By: Scott M. Cloud, MBA, CPC

There are several different types of plans from which business owners can choose to enable themselves and their employees to save for retirement.  The type of plan that is most appropriate for a business depends on a number of factors, including: how the business is structured, how much the owners wish to save, whether the business has employees, and whether the retirement plan is important to employee recruiting and retention.  As businesses age they often outgrow SEPs and SIMPLE IRAs in favor of a 401(k) plan, and business owners often have questions about how to complete the transition.  Later in this article we’ll describe what those transitions look like, but first we’ll provide a description of each type of plan and the business owners for whom each plan type tends to be the best fit.

Retirement Plan Types

SEP (Simplified Employee Pension)
Defining features:

  1. Does not permit “salary deferral contributions”, which are amounts that plan participants could otherwise elect to contribute from their own wages on a pre-tax basis
  2. Employees (if any) must share in the employer’s plan contributions starting in the employee’s third calendar year of service
  3. The employer’s contribution percentage is the same for all eligible plan participants
  4. Contributions are limited to 25% of eligible income

SEPs are generally only a fit for self-employed individuals who wish to save no more than 25% of their income each year and who don’t have any employees who are at least in their third calendar year of service.  Once an employee becomes eligible they must receive the same contribution (as a percentage of income) as the owner(s), which can be expensive for the employer to fund.

Solo 401(k) Plan
Defining features:

  1. Only available to an owner-only or an owner and their spouse.  Not available to business owners with any employees who work more than 1,000 hours per year.
  2. Allows plan participants to make salary deferral contributions of up to $19,500 per year (the limit is $26,000 for those age 50 or older)
  3. Salary deferral contributions can be made on a pre-tax basis or on a Roth (post-tax) basis
  4. In addition to salary deferral contributions, the business owner is able to make a contribution of up to 25% of eligible income

For self-employed individuals who don’t have any employees but who wish to save more than 25% of their income each year, a Solo 401(k) Plan is a better fit than a SEP because the annual contribution limit to a Solo 401(k) Plan is 25% of eligible income plus the “salary deferral” contribution limit of $19,500 ($26,000 if age 50 or older).

SIMPLE IRA (Savings Incentive Match Plan for Employees)
Defining features:

  1. Allows plan participants to make pre-tax salary deferral contributions of up to $13,500 per year (the limit is $16,500 for those age 50 or older)
  2. The employer is required to make either a 2% “nonelective” contribution to all eligible employees (whether or not they make salary deferral contributions) or a dollar-for-dollar “matching” contribution up to an employee’s first 3% of wages that they contribute as salary deferrals.  No additional, discretionary employer contributions are permitted.
  3. Employees must be eligible for the plan starting in the employee’s third calendar year of service in which they have total wages of $5,000 or more
  4. Is easy and inexpensive to set up and administer

A SIMPLE IRA tends to be a good fit for business owners who:

  1. Wish for their employees to be able to contribute towards their own retirement
  2. Are committed to making retirement plan contributions for their employees each year
  3. Don’t wish to save more than $20,000 each year themselves
  4. Don’t consider the familiarity and cachet of 401(k) plan to be important for employee recruiting and retention

Safe Harbor 401(k) Plan
Defining features:

  1. Allows plan participants to make salary deferral contributions of up to $19,500 per year (the limit is $26,000 for those age 50 or older)
  2. Salary deferral contributions can be made on a pre-tax basis or on a Roth (post-tax) basis
  3. The employer is required to make either a 3% “nonelective” contribution to all eligible employees (whether or not they make salary deferral contributions) or a dollar-for-dollar “matching” contribution up to an employee’s first 4% of wages that they contribute as salary deferrals
  4. Allows for additional, discretionary “profit sharing” contributions, which can be made on an age-weighted basis to favor business owners and can be subject to a vesting schedule
  5. Is more familiar to most workers than SEPs and SIMPLE IRAs

A Safe Harbor 401(k) Plan tends to be a good fit for business owners who:

  1. Wish to be able to maximize their own annual salary deferral contributions at $19,500 ($26,000 if age 50 or older)
  2. Wish for their employees to be able to contribute towards their own retirement
  3. Are committed to making retirement plan contributions for their employees
  4. Wish to have the option to make additional, discretionary contributions for themselves and their employees
  5. Wish to apply a vesting schedule to discretionary employer contributions
  6. Consider the familiarity and cachet of a 401(k) plan to be important for employee recruiting and retention

Cash Balance Plan

For business owners wishing to make tax-deductible retirement contributions in excess of $100,000 (and as much as $250,000) per year, cash balance plans are very popular.  Cash balance plans are a good fit for business owners who:

  1. Are at least age 40,
  2. Have few employees (or no employees) and employees, if any, are younger than the owner(s) (and the wider the age gap the better), and
  3. Have high annual income/profits and wish to significantly reduce their annual tax bill

While the focus of this article is on SEPs, SIMPLE IRAs, and 401(k) plans, more information about cash balance plans can be found in our article Frequently Asked Questions about Cash Balance Plans here.

