Small-business retirement plans offer financially irresistible features for both employers and employees. Setting up a small-business retirement plan has never been easier, and the benefits are just too attractive to pass up.
Employers may possibly receive tax deductions and credits - savings that could be reinvested in the business. For example, an employer in the 25% tax bracket who makes a $10,000 plan contribution could reduce federal taxes by $2,500 (refer to the table below). Also, plan contributions invested in tax-advantaged retirement accounts can grow untaxed for decades.
Here is a quick review of the more appropriate plans for small businesses, including partnerships and sole proprietorships. In small businesses that do not have employees, the owners usually benefit in their dual roles of employer and employee. If employees come on board later, owners may want to modify or change the retirement plan.
These are general plan descriptions that do not cover the many exceptions, caveats, and limitations imposed by the fine print of tax law. When evaluating this'alphabet soup' of plans to determine which actually makes the most sense for your particular business, keep several key decision points in mind:
Payroll Deduction IRA
The Payroll Deduction IRA, the easiest retirement plan to set up, is not really an employer plan. Yet for an employer who just can't do more, it may benefit some employees.
Employees simply set up either traditional or Roth IRA accounts at the institution of their choice. Some employees will already have personal IRA accounts. Employers may provide help, encouragement, and assistance for those who don't.
The employer merely offers to make elective payroll deductions from the employee's paycheck to fund the IRA. Then the employer forwards the deduction to the appropriate financial institution, where it is invested in the employee's traditional or Roth IRA account.
This plan doesn't really offer much in the way of benefits to the employer. But it does provide one major attraction for some employees. Many workers want to contribute to an IRA but do not. One reason is that they may wait until the end of the year to set aside the money, and then find that they do not have sufficient funds to do so. Payroll deductions help workers save smaller amounts each pay period. For many people, this is much easier than making a large IRA contribution all at once.
This Payroll Deduction IRA offers no advantages to businesses that have no employees. Owners are hopefully able to establish and fund their own IRA accounts without payroll deductions.
IRA contribution limits are capped at $5,500 per year as of 2013 (or $6,500 for workers over 50). For higher contribution limits and better employer benefits, choose one of the plans discussed next.
The SEP (Simplified Employee Pension) plan is generally very easy to establish and operate. As of 2014, the limits for a SEP are the lesser of two values: either 25% of the employee's compensation, or $52,000. That includes grandfathered SARSEP plans from previous years.
With a SEP, if the employer can't or doesn't want to make a contribution one year, no problem. Operating costs are normally low, and contributions are tax-deductible. Employees may also fund separate personal IRAs that could allow them to divert several thousand more into their retirement accounts.
However, the employer is normally responsible for making all SEP contributions. Contrast this to the Payroll Deduction IRA discussed earlier, where contributions were deducted from the employee's paycheck.
Also, the employer cannot discriminate. If a contribution is made to anyone, it must be made to all qualified employees according to a formula, although it is possible that some employees may not qualify.
Like the SEP, the SIMPLE (Savings Incentive Match Plan for Employees of Small Employers) IRA is easy to set up and operate. SIMPLE plans are usually funded by both the employer and the employee. Employer contributions are mandatory, but in some arrangements, the employer need not make contributions for those employees who do not elect to make salary-reduction contributions. Current IRS rules for 2014 show that SIMPLE contributions are limited to $12,000 or a total of $17,500 in multiple accounts.
Contributions are tax-deductible, and employees may also be able to fund separate personal IRAs and sock away several thousand more for retirement. There are a few other restrictions and limitations that could exclude some small businesses, but the SIMPLE IRA is a good choice for many employers.
The plans discussed so far are all IRA-based. With the 401(k), however, the small business may take a big step into the major leagues of retirement plans. The 401(k) plan has experienced broad popularity and wide adoption for good reasons. First, with a 401(k), a lot of money can quickly be diverted into tax-advantaged retirement accounts. In 2014, limits for 401(k) contributions are set at $17,500.
Second, the 401(k) is generally funded by both the employer and employees. But employer contributions may be discretionary, even when the employee contributes. This provides employers needed leeway in cash-strapped years.
Contributions are tax-deductible, and employees may be able to fund separate personal IRAs. A wide variety of bells and whistles can help small businesses customize 401(k) plans for special needs.
This added flexibility comes at a price, however. The 401(k) plan can be more expensive to set up and operate than IRA-based plans. Paperwork requirements are generally higher, and regulators are more likely to scrutinize these plans.
But just because 401(k) plans can be complicated and expensive doesn't mean that they must be. Several simplified versions are now available from plan providers. These have names like Solo 401(k) and Safe Harbor 401(k). There is even a SIMPLE 401(k), but for many employers, a regular 401(k) offers a much better deal.
Stripped down, these simplified 401(k)'s are still not as easy to set up and operate as IRA-based plans, but their level of complexity is much more manageable. For small-business owners who want to ramp into a high-octane plan, they are certainly worth exploring.
In the chart on the next page we can see how, in the four options discussed so far, contributions might ramp up at various levels of income for a worker under age 50. Those over 50 might do a bit better. As this chart shows, a faster contribution ramp and higher limits generally require more complex plans.
Defined Benefit Plan
But suppose that even the rapid potential rise and relatively high limits of the 401(k) plan are insufficient for your needs. Perhaps instead of wisely building your retirement accounts, you wildly misspent your youth as well as every dollar you ever got your hands on.
Now, in your 50s, through an amazing stroke of good luck, you find yourself raking it in, making much more than you ever thought possible. All your friends are bragging about the size of their 401(k)'s that is, when they are not bragging about the five properties they've just flipped on their way to becoming the next Donald Trump and you realize that you are behind the curve.
Now that you finally made the big time, is there a way that you could put much more of your earnngs into a retirement account and save a bunch on taxes to boot?
The answer may be 'yes' - through a defined benefit plan.
The defined benefit plan is that well-worn pension plan of old, more commonly found in businesses like steel companies and airlines. It normally pays out a benefit to company retirees based on a formula- for example, $100 a month for each year of employment with the company. The company is on the hook for these benefits far into the future, unless it goes bankrupt.
(This has happened to steelworkers and airline pilots, whose pension benefits took a haircut when companies declared bankruptcy and turned their defined benefit plans over to the Pension Benefit Guarantee Corporation, which is supposed to back up failed pension plans. The PBGC doesn't pay the full value of the company pension to workers. The PBGC may itself be on the verge of insolvency due to chronic underfunding, and politicians are now talking about a taxpayer bailout that could reach a half trillion dollars.)
Thus, this option is not for the faint of heart, and it may not work for you at all if you have employees or irregular cash flows from your business.
Setting up and operating a defined benefit plan is generally costly and labor-intensive. Experts will need to be consulted. Finally, employer contributions to the plan are mandatory, even in lean years or when the business suffers a loss. But for those who might fit the above 'profile' of the older sole proprietor with significant and steady earnings, the defined benefit plan just might help you quickly stuff a lot of your earnings into a tax-advantaged retirement plan.
How much? It's difficult to say. It will be whatever your actuary says is required to fund the projected benefits, which currently are limited to $170,000 a year. An actuary will make the determination as to the maximum annual contribution, which is identical to the mandatory minimum contribution.
Deciding Among the Options
In summary, we've looked at five options:
These generally provide sufficient flexibility for most small businesses. Determining which is best for you will require an analysis of your situation, needs, and expected business growth.
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