Please note that the information on this page is for reference only. Although accurate when originally released, it may now contain out-of-date information. It remains solely for historical purposes and is not considered current guidance. Always consult a professional regarding your individual situation.
As the owner of a closely-held business, you’ve worked long and hard to build the business to what it is today and what you have planned for in the future. Owning a business requires the coordination of many moving parts – from sales, customer service, equipment, physical plant, government regulations, taxes, credit, bonding, licensing, merchandise distribution, cash flow and more. However, one of the most time-consuming pieces and one of the most important objectives for many business owners is the search for and retention of great employees. Often, that requires the offer of a great suite of employee benefits. One of the most important benefits is the provision of a retirement savings vehicle to your employees. A good retirement savings plan is also beneficial to you, allowing you to convert some of your hard-earned time and money in the business to financial security for yourself and your family.
But what’s the right type of plan? There’s a veritable alphabet soup of plans that you may have already heard of – from SEPs, SIMPLEs, IRAs, 401(k)s or DB plans. There are probably still more types of plans that you’ve never heard of. But which is right for you and your business? Do you need to provide the plan to all of your employees or just some? Do you need to provide the same benefit? Do you have the cash flow to contribute to the plan? Do you want to contribute to your employees’ plan or simply let your employees fund their own futures? Do you want to maximize income tax deductions for your business? Do you want to control investment choices or let you employees be accountable?
These are just a few questions that might go through your mind as you contemplate the world of retirement plans as an employee benefit. That’s why you need to consult with a financial professional familiar with these plans as well as your accountant or CPA because of the tax consequences of these plans.
To get you to start thinking about this topic, we’re going to describe some of the basic characteristics of various plans that might be available to your business and when it might be appropriate based upon the maturity and life stage of your business.
For a newer business or a startup, where cash flow may be limited, you might not be ready to offer a retirement savings plan to your employees. However, you should not forgo saving for your own financial security by using a Traditional IRA (“Individual Retirement Account”) or Roth IRA.
Traditional and Roth IRAs are retirement savings vehicles set up by individuals. They are not employer sponsored retirement plans. The annual contribution limit is only $5,500 for 2018 but those age 50 and over can contribute an additional $1,000. Contributions to a Traditional IRA may be income tax-deductible but Roth IRA contributions are made on an after-tax basis.
If your business is at the point where you are enjoying some success, steady cash flow and profits, and you have some employees, you may wish to set up a SEP (“Simplified Employee Pension Plan”) IRA Plan or a SIMPLE (“Savings Incentive Match Plan for Employees”) IRA Plan.
SEPs and SIMPLEs are employer sponsored retirement plans where the employer is required to make contributions to the accounts of their employees. Both types of plans are relatively simple to establish and maintain and are not as complex as other types of employer sponsored retirement plans. In a SEP, contributions are made by the employer only and can be up to 25% of an employee’s salary up to $55,000 (for 2018). For a SIMPLE plan, contributions are made by the employees through salary deferrals up to $12,500 per employee (for 2018) with an additional $3,000 catch-up for those age 50 and over. However, the employer is also generally required to make either a matching contribution for employees who make salary deferral contributions, or a nonelective contribution for each employee regardless of whether or not an employee makes a salary deferral contribution, in either case up to a certain amount.
If you are the sole employee of your unincorporated business and you are enjoying some success and steady cash flow and profits, you may wish to set up a (“Solo”) 401(k) Plan. For 2018, you can make salary deferrals of $18,500 with a catch-up provision of $6,000 for those age 50 and over. Since you’re also the employer, you can additionally make a profit-sharing contribution to your (“Solo”) 401(k) plan of up to 20% of “net self-employment income” for a maximum contribution of $55,000 plus the catch-up provision.
If your business has enjoyed a few years of success, continues to grow, has steady cash flow and profits, and you have full-time employees, then a SEP IRA Plan or SIMPLE IRA Plan may still be appropriate. But, depending upon your level of success and profitability, you may also be able to consider a Traditional 401(k) Profit Sharing Plan or Safe Harbor 401(k) Plan particularly if you have other employees.
The employee salary deferral limits with catch-up provisions are the same as a Solo 401(k) Plan. In a Traditional 401(k) Plan, discretionary profit-sharing contributions by the employer can be up to 25% of employee compensation. 401(k) plans are more complex and typically require the services of a third-party administrator to help run the plan and keep it compliant with various regulations. However, these plans may provide some flexibility in design characteristics (e.g., different contribution allocations for separate classes of employees; favor older, more highly compensated employees; allow for pre and post-tax contributions; and more). Nevertheless, 401(k) plans must still meet rigorous qualification and non-discrimination rules established by the federal government.
Safe Harbor 401(k) Plans seek to simplify the administration of 401(k) Plans by eliminating certain nondiscrimination tests and enabling highly compensated employees to make salary deferral contributions up to the maximum allowed by law regardless of the amount of salary deferral contributions that the non-highly compensated employees may make. It requires the employer to meet certain IRS requirements and minimum contributions to the plan for the non-highly compensated employees.
If your business is one that has existed for many years and has enjoyed consistent success and profitability, and you are starting to think about your retirement or exit strategy from the business to do other things, then you have a mature business. Traditional and Safe Harbor 401(k) Profit Sharing Plans are still viable retirement savings vehicles. However, depending upon the make-up of the company (e.g., number of employees; the business succession plan; demographics of the company; etc.), defined benefit pension plans (“DB plans”) may also be options. DB plans can be in lieu of, or in addition to, a 401(k) plan. DB plans can be great tools particularly if you have not sufficiently saved for retirement or if the savings in a 401(k) Profit Sharing Plan will not allow you to maintain the lifestyle in retirement that you’ve been accustomed to.
There are several different types of DB pension plans (i.e., Traditional, Cash Balance and Fully Insured Defined Benefit Pension Plans) but each “defines” the retirement benefit and therefore, depending upon the participant’s current age, retirement age, and promised benefit, the contribution will be actuarially determined in order to meet the defined benefit rather than as may arbitrarily be determined by the employer and/or eligible employees within the limits specified by law. Of course, the defined benefit is also subject to government rules and regulations (e.g., for 2018, the maximum single life annuity retirement income for a plan participant is $220,000 per year for life) but contributions can well exceed what can be put into a 401(k) and profit-sharing plan.
Defined benefit pension plans are complicated, require the services of a third-party administrator and actuary, and have mandatory contributions each year. However, if you’re a business owner who has started late on your retirement savings, or if you and your employees who are high income earners cannot save enough in some of the other types of plans such as a 401(k) plan, a defined benefit pension plan may be the solution.
We’ve, very briefly, discussed a variety of retirement plans that may help you to recruit and retain top performers to work in your company. These retirement plans may also help you, as the business owner, plan for your own financial security. There are still other types of plans that we did not touch upon and which may apply, particularly if your company is a non-profit or charitable organization. As you can see, there are so many types of plans that may be appropriate for your company. That’s why it is important to work with an experienced financial professional as well as with your CPA.