Retirement Plan Options for Small Businesses and the Self-Employed

Retirement Plan Options for Small Businesses and the Self-Employed

May 20, 2021
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 Studies show that among the smallest businesses (those with no more than 4 employees), only 5% provide their employees access to a retirement savings plan. The percentages grow with the sizes of the businesses. Almost a third (31%) of businesses with 26-to-100 employees provide access to a retirement savings plan for employees.  Larger companies – those with 1,000 or more workers -- are much more likely to offer these plans to their employees. In fact, about 94% of them do. *


 The shortage of small businesses with retirement plans suggests that a lot of business owners and their employees may not be as prepared for retirement as they should be. Access to a retirement plan can make a big difference.  Fortunately, there are effective and efficient tools that even the smallest business owners can use to create company-sponsored retirement plans that help their employees—and themselves—as they prepare for retirement. It also is a concrete way to demonstrate their support for existing employees, which can help retain them and attract new employees. 


 One of the most important reasons to invest in a retirement plan for your business is the tax benefits they provide. The contributions you make can help reduce current income taxes now, and your retirement account will have the potential to grow and compound, tax-deferred, to boost your savings.


 The importance of planning ahead and saving for retirement is important. One thing that has amped up concerns has been growing uncertainty surrounding Social Security. The retirement wave of the Baby Boom generation has had a big impact. People are also living longer, and the birth-rate is low. In 2010, Social Security began paying more out in benefits and expenses than it collected in taxes and other non-interest income. The trustees have projected that this pattern will continue for the next 75 years, with trust-fund reserves becoming depleted in 2035.** At that point, the payroll taxes and other income flowing into the program will be enough to pay only about 79% of the program’s costs.  


 The age to receive full benefits has also been pushed back. It was 65 when the program began but has been gradually rising and for those born in 1960 or later, your full retirement age is 67. Retiring and collecting Social Security before you reach your full retirement age can reduce your Social Security benefits by as much as 30%.  The average Social Security payment for the 45.8 million retirees collecting Social Security in June 2020, was about $1,500 a month.

 

Social Security was never meant to be the only source of income for retirees. It was meant to be part of a “three-legged stool” of income sources. Social Security is just the first leg. The second leg is made up of your personal savings and investments, including savings accounts, stocks, bonds, real estate, cash-value life insurance policies, taxable investment accounts, IRAs, Roth IRAS, and any other assets you own. The third leg was originally called the pension leg. Now that pensions are less common, this third leg relies on other company retirement plans. Company retirement plans offer multiple advantages for both you and your small business. Some of the most used plans to consider are SEP-IRAs, SIMPLE IRAs, profit sharing plans, and 401(k)s. All these plans provide business advantages in addition to the personal benefits of saving for retirement.

 

SEP IRAs

The flexibility, simplicity, and cost-effectiveness of The Simplified Employee Pension - SEP-IRA - make it a popular choice for business owners with few employees, and for sole entrepreneurs or self-employed individuals. It also does not require you to file annual reports, and administrative expenses are minimal.

 

You can set up a SEP-IRA and contribute to it at any point before your business’s tax returns are due—even if you have filed an extension for your business tax return. Your SEP-IRA plan should include most employees—even part time workers. To qualify, an employee must be at least 21 years old and have worked for you in at least three of the past five years, receiving a minimum of $650 in compensation from you during the current year. You can use less-restrictive participation requirements than these if you want – but not more restrictive ones.

 

There are a couple legal exceptions to the rules, however, such as employees covered by union contracts and nonresident alien employees who meet certain conditions. They can be excluded from the plan. ***

 You—and not your employees—make the contributions to SEP IRAs. The employees manage their own investment decisions within their account.  Even though the employees do not contribute, they are immediately and completely vested. You, as the employer and the person making the contributions in your employees’ behalf, get a tax deduction on your contributions. An employer can contribute up to 25% of compensation into an employee’s account—if the amount does not exceed $58,000, which is the limit set in 2021.  Keep in mind, too, that the business owner is also an employee qualified for an account. So, for business owners and employees who are just starting to save for retirement, a SEP-IRA may be the perfect choice.

