When you are running your own small business, starting a retirement savings plan can appear to be a fairly daunting task. This is especially true for people who are coming out of traditional employment and do not have much experience with how it works from the standpoint of a business owner.
Whether it seems like a hassle or not, investing in a retirement plan is a must. The good news is that there are many tax advantages that come with starting a retirement savings plan as both an employer and employee of a small business.
Having a retirement plan will, naturally, help you and your employees save for the future. But it’s also beneficial to improving the current state of your business. Not only are there multiple tax advantages, but having retirement plans in place as a small business can also help you to both attract and retain good employees.
The options are plentiful. Let’s take a deeper look at what types of retirement plans are available for small business owners.
IRA stands for Individual Retirement Account, and the self-directed type is also sometimes referred to as a personal IRA. This is the most popular option for people who have left traditional jobs and want to move their retirement funds from the 401(k) plan of their former employers to a personal one.
The rest is pretty self-explanatory. In a personal IRA, the person who owns the account is in charge of all investment decisions related to the retirement plan. However, there is a qualified trustee present in the equation that holds the IRA assets on behalf of the owner.
There are two types of self-directed IRAs: traditional and Roth.
If you are trying to defer taxes until after you retire or believe that tax rates will be lower once you are retired, then a traditional IRA is probably a good option for you. This is why it is popular with people who are in the high-income tax bracket while they are working and expect to be in a lower income tax bracket after retirement.
The biggest advantage is that contributions are tax-deductible, even though the amount you can deduct is limited.
The biggest negative aspect is that distributions are considered income, which means that they are taxable. And if you make withdrawals before you turn 59.5 years old, you can be hit with a significant distribution penalty.
The biggest difference with Roth IRAs is that withdrawals are free of all tax penalties as long as you meet all of the necessary conditions. And while contributions are not tax-deductible, they can be made well passed the age of 70.
If you don’t need to make withdrawals after the age of 70, you don’t have to. The money can stay in your account as long as you would like it to. Another aspect of the Roth IRAs that people like is that distributions can be inherited and qualified beneficiaries can make withdrawals after your death.
Roth IRAs are the more popular option for people who do not fall in the high-income tax bracket, and there are even income limits when it comes to qualifying for Roth IRAs. The main negative aspect is probably the fact that contributions can’t be deducted from your income tax.
The employer-sponsored IRA is popular among small business owners who would like to offer retirement benefits to current employees. Also, if you are looking to attract quality employees, these benefit packages can come in handy.
There are two options for these as well: Simplified Employee Pension IRAs (SEP IRAs) and Savings Incentive Match Plan IRAs (SIMPLE IRAs).
These IRAs are popular among employers because they are probably the easiest and most affordable to set up and they offer a lot of flexibility in terms of when and how much business owners want to contribute. Employees do not contribute to SEP IRAs, it is completely in the hands of the employers.
However, employers are not obligated to make contributions every year. But if they are contributing to themselves in any given year, then they have to contribute that same percentage to employees as well.
Another good thing about them is that all of the contributions are tax deductible. Many employers like SEP IRAs because they provide inspiration and motivation for employees to perform at a higher level. The better your company is doing and the more money it makes, the more contributions will be coming your way – plain and simple.
The biggest downside is that it can get pretty expensive if you plan on growing as a business, since every single employee that is eligible for the plan needs to be included in it.
The main difference with the SIMPLE IRAs is that employees can make contributions as well. Employers are obligated to make contributions too, however. Employers have the option to either match the employee contributions for up to three percent of the employee’s compensation or two percent of their eligible compensation.
Just like the SEP IRAs, these are also very easy to set up; you can get all of the forms you need from the IRS. It doesn’t cost you anything to set up either. Another pro of the SIMPLE IRAs is that the paperwork at the end of the year is actually really easy to understand and file.
Also, the money that you contribute to your employees’ plans is deductible as a business expense.
This is a plan that really is tailored to small businesses, so if you have more than 100 employees, it isn’t even offered as an option to you. It’s something you need to take into consideration if you are planning on growing your business beyond that. But if you do become a company of 100+ employees one day, you can simply change your plan.
One negative aspect with SIMPLE IRAs comes with early withdrawals. If you need to withdraw money from the plan early, you are going to be penalized heavily, as much as 25 percent of the account balance.
The major difference between SIMPLE and SEP IRAs for employers is that contributions are mandatory with SIMPLE IRAs and voluntary for SEP IRAs.
The 401(k) plan is easily the most popular type of retirement plan generally and tradition ones will allow employees to contribute parts of their salaries to their personal accounts. Employers can then make or match these contributions, but with the stipulation that they are able to reclaim that money if the employee leaves the company before a set period of time has transpired.
Of course, there are several types of 401(k) plans as well. Let’s look at some of the most popular ones.
