Running a small business means lots of daily fires and immediate problems to solve. There are only so many hours in a day, so longer-term decisions, like planning for retirement, can get pushed aside in the face of more on-the-spot issues. In fact, finding and researching the best retirement plans for small businesses can take time and effort you may not have right now. But in the end, carving out some time to put a retirement plan in place can offer you and your employees peace of mind and financial security. So, what retirement plan is best for small business owners? There are multiple options to choose from, each with its pros and cons.
Retirement plans for small businesses
Retirement plans for employees of small businesses have some similarities to retirement plans for larger companies. Both want to provide a package that looks out for their employee’s futures while keeping costs as low as possible.
Depending on the size of your business and how much time you have, a smaller retirement plan might be a better option. There are several to choose from, so we narrowed it down to these top four to consider.
1. SEP IRA
A SEP IRA, or simplified employee pension plan, is an employer-sponsored option for companies with one or more employees. SEP IRAs follow the rules of a traditional individual retirement account (IRA), but they have higher contribution limits. Employees can also contribute to a traditional or Roth IRA while receiving employer contributions in a SEP IRA.
These plans are generally more accessible for a business owner to set up and maintain than a traditional 401(k) plan. However, the employer must contribute to the employee’s retirement account under a SEP IRA, unlike a regular 401(k).
Employer Contribution Limit: Up to 25% of an employee’s compensation or up to $66,000, whichever is less under the IRS-set compensation limit of $330,000.
Employee Contribution Limit: Employee contributions are not allowed in a SEP IRA.
Pros and cons of this retirement plan for small businesses
Pros of a SEP IRA include:
- Easy to set up and operate: A SEP IRA is easy to set up and maintain. It also has lower administrative costs than other plans. SEP IRAs also don’t require yearly filings like 401(k)s or other retirement plans.
- Flexible annual contributions: Employers can vary the amount yearly, and contributions aren’t mandatory. You just need to ensure that whatever percentage of pay you contribute for yourself, you also contribute to each employee.
- Higher contribution limits: The contribution limits are higher than other retirement plan options for small businesses.
- Tax advantage: SEP IRA contributions are generally tax-deductible by the business for contributions to employees.
- Early withdrawals are allowed: You (or your employees) can take an early withdrawal from a SEP IRA if times get tight. Just know you’ll face a 10% penalty plus taxes if you remove money from the SEP IRA before age 59½.
Cons of a SEP IRA include:
- Employer-only contributions: Only employers can contribute to a SEP IRA. There are no catch-up contributions for people older than 50.
- Employers must contribute equally: To contribute to a SEP IRA, business owners must contribute the same percentage of salary for each employee. So, if you contribute 10% to one employee, including yourself, you must contribute 10% to all employees.
- No participant loans: While you can make an early withdrawal, participants can’t take a loan from a SEP IRA, and the assets can’t be used as collateral for other loans.
2. Small business 401(k)
A 401(k) may be one of the best retirement plans for small business owners with employees, especially if your business is big enough and has the resources to maintain the plan. These plans come in various types and are generally available to business owners with one or more employees. People are most familiar with a Traditional 401(k) plan. But there are also Safe Harbor 401(k) and Automatic Enrollment 401(k) plans, among others.
Employer Contribution Limit: Varies based on the type of 401(k) plan selected and how the plan is set up. Employers can make matching or other types of contributions.
Employee Contribution Limit: Up to $22,500 in 2023 for a traditional 401(k), with $7,500 in catch-up contributions available to those ages 50 and older if the plan permits.
Pros and cons of this retirement plan for small businesses
Pros of a small business 401(k) include:
- Tax advantages for employee and employer: Contributing to a 401(k) plan allows employees to save money on this year’s tax bill. By contributing before-tax dollars to a 401(k) through salary deferrals, an employee’s taxable income is reduced for the year in which the contribution is made. The money can grow tax-free until it’s withdrawn in retirement. Businesses that make contributions to employee 401(k)s can take a tax deduction on their tax returns. That is, as long as they don’t exceed limits set by the IRS.
- Employer flexibility: A Traditional 401(k) offers the most flexibility. Employers can decide whether they contribute for all participants, provide a match to employee contributions, do both or decide not to provide any employer contribution. Other types of 401(k) plans, like a Safe Harbor 401(k), may have more restrictive rules.
- Higher contribution limits: 401(k) plans offer higher contribution limits than other options. However, other plans, like the SEP IRA, may allow you and your employees to save more.