           

Jobs and salaries vary – but the formula you use for every employee in the plan must be uniform and pass nondiscrimination testing standards. For example, if you have an employee with a $250,000 salary, their contribution if you followed just the 25% rule would be $62,500. That surpasses the $58,000 maximum contribution amount for 2021 so that employee’s contribution is capped at the $58,000.

 

A SEP-IRA plan may also use the “permitted disparity” rule, which can be complicated, and factors in projected Social Security retirement benefits. If you need more information about this, you can find it on IRS.gov.

 

Another advantage to SEP-IRA plans is that you have the flexibility to change what percentage you will contribute each year. It might be 8% this year, 2.5% the next, and then jump to 25% for a year when you have record profits. 

 

Simple IRAs

The Savings Incentive Match Plan for Employees – the SIMPLE IRA – lives up to its name. It is easy to set up, and you do not have the start-up and operating costs of a conventional retirement plan. There are no annual filing requirements for the employer, and you do not have the nondiscrimination requirements found in the SEP-IRA and other retirement plans.

 

Also, employees can contribute—unlike the SEP-IRA. The employee contributions are made as elective salary deferrals, reducing their paycheck by the percentage that is being directed into the plan. To make contributions for the current year, you must set up your plan by October 1 (unless your business is created after that date).

 

As the business owner, you will have to match each employee’s salary-reduction contributions on a dollar-for-dollar basis up to 3% of the employee’s salary. You can choose to do a 1% match for two years but then you must change it to 3%. If you are cash strapped, after year five you can go back down to 1% again for two years but once again must go back up to 3% after those two year. Or, instead of a matching plan, you can choose to make non-elective contributions equal to 2% of each participant’s compensation. In this case only the employer contributes, not the employees.

 

Only businesses with 100 or fewer employees qualify for the SIMPLE IRA. Their employees are eligible to participate in their company’s SIMPLE IRA plan if they earned a minimum of $5,000 from the employer for any of the two previous years of service—and if they are expected to earn at least that much during the coming year.  They are immediately and completely vested in their contributions.

 

The employer may designate a financial institution for the SIMPLE IRA accounts but if it is a Simple 5304 plan the employee has the option to have his/her SIMPLE IRA funds deposited with the firm of their choosing. Like the SEP IRA employees manage their own investments inside their SIMPLE IRA account.

 

 

Profit Sharing Plans

A Profit-Sharing Plan will allow you and your employee to share in the profits you have worked hard to create—and could help your business retain and attract talent. It also gives you flexibility because business conditions and profits change from year to year, and you may want to change the plan’s amount of contributions or even contribute nothing in years when profits are very low or non-existent. The maximum that can be contributed for each participant in 2021 is the lesser of 25% of your employee’s income—or $58,000 (minus the sum of the employee’s pre-tax and after-tax contribution).

 

While the contributions are discretionary and can change them, you must use the same formula for each participant so that each employee receives the same percentage of their annual salary. Employees must be included in the plan if they are 21 or older, and if they’ve worked at least 1,000 hours during a plan year. You cannot require more than 1,000 hours of service.

 

The contributions made to the plan can either be fully vested when made—or be vested over time according to a vesting schedule. If your plan requires two years of service before participating, all contributions are immediately vested. Because administering a profit-sharing plan is more complicated than some of the other plans we have discussed, it typically requires assistance from a professional.

 

 

401(k) plans

One survey from 2017 said that the main reason why small-businesses owners do not offer their employees a 401(k) plan is they believe their business is too small to qualify. About 60% of the small business owners who responded believe this, and 67% of self-employed and sole proprietors also said they feel this way.**** This is not the case.

