute 2% of employee’s annual salary to their account, regardless of whether the employee contributes.
Contributions by the employer to employee accounts are immediately vested. In addition, the plan must be offered to all employees who earn more than $5,000 per year, regardless of the length of employment or their status as either part-time or full-time employees.
Tax Advantages
Contributions to a SIMPLE IRA are deductible by employers as a business expense. Employee pre-tax contributions reduce the amount of employee’s taxable income for the same tax year.
Pros and Cons of SIMPLE IRA
How to Open a SIMPLE IRA
The first step in opening a SIMPLE IRA is identifying a provider. Providers have different investment options, structures, and fees. Check with several different providers to understand the various options available and choose the one that is right for your needs. Once you select a provider, they will walk you through the steps of setting up a SIMPLE IRA.
The IRS outlines three steps to set up a SIMPLE IRA plan.
- Adopt a SIMPLE IRA plan document. This can be done through your account provider.
- Provide each eligible employee with certain information about the SIMPLE IRA plan and where you’ll deposit employee contributions prior to the employee election period (typically 60 days prior to January 1).
- Set up a SIMPLE IRA for each eligible employee with the account provider.
A SIMPLE IRA can be established up until October 1 in any calendar year and thereafter must be maintained on a calendar year basis. Employer contributions can be made up until the employer’s tax filing deadline.
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Solo 401(k)
The solo 401(k) is an individual 401(k) plan designed for a business owner with no employees. You cannot contribute to a solo 401(k) if you have employees, though you can use the plan to cover both you and your spouse.
A solo 401(k) is an attractive plan for business owners that can and want to save more for retirement than a SEP or SIMPLE IRA allows. The solo plan offers flexible contribution options with an option to contribute as much as possible or to even suspend contributions, if necessary.
Contribution Limits
The total solo 401(k) contributions limit is up to $55,000 in 2018. A catch-up contribution of up to $6,000 can be made for those 50 or older. The $55,000 contribution limit is made up of employer and employee contributions. To understand how the contributions rules work, you should think of yourself as both the employer and employee.
- As an employee, you can contribute up to $18,500 in 2018, or 100% of compensation, whichever is less. If you are 50 or older, you can contribute up to $24,500.
- As the employer, you can make an additional profit sharing contribution of up to 25% of your compensation or net self-employment income. Net self-employment income is net profit less half your self-employment tax and the plan contributions you made for yourself. The compensation limit used to factor your contribution is $275,000 in 2018.
You should note that the contribution limits apply to contributions across all plans, not each plan individually. If you have a traditional 401(k) through an employer and also have a solo 401(k) for your side business to set aside additional retirement savings, you must look at both plans together when determining your contributions.
Spouse Contributions
The exception to the solo 401(k) no-employees rule is that your spouse is allowed to participate if he or she earns income from your business.
Depending on your income, this could effectively double the amount you can contribute to a retirement account as a family. Your spouse can make elective deferrals as your employee of up to $18,500 and as the employer, you can then make a profit-sharing contribution for your spouse of up to 25% of compensation.
Tax advantages
The solo 401(k) works like a standard, employer offered 401(k) in that you make contributions pre-tax, and the distributions are taxed. One feature of the solo 401(k) is that you get to pick your tax advantage: You can opt for a traditional 401(k) or a Roth 401(k). Traditional 401(k) contributions reduce your income in the year they are made, and distributions in retirement are taxed as ordinary income. A Roth 401(k) offers no initial tax break but allows you to take distributions in retirement tax-free. A Roth is a better option if you expect to be in a higher tax bracket in retirement than the one you currently occupy.
Pros and Cons of Solo 401(k)
How to Open a Solo 401(k)
A solo 401(k) can be opened online through most brokers. You will need an employer identification number to open the account. The broker will provide you with the required plan adoption agreement as well as an account application. Once you have completed the plan adoption agreement and account application, you can set up your contributions.
To attract more customers, many banks, mutual-fund, and brokerage firms offer 401(k) plans with no setup fees or low annual investment fees. Make sure you understand the fees these companies charge, and the full range of services that these plans provide. It is wise to get quotes from several providers before committing to a plan.
You have until December 31, 2018, to set up your 401(k) plan to make it count for tax year 2018. The good news is that you have until the due date of the tax return to make deductible contributions for 2018.
Traditional 401(k)
A traditional 401(k) is an employer-sponsored retirement plan that eligible employees may make salary-deferral contributions to on a pre-tax or post-tax basis. This type of plan is best for a small business that prefers flexibility and has greater than ten employees. To justify the administration costs, the number of participating employees will need to be higher than in other small business retirement plans discussed above. Traditional 401(k)s have the highest overall administrative costs and additional IRS burdens. The IRS requires annual testing to ensure your plan is fair to all employees and each year you must file IRS Form 5500, Annual Return/Report of Employee Benefit Plan for your 401(k) plan.
Contribution Limits
For 2018, employees can contribute a total of $55,000 to a 401(k) plan. This $55,000 is made up of up to $18,500 of salary deferrals, $18,500 of employee matching, and the remaining $18,000 through employer profit-sharing contributions. For employees age 50 and older, additional catch-up contributions of $6,000 are allowed for a total of $61,000 in total contributions.
Employer Matching Contributions
A traditional 401(k) offers the most flexibility for employer matching contributions. If plan documents permit, the employer can make matching contributions for employees who contribute elective deferrals to the 401(k). However, employers are not required to match at all in a traditional 401(k) plan. One of the advantages of the traditional 401(k) over other small business retirement plan options is that employers can structure the matching formula in any way they want, including profit-sharing. Once you decide on the terms of matching, the matching guidelines should be included in the plan documents and followed carefully to ensure compliance with the plan.
Tax Advantages
Employer contributions are deductible on the employer’s tax return as a business expense. The employee elective deferrals and investment gains are not taxed until distributed.
Pros and Cons of Traditional 401(k)
How to Open a Traditional 401(k)
The first step to starting a traditional 401(k) is to find a plan provider to administer the plan. You will want to shop around for a provider that meets all your needs without breaking the bank. Plan to get quotes from several providers before committing to a plan. There are several types of fees that providers charge. Some of these fees may be charged as one-time fees or as an ongoing fee, for example, a one-time fee to start the plan or an ongoing monthly or annual fee to administer and manage your account. There are two types of costs you should know about:
- Fees your company will need to pay (typically based on your number of employees), and
- Management fees that are taken out of employee’s investments
Once you have selected a provider, they will guide you through the process of adopting the plan, arranging a trust fund for the plan’s assets, develop a record keeping system, and provide plan information to participants.
While retirement plans can seem overwhelming, there are several options for small businesses to choose from; all with their own advantages and disadvantages. Now that you know more about setting up retirement plans for your small business, you can start helping your employees plan for their future as well.