Cons of a small business 401(k) include:
- Administration cost and paperwork: A Traditional 401(k) comes with many administration expenses. As an employer, you’ll have to provide documentation when setting up the account, as well as annual reports and testing.
Testing ensures that the benefits you offer to your lowest-level employee are proportional to what you provide to owners and managers.
3. The SIMPLE IRA
The Savings Incentive Match Plan for Employees, or SIMPLE IRA, is an individual retirement account allowing the business owner and employee to save for retirement through mandatory employer contributions and optional employee contributions.
The SIMPLE IRA has a lower contribution limit than a SEP IRA. Employers must contribute to employee accounts based on rules laid out by the IRS.
Employer Contribution Limit: Employers are required to match employee contributions up to 3%. Instead of a matching contribution, the employer can make non-elective contributions of 2% of each employee’s compensation, up to the salary cap of $330,000, even if the employee chooses not to contribute.
Employee Contribution Limit: In 2023, employees can contribute up to $15,500 with a catch-up contribution of $3,500 for those ages 50 or older. If you have any other employer-sponsored retirement plan that you contribute to, your total contributions cannot exceed $22,500 across both plans.
Pros and cons of this retirement plan for small businesses
Pros of a SIMPLE IRA include:
- Easy setup and low cost: A SIMPLE IRA is easy to set up and use. Employers and employees are able to contribute as long as the business employs fewer than 100 people. Unlike a 401(k), the company is not required to do discrimination testing or file yearly reports.
- Employee contributions: Although a SIMPLE IRA has some drawbacks, one of its primary benefits is that the employee can choose if they want to contribute using a salary deduction, even though employers are required to contribute to the employee’s IRA. Employees are always 100% vested in the plan.
- Tax-deductible: Employer contributions are tax-deductible for the business in the year they are made. Employer contributions can be deducted as a business expense. Employee salary reduction contributions are not tax deductible.
Cons of a SIMPLE IRA include:
- Low contribution limits: A SIMPLE IRA has lower contribution limits than other retirement plans. Employees can only save up to $15,500 in 2023, compared to $66,000 with a SEP IRA. A Traditional 401(k) plan allows employees to contribute up to $22,500, plus catch-up contributions for those who qualify.
- High early withdrawal penalties: SIMPLE IRAs allow early withdrawals. However, you’ll have to pay a 10% penalty on top of any taxes you owe. If withdrawals are made within the first two years of participation, the penalty jumps to 25% plus taxes. You cannot take out a loan against your SIMPLE IRA or use it as collateral.
4. Defined benefit plan
Defined benefit plans are among the small business retirement plan options but likely won’t be your first choice in retirement plans. These plans provide a set, predetermined monthly payment to participants, often based on their length of employment, salary history and investment returns. While you can save a lot for retirement quickly, defined benefit plans can be costly and time-consuming to maintain. The contribution amount has to be determined by an actuary every year.
These plans are generally best for people with only a few employees or a self-employed individual with a high income who wants to save a lot for retirement.
Employer Contribution Limit: This is determined annually, and contribution amounts can be higher than in other plans.
Employee Contribution Limit: Employees can contribute, but employers are primarily the ones making contributions.
Pros and cons of this retirement plan for small businesses
Pros of a defined benefit plan include:
- Predictable retirement benefit: A defined benefit plan provides a set amount to employees through consistent monthly payments, like a regular pension or a single lump-sum payment. The plan may also allow for survivor benefits for a spouse.
- Substantial benefits in a short time: Employers can contribute (and deduct) more than with other retirement plans. This can be an attractive option for high-earning small business owners who want a reliable income stream in retirement. However, it can get expensive if you have a lot of employees.
- You can have other retirement plans: Setting up a defined benefit plan does not prevent you from offering a 401(k) or other retirement plans through your business.
Cons of a defined benefit plan include:
- Costly and time-consuming to maintain: A defined benefit plan puts nearly all administrative and contribution risks on the employer or business owner. However, an employee can contribute to the plan under certain circumstances.
- Actuary oversight: Defined benefit plans require an actuary to determine the yearly contribution that the business makes to the plan based on annual income and expenses. You’ll have to pay additional fees if you change the amount you contribute each year, either contributing more or less than the actuary determines.
Bottom line
Creating a small business retirement plan isn’t just a practical idea to help you save for the future. It can help you attract and keep employees as part of your overall benefits package and ensure that you, as the business owner, save for retirement.
While you’re the only person who can make the best decision for your business, it can be beneficial to work with a tax professional to help you find the retirement plan that best fits your business and employees.
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