Choosing a retirement plan for your business can be a balancing act between reaching your own retirement savings goals, providing suitable retirement savings options for your team, and minimizing the time and effort spent maintaining the plan. There are many options for business retirement plans, and each has unique benefits and drawbacks. Consider these common types of business retirement plans and how they could work for your team.
Common Types of Business Retirement Plans
The most common types of business retirement plans are Solo 401(k), traditional or safe harbor 401(k), SEP IRA, and SIMPLE IRA. You should be aware that each of these has different rules, tax benefits and contribution amounts that can be beneficial to specific situations.
Solo 401(k)
Solo 401(k) plans, also known as i401(k), are intended to help self-employed individuals save for their retirement. These types of plans can only be used by businesses with no employees. There is an exception, however, for business owners who hire their spouse. Businesses with employees other than their spouse would not be eligible to establish a Solo 401(k).
With a Solo 401(k), business owners can make contributions as both employer and employee. The maximum total contribution amount is $61,000. This includes employee and employer contributions. Employee contributions, also known as elective deferrals, are capped at 100% of compensation or $20,500 for 2022. For those age 50 or older, an additional $6,500 catch-up contribution is allowed. This brings the maximum contribution amount to $67,500 for those individuals. Additionally, employer contributions can be made up to 25% of compensation until the combined maximum contribution is made. A special calculation is used to determine the maximum employer contribution for self-employed individuals whose businesses are not incorporated.
With a Solo 401(k), in-service withdrawals are not permitted. This means that employees cannot take a distribution from their retirement account while they still work for the business if they have not reached age 59 ½. However, loans from the 401(k) may be permitted based on the plan.
One feature of Solo 401(k)s that many business owners find attractive is that salary deferrals may be directed to a designated Roth account. Unlike Roth IRAs, a designated Roth account inside a 401(k) is not subject to income limits. This can give business owners additional flexibility for retirement savings if their income exceeds the Roth IRA threshold. In all retirement plans, employer contributions must be made on a pre-tax basis, and cannot be directed to a designated Roth account.
Traditional 401(k) and Safe Harbor 401(k)
The most common type of employer sponsored plan is the 401(k). These plans allow employees to make salary deferral contributions and employers to make matching and / or profit-sharing contributions.
Contribution limits in a traditional 401(k) are the same as those in a Solo 401(k). The maximum total contribution allowed is $61,000 for 2022. Employee salary deferrals are capped at 100% of compensation or $20,500 in 2022. An additional $6,500 catch-up contribution is allowed for employees age 50 or older. This catch-up contribution brings the total contribution limit to $67,500. Employer contributions including matching and profit sharing can be up to 25% of an employee’s first $305,000 of compensation. Employer contribution limits are calculated differently for self-employed individuals whose businesses are not incorporated.
No in-service withdrawals are allowed in a 401(k) plan before age 59 ½, but loans may be permitted. One advantage of 401(k) plans is that employee contributions can be directed to a designated Roth account. Employer contributions, however, must be made on a pre-tax basis.
In a traditional 401(k) plan, employer contributions can be subject to a vesting schedule. This means that if an employee leaves the company prior to meeting the requirements of the vesting schedule, all or a portion of their accumulated employer contributions are forfeited. Vesting can occur on a graduated scale of up to six years or can become vested all at once according to a cliff vesting schedule. The maximum length of time for a cliff vesting schedule is three years.
The downside to traditional 401(k) plans is that they require annual nondiscrimination testing. This testing ensures the fairness of the plan by making sure that the plan is not weighted to be more beneficial to highly compensated employees and officers in the company. Because this testing can be expensive and time consuming, some small businesses opt to label their plans as safe harbor. Safe harbor 401(k)s have additional rules to ensure fairness in the plan but avoid nondiscrimination testing.
For a 401(k) to be considered safe harbor, all contributions must be vested immediately. Additionally, safe harbor rules dictate which types of employer matching is allowed. There are several options for employers who maintain a safe harbor 401(k). Employers can choose the basic match method which dictates 100% matching on the first 3% of salary deferrals plus 50% matching on deferrals between 3% and 5% of the employee’s salary. If the employer does not want to use the basic match method, they can choose another method that is equal to or exceeds the basic match. A common formula is 100% match on the first 4% of employee deferrals. Alternately, employers can make a 3% nonelective contribution. Under this type of contribution, instead of matching employee deferrals, the employer must contribute to each eligible employee’s 401(k) regardless of whether the employee makes a contribution.
In traditional, non-safe harbor plans, employer contributions can be discretionary — meaning that the employer is not obligated to make contributions each year. Under safe harbor rules, employers must contribute each year.
SEP IRA
SEP IRAs allow business owners to make employer contributions to their own and their employees retirement accounts. Employee contributions and salary deferrals are not a part of this type of retirement plan.
Employers can contribute 25% of each employee’s first $305,000 of compensation up to a maximum of $61,000 per employee. The calculation differs for self-employed individuals whose businesses are not incorporated.
