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 for tax purposes, how much the owner(s) wish(es) to save, whether the business has employees, and whether the retirement plan is important to employee recruiting and retention. In this article, we describe each type of retirement plan and which businesses tend to be the best candidate for each.
SEP (Simplified Employee Pension)
Defining features:
- 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
- All contributions to the plan are funded by the sponsoring employer/entity on a pre-tax basis and are tax-deductible to the sponsoring employer/entity
- Does not allow contributions to be made on a Roth basis
- Employees (if any) must share in the employer’s plan contributions starting in the employee’s third calendar year of service
- The employer’s contribution (as a percentage of wages/income) is the same for all eligible plan participants
- Contributions are limited to 25% of eligible wages/income (up to a maximum of $61,000)
SEPs are generally only a fit for self-employed individuals who wish to save no more than 25% of their income each year, who don’t have any employees who are at least in their third calendar year of service, and who don’t wish to make retirement plan contributions on a Roth basis. Once an employee becomes eligible they must receive the same contribution (as a percentage of wages/income) as the owner(s), which can be expensive for the employer to fund.
Solo 401(k) Plan
Defining features:
- Only available to an owner-only or an owner and their spouse. Not available to business owners with any W-2 employees who work more than 1,000 hours per year.
- Allows plan participants to make salary deferral contributions of up to $20,500 per year (the limit is $27,000 for those age 50 or older)
- Salary deferral contributions can be made on a pre-tax basis or on a Roth basis (unlike with a Roth IRA, one’s ability to designate salary deferral contributions as Roth is not phased out or eliminated as income increases)
- In addition to salary deferral contributions, the business owner is able to make an “employer” contribution of up to 25% of eligible income
- Total annual contributions (salary deferrals plus “employer” contributions) are limited to $61,000 ($67,500 for those age 50 or older)
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 for a Solo 401(k) Plan is 25% of eligible income plus the “salary deferral” contribution limit of $20,500 ($27,000 if age 50 or older). A Solo 401(k) Plan is also a better fit for self-employed individuals who don’t necessarily wish to save more than 25% of their income each year but who wish to make significant contributions on a Roth basis.
SIMPLE IRA (Savings Incentive Match Plan for Employees)
Defining features:
- Allows plan participants to make pre-tax salary deferral contributions of up to $14,000 per year (the limit is $17,000 for those age 50 or older)
- Does not allow contributions to be made on a Roth basis
- 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.
- 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
- Is easy and inexpensive to set up and administer
A SIMPLE IRA tends to be a good fit for business owners who:
- Wish for their employees to be able to contribute towards their own retirement
- Are committed to making retirement plan contributions for their employees each year
- Don’t wish to save more than $20,000 each year themselves
- Don’t consider the familiarity and cachet of the 401(k) plan to be important for employee recruiting and retention
401(k) Plan
Defining features:
- Allows plan participants to make salary deferral contributions of up to $20,500 per year (the limit is $27,000 for those age 50 or older)
- Salary deferral contributions can be made on a pre-tax basis or on a Roth basis (unlike with a Roth IRA, one’s ability to designate salary deferral contributions as Roth is not phased out or eliminated as income increases)
- Provides a good deal of flexibility with regard to employer matching and nonelective (“profit-sharing”) contributions, which can be subject to a vesting schedule
- Allows plan participants to borrow against their balance in the plan (i.e. “participant loans”) if the employer wishes to make the option available
- Is more familiar to most workers than SEPs and SIMPLE IRAs, and is therefore more effective for employee recruiting and retention purposes
A 401(k) Plan tends to be a good fit for business owners who:
- Wish to be able to maximize their own annual salary deferral contributions at $20,500 ($27,000 if age 50 or older)
- Wish for their employees to be able to contribute towards their own retirement
- Wish to make “employer” contributions for themselves and their employees
- Wish to apply a vesting schedule to employer contributions
- Consider the familiarity and cachet of a 401(k) plan to be important for employee recruiting and retention
401(k) plans are subject to annual compliance testing and can sometimes limit the salary deferral contribution amounts of the business’ owners and “highly compensated employees” (HCEs). A description of those testing requirements – and how a “safe harbor” employer contribution gives the plan an exemption to those testing requirements – is provided in our article The Advantages of Including a Safe Harbor Contribution Feature in Your Company 401(k) Plan here.
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:
- Are at least age 40
- Have few employees (or no employees) and employees, if any, are younger than the owner(s) (and the wider the age gap the better)
- Have high annual income/profits and wish to significantly reduce their annual tax bill
- Wish to accumulate tax-deferred retirement savings much more quickly than with a SEP or 401(k) plan
A detailed description of cash balance plans is provided in our article Frequently Asked Questions about Cash Balance Plans here.
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 different type of retirement plan that is a better fit for themselves and their employees. Business owners are encouraged to speak with an investment professional and/or tax advisor to determine which type of plan is the best fit to meet their own retirement savings goals, reduce current taxable income, and attract new employees.