Small Business Retirement Plans: What You Need to Know

By

Brendan Tuytel

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March 14, 2023

This article is Tax Professional approved

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Retirement plans are a great way for you and your employees to save on your taxes and for the future. Whether you’re looking to set up an Individual Retirement Account (IRA) which is a versatile savings vehicle available only to small businesses with 100 or fewer employees or the more rigid 401(k), it’s imperative you know how each works and what options you have.

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So before you go rushing to set one up, there are some things you should know.

There are five primary retirement plans defined by the IRS. They are: :

  • 401(k) plans
  • SIMPLE IRAs
  • SEP IRAs
  • Roth IRAs
  • Traditional IRAs

What plan works best for you depends on a couple of different factors. We’ll define each of these options as well as their advantages and disadvantages so you can make the right decision for you and your business.

How do retirement plans work?

With a retirement plan, employees or individuals can contribute part of their earnings into a savings account that they typically can’t access until they retire or hit a certain age.

Depending on the plan you choose, these contributions can be taken directly from someone’s paycheck and matched by the employer. The money is then pooled into investments to generate interest.

Unlike the capital gains you would make on your personal investments (like a portfolio of stocks), you either don’t pay taxes on the interest generated or pay when you withdraw. This allows contributions of all sizes to grow for your financial future.

How do retirement plans differ?

There here are four key differences between plans:

  1. Whether contributions are made before or after taxes have been calculated.
  2. What types of investments the money can be invested in.
  3. What the maximum contribution limits are.
  4. Whether they must be set up by an employer.

For the self-employed, this means some plans will not be available to you unless you’re running payroll. Otherwise, choosing a retirement plan is a matter of preference between the features and limitations of each.

401(k) Plans

Generally speaking, 401(k) plans are the most common retirement plans among employers. Contributions are taken directly from the employee’s paychecks and pooled in an investment account to accumulate interest. Employers can also make contributions and enjoy some of their own tax savings, but it’s not required.

There are two different types of 401(k) plans businesses can offer:

  • Traditional 401(k): Contributions are taken from their pay before income taxes have been deducted. The employee benefits by deferring the income tax they’d pay until they draw the funds in the future.
  • Roth 401(k): Contributions are taken from their pay after income taxes have been deducted. The employee benefits by not paying income taxes when they draw the funds in the future.

Employers aren’t limited to offering one type of 401(k). Typically, businesses offer both, giving the employee the option of making contributions to a traditional 401(k), Roth 401(k), or a combination of the two. With both types of 401(k) plans, the employee selects from a number of investment options, mainly mutual funds.

Advantages

  • High contribution limits: To date, workers are limited to $66,000 in total employee and employer contributions. For workers over 50, the limit is $73,500.
  • Tax incentives for matching contributions: Setting up a 401(k) can generate you a tax credit and matched contributions are both tax deductible. Every dollar you match saves you money on your year-end taxes.
  • Investment advice is included: 401(k) plan providers want you to make the most of the plan you implement. This means they’ll offer helpful resources like advisors that help you manage the funds or online assessments to ensure the plan meets the investing goals.

Disadvantages

  • Lots of rules to follow: There are many legal protections in place to make sure 401(k) plans are not misused or misreported. You must disclose all important facts about your plan features and funding to employees. Employees have the right to sue for benefits and breaches of fiduciary duty if they believe there’s any mismanagement of the account
  • Penalties for early withdrawals: Employees may be hesitant to make contributions given they will face a 10% early distribution tax (on top of the income tax) if they withdraw funds before turning 59 ½ or meeting certain conditions (like permanent disablement).
  • High account fees: There are two fees that come with a 401(k). Plan providers have static fees that are the same regardless of how much money is being held. Then there’s an additional fee of 0.5% to 2% of the money held in the 401(k). The larger the 401(k), the more costly the account fees get.

How to open a 401(k)

401(k)s have one of the most complicated setup processes. You must create a plan document in line with the IRS Code and set up a trust with at least one trustee who oversees the plans contributions, investments, and distributions. Setup costs can range from $500 to $3,000 depending on the service provider.

SIMPLE IRA

Since retirement plans can be complicated, the SIMPLE IRA might be tempting on name alone. But SIMPLE is actually an acronym for “Savings Incentive Match Plan for Employees”—no surprise they shortened it.

SIMPLE IRAs are only available to small businesses with 100 or fewer employees. If you fall into this category, you get to enjoy one of the more versatile retirement plans. While 401(k)s are rigid with regards to what kind of investments you offer and how it’s run, SIMPLE IRAs have less bureaucracy and more investment opportunities.

Advantages

  • Easy to run: Unlike a 401(k), there are less conditions and bureaucracy to worry about. If you want to start offering retirement plans with a simplified process, a SIMPLE IRA could be the best option for you.
  • Lots of investment options: There’s a wider selection of investments that can be included in a SIMPLE IRA. You aren’t limited to mutual funds and can build out a unique portfolio of individual stocks and other similar investment types.

Disadvantages

  • Employers must make contributions: You must contribute either matching contributions up to 3% of an employee’s compensation or 2% of an employee’s compensation if they do not make their own contributions.
  • Lower contribution limits: To date, employees can defer $15,500 which is upped to $18,500 if an employee is 50 or older and making catch-up contributions.
  • Taxes on early withdrawals: If you withdraw from a SIMPLE IRA before age 59 ½, you must pay an additional 10% tax on top of the income taxes you’re paying.