It is important to note that with a SEP IRA, the business must contribute the same percentage for all employees who are eligible to participate in the plan. This means that an employer cannot contribute a higher percentage for themselves and a lower percentage for their employees. This consideration may make a SEP IRA less attractive for business owners who are looking to maximize their own retirement savings while providing a more modest contribution to each employee’s retirement plan.
Employees must be included in the plan if they are over age 21, worked for the business in at least 3 of the last 5 years, and received at least $650 in compensation. An employer can use less restrictive criteria to determine eligibility but cannot make eligibility requirements more restrictive.
Contributions to a SEP IRA are always 100% vested. This means that once contributions are made on an employee’s behalf, the employee takes ownership of those funds. If the employee leaves the business, they are able to take with them all funds in their retirement plan.
Unlike 401(k)s, withdrawals from a SEP IRA are permitted at any time, even if the employee still works for the business and is not yet retirement age. Early withdrawals may be subject to a 10% tax penalty. Loans are not permitted in a SEP IRA.
Since SEP IRAs only accept employer contributions, there is no additional contribution amount allowed for age-based catch-up contributions. Also, employer contributions must be made on a pre-tax basis so there is no Roth option in a SEP IRA.
SIMPLE IRA
A SIMPLE IRA is a type of small business retirement plan which offers both employee and employer contribution options. In order to maintain a SIMPLE IRA, employers must have fewer than 100 employees.
In 2022, employee deferrals are limited to $14,000 in a SIMPLE IRA. An additional $3,000 can be contributed by those 50 or older as a catch-up contribution. Employers can choose to offer either a 2% nonelective contribution, or a 3% matching contribution. If the employer chooses to use a matching contribution, only the first $305,000 of an employee’s compensation can be used to calculate the match.
Both employee and employer contributions are always 100% vested. In a SIMPLE IRA, loans are not permitted but early withdrawals are allowed. It is important to note that the early withdrawal penalties for SIMPLE IRAs are more stringent than in other types of plans. There is a 25% early withdrawal penalty for those who are under age 59 ½ and have participated in the plan for less than two years. After two years of participation, the early withdrawal penalty falls to 10%.
A SIMPLE IRA cannot be a Roth IRA and cannot have a designated Roth account.
Employees must be allowed to participate in the plan if they earned at least $5,000 in any two previous years and are expected to earn at least $5,000 in the current year. An employer can set less restrictive guidelines for participation but cannot make eligibility more restrictive.
Employers must contribute to the plan each year. If needed, employers can reduce their contribution to all employees’ accounts in a given year but must still contribute at least 1% in matching contributions. Employers cannot reduce their contributions more than two out of every five years.
How much can you contribute to each type of business retirement plan?
Many business owners seek to save as much as possible for their own retirement. To compare how much the owner of a business can save for his or her retirement with each plan, assume that the business owner makes a salary of $100,000.
If the business establishes a Solo 401(k), they can contribute the maximum employee deferral amount, $20,500 and make a profit-sharing contribution up to 25% of their compensation. Total, this would be an annual contribution amount of $45,500.
If the business chooses a traditional or safe harbor 401(k) and matches contributions at 4%, the business owner could defer the maximum amount, $20,500, and then match 100% of contributions up to 4% of their salary. The total contribution amount would be $24,500 in this case.
In a SEP IRA, the business owner can contribute up to 25% of their compensation as an employer contribution, making the annual contribution amount $25,000. Remember that in this case, the employer would have to contribute the same percentage to each of their employees’ plans.
With a SIMPLE IRA, the business owner could defer the maximum amount, $14,000, and the business could match 3%. In this case, the total contribution amount would be $17,000.
How to Choose the Right Retirement Plan for Your Business
When choosing a retirement plan for your business, first consider how much you want to contribute for your own retirement. To determine the amount to save for retirement, speak to a financial advisor who can help you estimate your expenses in retirement, the expected investment returns for your holdings, and estimate the impact of inflation and taxes on your retirement plan. You should also speak to your financial advisor about whether it would be beneficial for a portion of your retirement savings to be in a Roth account. Since SEP and SIMPLE IRA plans do not permit Roth contributions, this could be a determining factor when choosing a retirement plan.
After you have considered your own retirement goals, determine how much you can afford to contribute to your employees’ retirement plans. The amount that you are comfortable matching or contributing to employees’ accounts can make a big difference in which type of plan you choose.
Lastly, speak with the professionals at Meld Financial about the costs associated with setting up and maintaining each type of plan. While each of the plans in this article are considered low-cost, set up and maintenance fees can vary with each plan and plan sponsor.
Plan for a Successful Retirement with Meld Financial
At Meld Financial, our team of tax, legal, and financial professionals can help you determine which retirement savings strategies are best suited to you and your business. If you need help planning for your own retirement, or choosing a retirement plan for your business, reach out to one of the experienced financial advisors at Meld.
Contact us today to get started.
