There are several retirement plans that are popular among small businesses. The best retirement plan for a small business will depend on factors such as the number of employees, the business structure, and the desired level of contribution flexibility. Let’s take a look at some of the most common retirement plans for small businesses:
Simplified Employee Pension (SEP) IRA
A SEP IRA is a tax-deferred retirement plan that allows employers to make contributions to their own account and their employees’ accounts. SEP IRAs are easy to set up and administer, and there are no annual filing requirements. Here’s how a SEP IRA works:
Eligibility: Any employer can establish a SEP IRA, including self-employed individuals. Employees are eligible to participate if they are at least 21 years old, have worked for the employer for at least three of the past five years, and have received at least $650 in compensation from the employer in the current year.
Contribution limits: Employers can contribute up to 25% of an employee’s eligible compensation or $66,000 (for 2023), whichever is less. Employers can choose to make contributions in any year, and can vary the contribution amount from year to year.
Tax benefits: Contributions to a SEP IRA are tax-deductible for the employer, and the contributions grow tax-deferred until the money is withdrawn in retirement. Employees do not pay taxes on SEP IRA contributions until they withdraw the money in retirement.
Investment options: A SEP IRA can be invested in a wide variety of investments, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs).
Savings Incentive Match Plan for Employees (SIMPLE) IRA
A SIMPLE IRA is a retirement plan that is designed for small businesses with 100 or fewer employees. Employers can choose to match their employees’ contributions or contribute a fixed percentage of each employee’s salary. Here’s how a SIMPLE IRA works:
Eligibility: Any employer with 100 or fewer employees who earned at least $5,000 in the previous year can establish a SIMPLE IRA. For employees to be eligible to participate, they must be at least 21 years old, have earned at least $5,000 in any two prior years, and expect to earn at least $5,000 in the current year.
Contribution limits: Employees can contribute up to $15,500 (for 2023) of their income to their SIMPLE IRA. Employers are required to either match their employees’ contributions dollar for dollar up to 3% of the employee’s compensation or contribute a fixed percentage of each employee’s compensation up to 2%, regardless of whether the employee makes contributions.
Tax benefits: Contributions to a SIMPLE IRA are tax-deductible for the employer, and the contributions grow tax-deferred until the money is withdrawn in retirement. Employees do not pay taxes on SIMPLE IRA contributions until they withdraw the money in retirement.
Investment options: A SIMPLE IRA can be invested in a variety of investments, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs).
Solo 401(k)
A Solo 401(k) is a retirement plan designed for self-employed individuals with no employees or for business owners who employ only their spouse. Because it allows the business owner to make both employee and employer contributions, it can be a good option for those looking to maximize their retirement savings. Here’s how a Solo 401(k) works:
Eligibility: To establish a Solo 401(k), you must be self-employed or a small business owner with no employees, other than a spouse. You must also have earned income from your business to be eligible to make contributions to the plan.
Contribution limits: As both the employer and employee, you can make contributions to your Solo 401(k) plan. For 2023, the maximum contribution is $66,000, or $73,500 if you are age 50 or older. You can contribute up to 100% of your earned income, up to the annual contribution limit.
Tax benefits: Contributions to a Solo 401(k) are tax-deductible for the employer, and the contributions grow tax-deferred until the money is withdrawn in retirement. You do not pay taxes on your contributions until you withdraw the money in retirement.
Investment options: A Solo 401(k) can be invested in a wide range of investments, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs).
Traditional 401(k)
A traditional 401(k) is a type of employer-sponsored retirement plan that allows employees to make pre-tax contributions to their retirement accounts. Employers can choose to match their employees’ contributions, and can also make contributions on behalf of their employees. Here’s how a traditional 401(k) works:
Eligibility: Employers who offer a traditional 401(k) plan generally offer it to all employees who work at least 1,000 hours per year. Eligible employees can choose to enroll in the plan during the enrollment period.
Contribution limits: Employees can contribute up to $22,500 (for 2023), or $30,000 if you are 50 or older, of their income to their traditional 401(k) plan. Employers can also make contributions to the plan on behalf of their employees, either as a matching contribution or a non-elective contribution.
Tax benefits: Contributions to a traditional 401(k) plan are made on a pre-tax basis, which means that they reduce the employee’s taxable income in the year they are made. The contributions grow tax-deferred until the money is withdrawn in retirement. At retirement, withdrawals are subject to income tax.
Investment options: A traditional 401(k) can be invested in a variety of investments, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Employees can choose their own investments or work with a financial advisor to create a portfolio that suits their needs.
Profit-Sharing Plan
A profit-sharing plan is a retirement plan that allows employers to contribute a percentage of their profits to their employees’ retirement accounts. Employers have flexibility in determining the amount and timing of contributions, and they can adjust contributions based on the business’s profitability. Here’s how a profit-sharing plan works:
Eligibility: Employers who offer a profit-sharing plan generally offer it to all employees who work at least 1,000 hours per year. Eligible employees can choose to enroll in the plan during the enrollment period.
Contribution limits: Employers can contribute the lesser of 25% of compensation or $66,000 for 2023, whichever is less, to the employee’s profit-sharing account. There is no set amount that the law requires the employer to contribute. The employer can choose to make contributions each year based on the company’s profits, and the contribution amount can vary from year to year. Only the employer contributes to this plan.
Tax benefits: Contributions to a profit-sharing plan are tax-deductible for the employer, and the contributions grow tax-deferred until the money is withdrawn in retirement. Employees do not pay taxes on their contributions until they withdraw the money in retirement.
Vesting: Employers can choose to include a vesting schedule in their profit-sharing plan. Vesting refers to the employee’s ownership of the employer’s contributions to their account. With a vesting schedule, the employee’s ownership of the employer’s contributions increases over time, up to 100%.
Filing requirements: Annual filing of a Form 5500-series return/report is required to make sure benefits do not discriminate in favor of highly compensated employees. Participant disclosures are also required.
Note, administrative costs for a profit-sharing plan may be higher than with other plans listed here.
Distributions from retirement plans are all similar. Withdrawals are subject to income tax and a 10% penalty if taken before age 59 1/2. Required minimum distributions (RMDs) must begin at age 72 or age 73 if you reach age 72 after Dec. 31, 2022.
Please note that retirement plans for small businesses can be complex, and it’s important to work with a qualified financial advisor or tax professional to determine which plan is best for your business.
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This post is for informational purposes only. It is not intended as investment advice as each person’s financial situation is different. I strongly recommend working with a financial advisor who can deliver current information to you quickly and offer help with sorting through the various investing options. Bret Wilson is a Financial Advisor with Wilson Investment Services, based in Rockwall, Texas.
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