Choosing which type of retirement plan to offer employees is critical as a business owner. The right choice can help a retirement plan serve as a significant incentive to attract and retain top talent. It can also enhance the well-being of employees and help them catch some tax breaks along the way. However, choosing the wrong plan could hurt the team and the business itself. IIt could even put the business owner at legal risk if the program is filed or managed incorrectly.
As the advisor, it’s up to you to thoroughly but briefly explain the different retirement plan options to clients. You must consider which plan style might be best for their needs. For example, in some states, such as California, business retirement plans are required for companies with over five employees.
It’s also a key pillar in how we can better serve business-owner clients — by talking about building wealth outside of their businesses, we help them build wealth, save money in taxes and improve employee retention in their businesses.
The main business retirement plan options that stand out are Simplified Employee Pension Plan (SEP-IRA), SIMPLE IRA, One-Participant 401(k)s and SIMPLE 401(k)s.
Simplified Employee Pension Plan (SEP IRA)
A Simplified Employee Pension Plan (SEP IRA) works similarly to a traditional IRA. In fact, this plan requires the employer to set up traditional IRAs for each of their employees. The employer then contributes to these plans directly. But, keep in mind that it does not allow for the employee to make their own contributions.
One of the most significant advantages of the SEP IRA is that employers can contribute much more to this plan than a traditional IRA. This means more retirement savings for employees and a lower taxable income for the employer.
There are a few main things to note regarding SEP IRAs:
- They are available to businesses of all sizes (this is just one reason they are so popular).
- The employee has complete ownership of all money invested in their SEP IRA. However, they will incur a fee if they withdraw their funds early.
- The percentage that an employer contributes must remain constant across all parties. For example, if the employer contributes $1,000 to their own plan, they must also contribute $1,000 to each employee’s plan.
Also, note that SEP IRAs are not available for all employees. They are only available for workers over 21-years-old that have worked with the employer for three out of the last five years.
Pros of a SEP IRA
- Relatively easy to set u There is no filing requirement for the employer.
- There are minimal start-up and operating costs.
- Flexible annual contributions. Since the contributions are at the employer’s discretion, they are flexible.
- Tax advantages. Money contributed is not treated as taxable income.
Cons of a SEP IRA
- Limited contributions. Employers can only contribute the lesser of 25% of the employee’s compensation or $61,000.
- Matched contribution. Employers must contribute the same amount to employees that they contribute to their own IRA.
- Not ideal for an older workforce. SEP-IRAs do not allow for “catch up” contributions for employees over 50.
Savings Incentive Match Plan for Employees (SIMPLE)
Savings Incentive Match Plan for Employees (SIMPLE) IRAs are designed to simplify retirement planning for employers.
This plan allows employees to opt for a salary reduction that contributes to a regular Individual Retirement Account or Annuity (IRA). If the employee chooses a salary reduction, the employer must make a matching or nonelective contribution.
The plan itself is an IRA, following the same investment, distribution and rollover rules as a traditional IRA. One thing to note is that a SIMPLE IRA is reserved for any employer that has less than 100 employees who earned $5,000 or more during the last calendar year. If you have more than 100 employees, you won’t be able to open a SIMPLE IRA.
Pros of a SIMPLE IRA
- It’s simple. As the name implies, a SIMPLE IRA is easier to set up and run compared with other retirement plans like a 401(k), 403(b) or a 457.
- Tax credits are available. Under the SECURE Act, small businesses can receive a tax credit to offset the cost of starting a SIMPLE IRA.
Cons of a SIMPLE IRA
- It’s only for small businesses. Employers with over 100 employees will not be able to open a SIMPLE IRA.
- It has contribution limits. The total contribution limits for a SIMPLE IRA are $14,000, (or $17,000 for people 50 or older). However, employees will also be able to simultaneously contribute to other plans like a traditional/Roth IRA.
One-Participant 401(k)
Not every business has employees. But even if it’s a one-person operation, the business owner can still ensure that they’re properly prepared for retirement. The business owner should consider a one-participant 401(k) in this scenario. A one-participant 401(k) plan is often called a Solo 401(k), Single K, Uni-K or even a one-participant K.
This plan can be a little confusing because it legally allows the business owner to contribute twice to their retirement account. First, they are allowed to contribute as the business owner. But they can also contribute as an employee.
Solo 401(k) plans tend to vary based on how the owner structures the business and chooses to compensate themself. While this might take a little more time to set up, it also gives the business owner much more opportunity to maximize their income.
A one-participant 401(k) has a contribution limit of $20,500 (as the employee) as well as 25% of net self-employment income (as the employer).
Pros of a Single K
- Maximizing retirement spend. Business owners can essentially pay for retirement twice by contributing as both an employee and employer. This is an excellent way to reduce the business’ taxable income while still using that money to save for retirement.
- Flexible tax advantages. The exact benefits depend on how you structure the plan. However, this is one of the more flexible options.
Cons of a Single K
- More in-depth. When you open a one-participant 401(k), more factors are at play. For this reason, the business owner might need a bit more outside help than with other plans.
SIMPLE 401(k)
SIMPLE 401(k)s are another retirement plan option for small business owners with less than 100 employees. Under this plan, workers can defer some of their compensation to contribute to the program. In this case, employers must either match up to 3% of each employee’s pay or make a nonelective contribution of 2% of each employee’s compensation. No other contributions can be made.
Pros of a SIMPLE 401(k)
- More flexibility. This plan does not need to follow the non-discrimination rules that normal 401(k) plans do.
- Easy to administer. This plan has a straightforward benefit formula that makes it easy to administer across your company.
Cons of a SIMPLE 401(k)
- Limits other options. No other retirement plans can be used in conjunction with a SIMPLE 401(k).
Which plan is best?
As with most financial decisions, there is no “right” answer here. The best retirement plan for business ownersdepends on many different factors. Your business-owning clients should consider the number of employees, the state(s) in which the business operates, and total yearly revenue before making a final decision. And, as a financial advisor, your help with retirement planning can lower their tax bill, reduce employee turnover in their businesses, and build wealth outside of their companies.
Marguerita (Rita) Cheng, CFP, is the chief executive officer of Blue Ocean Global Wealth. She is passionate about helping clients navigate some of life’s most difficult issues — divorce, death, career changes, caring for aging relatives — so they can feel confident and in control of their finances. Rita is a regular columnist for Kiplinger and MarketWatch, and a past spokesperson for the AARP Financial Freedom Campaign. Rita volunteers her time as a SoleMate, or charity runner for Girls on the Run, raising money to win scholarships for girls.