 

The solo 401(k) for self-employed and sole-proprietors allows contributions up to $58,000 for 2021—with catch-up contributions of $6,500 for individuals 50 or older. 

 

For small business owners who want to attract and retain talent by offering a traditional 401(k), your employees can contribute up to $19,500 for 2021 (with catch-up contributions of $6,500 allowed for employees 50 and older). You, as the employer, have the option to match whatever percentage of that you want. There is a limit, though. Combined, your contribution and the employee’s contribution cannot exceed $58,000—or $64,500 for those 50 or older. Even though you do not have to match the employee’s contribution, your match may be necessary to reach the level of employee participation that allows the owner and other key employees to make substantial contributions.

 

Another option that employers sometimes offer in conjunction with a traditional 401(k) plan is the Roth 401(k).  The Roth 401(k) allows employees to make after-tax contributions from their pay, enabling them to make tax-free withdrawals of their funds in retirement.

 

Factors to Weigh in Your Choice:

With the four plan options – SEP-IRAs, SIMPLE IRAs, profit-sharing plans, and 401(k) plans—you need to consider both tangible and intangible factors before making your decision. There are so many factors to weigh, and it is important to examine all your options as you prioritize the goals you want to establish for yourself and your business.

 

Are you looking for flexibility? Some plans impose funding rules, while contributions to others—such as SEP-IRA, 401(k), and profit-sharing plans—may be discretionary, depending on the specific plan provisions. 

 

Another critical consideration is if you are looking for an immediate tax deduction. Most plans are limited to a deduction equal to 25% of eligible compensation.

 

How many employees you have will also be a big factor in deciding which plan will work best for you and your employees. You will need to consider the maximum contribution limit allowed per employee. Qualified plans are limited to $58,000 or 100% of eligible compensation—whichever is less. SEP-IRA plans are limited to contributions up to 25% of employee compensation—or $58,000, whichever is less.  For SIMPLE-IRAs, employees can contribute up to $13,500 and you can either provide a time-limited 1% or 3% match or a non-elective contribution, depending on the option you choose.

 

You also need to determine if you plan to provide these benefits to all your employees or if there are exclusions. This can be very complex, depending on eligibility requirements for each plan as well as employee demographics.

 

There are also potentially complicated factors we have not discussed yet, such as limiting your own fiduciary responsibility, offering nontaxable loans to participants, and protecting your plan from creditors. These are topics you may want to dig into deeper with a plan professional, like myself, who can help guide you.

 

*Sources: CNBC: “A 401(k) retirement plan is not an option; it’s a must for all companies,” July 21, 2017;

Security; Government Accountability Office, “Challenges and Prospects for Employees of Small

Businesses,” July 16, 2013.  https://www.cnbc.com/2017/07/21/every-company-should-offer-401k-retirement-plan-with-job-no-excuses.html  

 

 

**Source: Social Security Administration, Fast Facts & Figures About Social Security, 2020.

 https://www.ssa.gov/policy/docs/chartbooks/fast_facts/2020/fast_facts20.html#page35  

 https://www.ssa.gov/benefits/retirement/planner/agereduction.html

 also from https://www.ssa.gov/benefits/retirement/planner/agereduction.html

 This info comes from https://www.ssa.gov/cgi-bin/currentpay.cgi

 This is from https://www.ssa.gov/history/lifeexpect.html It gives rates in 1930, so this is an approximation.  This is also supported by information found in this study: https://u.demog.berkeley.edu/~andrew/1918/figure2.html

 And in this fact check site by the Poynter Institute:  https://www.politifact.com/factchecks/2010/mar/08/glenn-beck/Glenn-Beck-Social-Security-life-expectancy/

 https://www.ssa.gov/oact/STATS/table4c6.html

 

***Source: Internal Revenue Service: “Who Can Participate in a SEP or SARSEP Plan?”

 

**** https://www.cnbc.com/2017/07/27/survey-34-percent-of-entrepreneurs-lack-retirement-savings-plan.html 

 

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