Transitioning Between Retirement Plan Types

Transitioning from a SEP to a Solo 401(k) Plan

Because a SEP limits annual contributions to 25% of eligible income, business owners often transition from a SEP to a Solo 401(k) Plan once they wish to begin saving more than 25% of their income each year.  The transition can be completed at any time as long as the business owner does not maintain an IRS model Form 5305-SEP and has not funded that SEP for the year in which the transition takes place.  An IRS model Form 5305-SEP prohibits an employer from funding any other type of retirement plan during the same year in which it funds the SEP (most “prototype” SEPs do not have the same limitation).  So, if the business owner has not funded an IRS model Form 5305-SEP for the year or if the business owner uses a prototype SEP, the transition to a Solo 401(k) Plan can be completed at any time during the year and the business owner would not need to wait until the beginning of the next year to do so.

From the bottom of the page on the IRS website hereTo terminate a SEP, notify the SEP-IRA financial institution that you will no longer be contributing and that you want to terminate the contract or agreement.  It is a good idea to notify your employees that you have discontinued the plan.  You do not need to give any notice to the IRS that you have terminated the SEP.

Transitioning from a SEP to a Safe Harbor 401(k) Plan or SIMPLE IRA

Once a business owner has any employees become eligible for a SEP, the SEP generally becomes cost-prohibitive because the business owner must fund the same contribution percentage for their employee that they fund for themselves.  At that time business owners typically transition to either a SIMPLE IRA or a Safe Harbor 401(k) Plan.  In general, a SIMPLE IRA would be a better fit for business owners who do not wish to save any more than $20,000 per year themselves, and a Safe Harbor 401(k) Plan would be a better fit for business owners who wish to save more than $20,000 per year themselves.

The deadline to establish a new Safe Harbor 401(k) Plan is October 1st (although because it typically takes at least a month to set up a new 401(k) plan it is recommended that the employer begin the setup process by the end of August).  The new Safe Harbor 401(k) Plan could be effective any time on or before October 1st as long as the business owner does not fund an IRS model Form 5305-SEP for the year in which the new Safe Harbor 401(k) Plan is effective.

The deadline to establish a SIMPLE IRA is October 1st (although because it typically takes at least a month to set up a new SIMPLE IRA it is recommended that the employer begin the setup process by the end of August).  The new SIMPLE IRA could be effective any time on or before October 1st as long as the business owner does not fund any contributions to a SEP (whether an IRS model Form 5305-SEP or a prototype SEP) for the year in which the new SIMPLE IRA is effective (i.e., an employer cannot fund any other type of retirement plan during the same calendar year in which it funds a SIMPLE IRA).

From the bottom of the page on the IRS website hereTo terminate a SEP, notify the SEP-IRA financial institution that you will no longer be contributing and that you want to terminate the contract or agreement.  It is a good idea to notify your employees that you have discontinued the plan.  You do not need to give any notice to the IRS that you have terminated the SEP.

Transitioning from a SIMPLE IRA to a Safe Harbor 401(k) Plan

Business owners often transition from a SIMPLE IRA to a Safe Harbor 401(k) Plan for any number of reasons, including:

  1. They wish for themselves and their employees to be able to make salary deferral contributions up to the higher limits of a 401(k) plan,
  2. They wish for themselves and their employees to be able to make salary deferral on a Roth (post-tax) basis rather than only on a pre-tax basis,
  3. They wish to make employer contributions that are higher than those permitted in the SIMPLE IRA (and perhaps apply a vesting schedule to those additional employer contributions),
  4. They wish to make additional “profit sharing” contributions on an age-weighted basis to favor business owners,
  5. They wish to offer a loan feature and/or limit employee distribution options, and/or
  6. They feel that the familiarity and cachet of a 401(k) plan has become important for employee recruiting and retention purposes

An employer may not fund any other type of retirement plan during the same calendar year that it maintains a SIMPLE IRA, so changing from a SIMPLE IRA to a Safe Harbor 401(k) Plan can only be done as of the beginning of the next calendar year as long as employees are notified of the SIMPLE IRA plan termination before November 2nd.  From the bottom of the page on the IRS website here:

Step 1: Notify your employees within a reasonable time before November 2 that you’ll discontinue the SIMPLE IRA plan effective the following January 1.

Step 2: Notify your SIMPLE IRA plan’s financial institution and payroll provider that you won’t be making SIMPLE IRA contributions for the next calendar year and that you want to terminate your contributions.

Step 3: You should keep records of your actions, but you don’t need to notify the IRS that you have terminated the SIMPLE IRA plan.

To start the new Safe Harbor 401(k) Plan the employer should work with a retirement plan financial advisor.  To have the 401(k) plan ready to start accepting contributions at the beginning of the next year, the employer should get started setting up the plan no later than mid-November (sooner if possible) to leave plenty of time to 1) design the plan and prepare its plan document, 2) set up the plan’s “Trust” account and investment arrangement, and 3) complete employee enrollments in time for the first payroll of the next year.

Summary

Business owners have several different types of retirement plans from which to choose to meet their own savings goals and to enable their employees to accumulate retirement savings.  As businesses age it is common for business owners to change to a type of retirement plan that is a better fit for themselves and their employees.  When transitioning between retirement plan types, employers are encouraged to work with a financial professional to help with terminating the existing plan and establishing the new plan, and to ensure that the transition is done within IRS guidelines.