Business owners are in a unique position to create retirement savings. Setting up a retirement plan builds tax-advantaged personal wealth away from the business and can lower business taxes. In addition, retirement plans are attractive to employees and can help you recruit and retain talented staff. A good plan can also add significantly to employee wellness, as it helps to create financial security.
Selecting the right qualified retirement plan for your business means weighing your choices based on the size of your company and your preferred monetary commitment. You may also have the option to add a non-qualified cash balance plan, which can help you monetize your business or factor into succession planning.
We break down the benefits and outline the different plan choices.
The Benefits of a Retirement Plan for your Business
In one of the tightest job markets in recent history, finding an edge to attract employees is critical. Employees’ priorities have changed, and in-office perks or flexible vacation time are no longer as attractive. A recent survey found that financial benefits are now the top priority. Leaving their current job for one that offered a high-quality 401(k) plan or other retirement plan was the choice of 65% of survey respondents, and 56% would change up their jobs to get a 401(k) employer matching contribution.1
Besides making your business more competitive in a tight labor market, there are tax benefits to setting up a plan and making matching contributions. Matching and non-elective company contributions to a retirement plan are tax-deductible business expenses.
Since the IRS classifies the plan as an employee benefit, the expenses of setting up and administering the plan may also be tax-deductible. Finally, the IRS allows tax credits for small business owners if they offer employees a 401(k) plan.
What’s the Right Plan for Your Business?
For a business owner, the main choices are to set up one of the two types of business-focused IRA plans. These are targeted toward different size companies and have other advantages. In either case, they can be set up so that you can offer only a traditional IRA, or you can offer both traditional and Roth IRA choices.
Suppose you have a broad range of salaries in your company, or you can lower your income from the business. You may want to consider offering the option to start with the Roth, and then shift to a traditional IRA when the salary cap kicks in. For 2022, your income must be below $129,000 as a single filer or below $204,000 for married filing jointly, in order to maximize your contribution. We go into the details of choosing between a Roth IRA and a traditional IRA for investors in a recent article.
SEP vs. SIMPLE
The first thing to consider is eligibility. If you have more than 100 employees, who each earned more than $5,000 last year, you are not eligible for a SIMPLE IRA.
Assuming you are eligible for either plan, let’s look at some key differences and how they can work for your business.
Allowing employee contributions to the plan can provide employees with an easy, tax-advantaged way to save for retirement. It will, however, complicate the administration of the plan and add to your expenses. A SIMPLE IRA is the only IRA plan that allows this, but as the employer, you will also be required to either match employee contributions (up to 3% of the employee’s salary) or make non-elective contributions of 2% of the employee’s salary (subject to salary caps).
A SEP IRA provides for only employer contributions, but the amounts allowed to be contributed are much higher. Limits are the lesser of 25% of the employee’s salary or $57,000 per year (subject to salary caps). The SEP allows you to maximize the long-term funding of the account in a tax-advantaged manner. There’s a little more flexibility, too – you are not required to make regular contributions. While you should consider the stability of your company’s income stream before setting up a retirement plan, the SEP can be helpful as it allows more wiggle room if you hit a rough patch.
If you think you may need to withdraw from the plan in the first two years, then the SEP IRA may be the way to go. The SIMPLE IRA can be subject to penalties.
If you want to know more about the differences and advantages of each plan – or you’re a more visual learner – we broke it down in a recent blog that includes a terrific visual decision tree.
Going the 401(k) Way
Setting up some form of a 401(k) can be extremely additive to your business and your retirement savings, but it’s important to get the right plan. There are three options to consider, based on the size of your firm, the amount you want to contribute, and the level of complexity you are up for.
The Solo 401(k): If you don’t have any employees besides your spouse (there’s a valuable exception for spouses that work in the business), and you want to contribute more than 25% of salary, but less than $58,000, the solo 401(k) might be your sweet spot. It’s easier to set up than a traditional 401(k), but contributions cannot exceed the lesser of 100% of compensation or $58,000, plus any additional catch-up contributions.
The Safe Harbor 401(k): This one is easier to administer than a traditional 401(k) but is less flexible, and contributions are lower. Employee contributions cannot exceed $20,500 in 2022. Employer contributions must be an employee matching contribution of up to 4% of the employee’s salary, or the employer must make mandatory contributions of 3% of the employee’s salary.
“Traditional” 401(k): This one offers the most flexibility, and for 2022 the maximum contribution for the employee is $20,500, but the employer can contribute significantly more than the standard match. The total contribution limit is 100% of the employee’s salary or $61,000, whichever is less. For a business owner, it’s a great way to contribute as both an employee and an employer and max out tax-advantaged retirement savings. It’s also the most complicated and expensive to administer.
If you’d like to see the 401(k) options laid out in a decision-tree format and understand how they compare to the IRA options, we’ve written a recent blog with a great visual that goes into detail on comparing them.
Considering Defined Benefit Plans
IRAs and 401(k)s are not the only options. If you’re an older business owner and willing to make mandatory contributions for yourself and your employees, you might consider a defined benefit plan. This type of plan may allow you to contribute significantly more than a 401(k). Contributions are based on a mandatory, actuarially calculated amount based on a benefit amount that is the lessor of a participant’s salary or $230,000.
If you decide to set up a 401(k) plan, you might also consider pairing it with a cash balance plan. A cash balance plan (CBP) is a traditional defined benefit pension plan offering either a lump sum payout or an annuity on retirement. Employee accounts are individually owned, which makes them portable, and they are transparent. CPBs have the advantage of not being dependent on market performance, and employees are not burdened with selecting the investments.
As an employer, you set an annual contribution as a percentage of salary, usually between 3-8%. If you choose to offer both, you can opt-out of matching the 401(k) contributions. The employer also pays a set interest amount, either a fixed or variable rate.
The Bottom Line
Adding a retirement savings plan to your business can be an excellent way to save for your retirement, make your business more competitive at attracting and retaining top talent, and save on taxes.
It’s complicated, and making the right choice in the beginning will help you get the maximum benefits.
1. Betterment for Business and Market Cube, September 2021. The Impact of the Great Resignation on Benefit Needs and Expectations.
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