How to open a SIMPLE IRA

A SIMPLE IRA can be set up by filling out Form 5304-SIMPLE or Form 5305-SIMPLE and filing it with the IRS. Alternatively, retirement providers like Fidelity can help you set up and manage the plan.

SEP IRA

The SEP in SEP IRA stands for “simplified employee pension.” By design, it’s one of the easiest options for an employer or self-employed individual to get started on. There are less start-up and operating costs than the common 401(k) plans, plus the eligibility requirements are fairly lenient (minimum age of 21 with at least three years of being in the workforce).

Unique to the SEP is the ability to use it in addition to another retirement plan. For the self-employed, this means you pair an SEP IRA with another IRA plan to maximize contributions and savings.

Advantages

  • Easy to set up: An SEP IRA can be set up in three steps by employers or the self-employed. This can be streamlined further by working with a bank, insurance company, or other qualified financial institution.
  • Flexible employer contribution amounts: It’s possible to change your contribution rate from one year to the next. This is helpful for smaller operations sensitive to their cash flow.
  • Higher contribution amounts: To date, the contribution limit is 25% of the employee’s total compensation to a maximum of $66,000 in the year.

Disadvantages

  • Restrictions on withdrawals: Withdrawing funds before age 59 ½ has a 10% fee and distributions must start by age 72.
  • No catch-up contributions: While employees over 50 have higher contribution limits to “catch up” before retirement on other plans, this isn’t an option with SEP IRAs.

How to open an SEP IRA

An SEP IRA can be set up by filing Form 5305-SEP with the IRS. Alternatively, you can work with a retirement plan provider like Charles Schwab to get help setting up and managing the plan.

Roth IRA

A Roth IRA offers individuals the opportunity to open up their own retirement account they can contribute after-tax dollars to. When you withdraw money from the account in the future, you won’t have to pay income taxes on that money. Your funds generate interest tax-free instead of the tax you would pay on capital gains.

Roth IRAs have the widest selection of investment options. You set your money aside in a bundle of investments including stocks, bonds, mutual funds, exchange traded funds, certificates of deposit, and money market funds. Even non-traditional investments like cryptocurrency are an allowable investment option via “Bitcoin IRAs.”

Advantages

  • Doesn’t need to be set up by an employer: For the self-employed, a Roth IRA is a great way to start saving for your future. You can easily set one up for yourself and start making contributions.
  • Money grows tax free: Since the contributions are made after taxes are calculated, you don’t pay taxes on the money you withdraw in the future. This includes paying taxes on any interest generated in the account.
  • Easier to pass on to beneficiaries: Roth IRAs do not require you to start making withdrawals once you reach a certain age. If you don’t need to withdraw money from it in the future, you can pass it on to the next generation.

Disadvantages

  • Low maximum contributions: The limit for contributions individuals under 50 can make in 2023 is $6,500. That increases to $7,500 for those over 50.
  • No tax deductions: Roth IRA contributions are not tax deductible. When you file your income taxes at year-end, your tax bill will be the same whether you make contributions or don’t.
  • Not available to high income individuals: In 2023, Roth IRA contributions start phasing out for individuals with a modified adjusted gross income (MAGI) of $138,000. Once your MAGI reaches $153,000, you’re ineligible for a Roth IRA.

How to open a Roth IRA

Roth IRAs are widely available and are likely offered by your bank. If you qualify, you can opt for a do-it-yourself approach where you work through an online broker and manage your own investments. Or, if you prefer someone else to handle management for you, look into whether your bank offers Roth IRAs or explore some of the top IRA providers.

Traditional IRA

With a traditional IRA, individuals make contributions using pre-tax dollars and pay taxes on distributions down the line. As of 2019, it became more widely available because of the SECURE Act, allowing account holders to be any age as long as they have earned taxable compensation.

Advantages

  • Doesn’t need to be set up by an employer: Similar to the Roth IRA, a traditional IRA is an option for the self-employed to start planning for their future. You can set one up for yourself and start making contributions easily.
  • Maximizes contribution amounts: Contributions are made before any income taxes are calculated. Though you’ll pay taxes on distributions down the line, you’re maximizing the amount in the retirement plan that generates interest.

Disadvantages

  • Low maximum contributions: Contributions top out at $6,500, upped to $7,500 for individuals aged 50 or older.
  • Early withdrawal penalties: Any withdrawals made before age 59 ½ are subject to a 10% tax unless an exception applies. Exceptions include any permanent disability that makes someone unable to work.

How to open a traditional IRA

Similar to Roth IRAs, you can choose between managing your own funds or having an advisor manage it for you. You can work with an online broker or your bank to set up a brokerage account and choose whether you want to work with an advisor. Check out the top IRA providers for the options available to you.

The bottom line

Regardless of which retirement plan you select, you’re taking a step towards saving for the future and potentially enjoying some tax savings in the process. Since there’s no ‘best’ retirement plan, chat with your employees or spend some time figuring out what perks suit your needs most.

To maximize the benefit of your retirement plan, working with a bookkeeper will guarantee that you’re capturing every tax benefit to minimize your bill.

At Bench, we’re experienced working with a wide range of payroll providers to guarantee every expense is recorded properly. Come tax time, we’ll provide a year-end tax package containing all the info on your retirement plan contributions and other tax deductible expenses to make filing a breeze. Start a free trial today.


This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.
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