According to a 2020 J.P. Morgan survey, just under 50% of small businesses offer a retirement savings plan to employees. Another survey shows that less than 30% of businesses with under 10 employees use a retirement plan. While offering a tax-advantaged retirement plan can serve as a useful employee attraction and retention tool, there is also an opportunity for business owners to contribute substantial savings earmarked for their own retirement. While many owners may choose not to adopt a plan due to the potential for added cost, it may also be a lack of understanding of the plans available that contributes to the low usage rates. In this article, we will describe the types of retirement plans available to small businesses, including the Individual 401(k) which can only be used by business with no employees beside the owner(s).
One of the most popular retirement plans for small business owners is the Simplified Employee Pension (SEP) IRA. This plan can only receive profit-sharing contributions from the employer; employees are not able to defer portions of their salaries into a SEP IRA like they could into a 401(k) account. As such, this can be a costly plan for owners with many employees, as they must contribute the same percentage of salary to every employee—who is not putting anything into the plan from their own pay—as they are adding to their own account. They are flexible in that the owner can decide how much to contribute in each year (unlike a fixed matching percentage in a 401(k), for example) and each participant is able to invest the contributions according to the options offered by the plan trustee. The contributions are deductible to the business and taxed as income when withdrawn by the participant, just like a traditional IRA. The most that can be contributed is the lesser of $61,000 (for the 2022 tax year) or 25% of compensation. For self-employed individuals, this percentage is limited to 20% of net income from self-employment. Other than record-keeping, the SEP IRA plan is not costly to administer but the equal matching contributions across the employee- eligible base can present a cost challenge for businesses with many employees. For self-employed individuals, the SEP IRA allows for a large contribution to the owner’s retirement plan as long as the business income is high enough.
The second main IRA available for small businesses is the Savings Incentive Match Plan for Employees (SIMPLE) IRA. In order to establish a SIMPLE IRA plan, the business must have less than 100 employees. In contrast to the SEP IRA, the SIMPLE IRA allows employees to make pre-tax salary deferrals into their account. The annual limit for this contribution is $14,000 in 2022 ($17,000 if over age 50), so the maximum is less than the 401(k) employee contribution limit of $20,500/$27,000 for workers under/over age 50. However, the administrative cost to the business owner is significantly less than operating a 401(k) for all employees. For matching contributions, the employer can choose between a match of up to 3% of compensation for employees that contribute to the plan or a nonelective match of 2% for all eligible employees, whether they contribute to their accounts or not. Being able to limit matching only to employees that are contributing a portion of their salary to the plan could potentially save the business owner significant contribution costs versus a SEP IRA where all eligible employees receive the same percentage of pay into their plan accounts. SIMPLE IRAs can be invested the same way as a SEP IRA, and both can be rolled over or combined with other IRA accounts once the account owner is no longer active in the plan. Since these are both employer-sponsored IRA plans, contributing to a SEP IRA or SIMPLE IRA does not automatically preclude a participant from also contributing to a personal pre-tax IRA or Roth IRA.
Small businesses also have the option to offer a full-fledged 401(k) to their employees. These have the same contribution limits as large-company 401(k)s but the costs of administering the plan can be high. This is mainly due to 401(k) plans being covered by the 1974 Employee Retirement Income Security Act (ERISA), which adds layers of complexity on the compliance side for operating and maintaining these plans. The IRAs discussed in the previous section do not have this regulatory oversight and can be much easier to implement.
For the smallest of businesses, where the owner does not have any W-2 employees, the Individual 401(k) plan can be a great option. Also known as the Solo 401(k) or Owners 401(k), this type of plan can only be used by the owners of a small business and their spouses. The contribution limits are the same as a regular 401(k), but an additional benefit is that the owner can make contributions to the plan as both an employee of the business and the (sole) employer of the business. In 2022, owners can contribute $20,500/$27,000 as an employee if under/over age 50 (same as a traditional 401(k)) and can make an employer match of up to $40,500 if business income was high enough. The matching calculation is similar to the SEP IRA maximum contribution based on net income for the business. Another benefit of this plan, specifically compared to the SEP IRA, is that the employee-side contribution limit of $20,500/$27,000 is not dependent on net income; the owner can contribute that maximum as long as the total compensation is larger. Only the allowable additional matching from the employer side is dependent on the net income calculation.
There are some other company retirement plans available that are outside the scope of this article. These plans are comparatively expensive to set up and maintain and are only suitable for very specific employment and income parameters.
While there may not be a clear-cut choice for which retirement plan makes the most sense for a business to offer, it is important to understand the features and limitations of each before making an informed decision. With so few small businesses offering any retirement plan savings to their employees, establishing a plan could place one business clearly ahead of another as a desirable place to work. Ultimately, the best plan will likely be a combination of balancing administrative costs, attracting talent to work for the business, and being able to contribute enough for the owner(s) to save adequately for retirement. Please contact us if you have any questions on the various plan types and what might work best for your small business.
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