Solo 401(k) plans
A Solo 401(k) plan is pretty similar to a self-directed IRA, except these are for people who pretty much run and entire business on their own. For example, if you are a freelancer that has his or her own agency, this is probably a good option for you. With a Solo 401(k) plan, only the person who owns the business and his or her spouse can make contributions and participate in the plan.
Even though this type of plan sounds pretty limited, you actually have several options. If your spouse is an employee, you can contribute to the plan both as an employee and employer. Contribution options are also very flexible. There is no set amount that you have to contribute per year. This means that if business is booming, you can contribute more, and if you’re having a rough year, you have the option of contributing less.
This might sound pretty straightforward, but running a Solo 401(k) is actually more complicated than IRA options. You are not going to be able to do it on your own, which means that you are probably going to have to pay for a plan administrator to set one up for you. So right there, you already have administration fees that you wouldn’t have with an IRA plan.
Safe Harbor 401(k) plans
The Safe Harbor 401(k) plan is a better option for employees, since they are allowed to take all of the money with them if they decide to leave the company, no matter how long they worked at the previous company.
One thing that is great about this type of plan is that it is less complicated for everyone involved than a traditional 401(k). There is no nondiscrimination testing involved. This testing ensures that benefits are applied equally to all employees regardless of how high or low their wages are. Because of these tests that are necessary with traditional 401(k) plans, there’s a limit to how much you and your best-paid employees can contribute, and there is also a lot more paperwork and administration involved on your side.
You can forgo all of that with a Safe Harbor 401(k) plan. The downside is that there are a bunch of requirements that you need to meet in order to qualify for one. Employee contributions are mandatory, you need to ensure that every employee is eligible for safe harbor provisions as soon as they are eligible to contribute to the plan, and once the employee is eligible for these provisions, the employer must guarantee contributions every year.
Simple 401(k) plans
The Simple 401(k) is meant for smaller businesses, and if you run a company that has less than 100 employees, it could be a great option for you. The Simple plan is most similar to the Safe Harbor plan because there is no annual testing involved and the plan requires employers to vest contributions as soon as they are made.
There are numerous similarities between Simple and traditional 401(k) plans. Both options will allow you to take advantage of tax incentives, which enables you to save more money in the end. Also, you are allowed to invest this money in the financial markets and if you play your cards right, this is another way to grow your retirement money while avoiding being taxed on it.
When comparing the simple and traditional plans, naturally, the simple plan is a lot easier to administer and maintain. This is, again, because there is no testing required. So you have to deal with less paperwork and fewer fees if you choose a Simple 401(k) plan.
A profit sharing plan is another interesting option for small business owners. If you have one or more employees that have worked at least 1,000 hours in the last year, you are able to offer a profit-sharing retirement plan to them.
If you are looking to really make large contributions to your employees, this is a pretty great way to do so, because the limit for this plan is either $51,000 or 100 percent of the employee’s compensation if under that figure.
One of the best reasons for installing this type of plan is because it gives both you and your employees that link between doing good work and being rewarded. Sometimes promising raises is just not enough when it comes to motivating your staff. Letting them know that they can share in the financial success of the company seems to be the a better way these days to keep motivation high.
Some experts refer to this phenomenon as creating a “culture of ownership.” Employees feel as if they are part owners in the company because they are sharing in the financial gains of the company as it continues to grow and prosper.
It has also proven to be a good program when it comes to not only employee retention, but recruitment as well. It’s an appealing idea to employees for the most part. It has also been shown that younger workers tend to respond better to these types of plans while older workers will prefer a more traditional retirement plan.
Defined Benefit Plans
Employers like defined benefit plans because they really do allow them to contribute a lot of money, and employees tend to really like the fact that the have a fixed benefit. Generally, the biggest downside of this type of plan is that it can get really complex to set up, which also means that is more expensive to not only set up but maintain as well.
If you are a business owner making a good amount of money and you want to save as much of it for retirement as possible, this might be your best bet. With this plan, you can save more than $100,000 a year for retirement.
Another interesting aspect of the defined benefit plan is that it can be combined with others. Since it is so different from all of the other available retirement plans, you could potentially combine it with an SEP IRA or a Solo 401(k) and increase your annual savings even more.
A defined benefit plan can also help you to reduce tax liability by writing everything off as business expenses.
Obviously, the biggest downside is that it can get really expensive. You are going to have to determine minimum funding every year for each employee, which can really run up your costs. And even if your business has a bad year, you will still be obligated to pay the minimums that you have agreed upon, so it’s pretty restrictive when it comes to that aspect.
Realistically, this is a great plan for a very small business or solo business, but if you plan on running a larger business and growing it, the costs could skyrocket.
One thing is clear; there are many options out there when it comes to picking the right retirement plan for your small business.
Naturally, this also means that there is a lot to take into consideration. As the owner of the business, you need to act in not only the best interest of your retirement but also think about your employees and the long-term goals that you have set for your company.
While this guide does provide some basic information on what to expect with certain retirement options, it’s always recommended to consult a tax and retirement plan professional before making such an important decision.