Top 4 retirement plan options for small business owners

As a small business owner, you already know what it’s like to be responsible for making important business decisions every day. You have made the choice to be in control of your career, income, and future. One thing that nearly all small business owners have in common is the desire for professional and financial independence.

A small business retirement plan can be a very powerful tool to help you build wealth, reduce and manage taxes, and possibly grow your business.

Here are the four small business retirement plans you need to be aware of, how they work, and which one may be right for you and your business.

Reasons for establishing a retirement plan as a small business owner

Creating financial independence requires a well-informed and evolving strategy that can adapt to your personal circumstances and your changing business needs. As a small business owner, you are in control of creating wealth for you and your family and that requires a retirement planning strategy to save for the future. A small business retirement plan can be a great tool with many advantages including:

• Tax savings for your business
• Tax savings for you personally
• The ability to supercharge your retirement savings
• Tax-free growth of plan investments
• The ability to attract and retain good employees

With all of its benefits, a retirement plan can unlock potential for your money and your business. 

SEP IRA

A SEP IRA (or Simplified Employee Pension IRA) is a retirement plan designed for individuals that are either self-employed or that own a small business with a few employees. For reasons mentioned below, a SEP IRA may not be ideal for businesses that have many employees eligible to participate in a retirement plan.

Advantages

• Simple to set up and manage: SEP IRAs require very little paperwork to set up and there are no ongoing filing or reporting requirements with the IRS. Simply file a form to set up the plan, open an account with a financial institution (each participant will need their own account), contribute, and choose your investments.
• Investment flexibility: You can open a SEP IRA at most financial institutions which means you can have access to a very wide array of investment options from stocks to mutual funds to exchange-traded funds (ETFs).
• Contribution flexibility: There is no requirement for a business to make annual contributions so you can choose whether you want to contribute based on how your business performs.

Disadvantages

• The employer makes all contributions: SEP IRAs do not allow employees to contribute to the plan. The business makes 100% of the retirement plan contributions. If you make a contribution for one eligible employee, you have to make a contribution for all eligible employees.
• Contributions vest immediately: Some retirement plans have a vesting period which means employees must remain at the company for a number of years before employer contributions become theirs. With a SEP IRA, all contributions are fully vested when they are made. If an employee works for a short period of time and then leaves, they may still get to keep their contributions.
• No catch-up contributions: Other retirement plans allow participants that are over 50 years of age to contribute $69,000 per year plus an extra $7,500 “catch-up” when they reach 50. SEP IRAs do not allow for catch-up contributions like a traditional IRA does, and are capped at $69,000.
• No Roth contributions: Businesses cannot make Roth (or after-tax contributions) to a SEP IRA. All contributions must be made on a before-tax basis which limits your ability to manage your taxes over time.

Contribution limits and deadlines

The maximum employer contribution is limited to the lesser of (1) 25% of total compensation (or 20% of net earnings from self-employment), or (2 )$69,000 per participant per year. All contributions must be made by the company’s tax filing deadline, including extensions.

Who should open a SEP IRA?

A SEP IRA can be a great solution for self-employed individuals or business owners with only a few employees. It’s also a great fit if you want an easy way to maintain a retirement plan with minimal annual reporting requirements. 

However, because the business makes all contributions to the plan it can be more expensive than other options and because you cannot make Roth contributions, tax planning opportunities are limited.

SIMPLE IRA

A SIMPLE IRA (or Savings Incentive Match Plan for Employees) is a step up from a SEP IRA in that it allows both employers and employees to contribute to the plan. 

Employees can elect to save, or defer, part of their salary and employers can match those contributions up to a certain limit. These plans can be established by small businesses with up to 100 employees.

Advantages

• Ease of set-up: A SIMPLE IRA requires a little more work than a SEP IRA, but it is still easier to set up than a traditional 401(k) or defined benefit plan. There are required annual notices and meetings for your company and employees, but there are no major IRS reporting requirements.
• Employees can make contributions: Employees are allowed to contribute a portion of their salary to the plan. It’s a great way to get employees actively engaged in saving and planning for their retirement.
• Employers can match employee contributions: Unlike a SEP IRA, you aren’t on the hook for 100% of contributions. Your employees contribute their own money to the SIMPLE IRA plan, and you match those contributions up to a certain percentage of their total compensation.

Disadvantages

• Higher withdrawal penalties: Most retirement plans impose a 10% penalty on withdrawals made before the age of 59 ½. With a SIMPLE IRA, if you pull money out within two years of signing up for the plan, you could pay a penalty of 25%. The 10% penalty still applies after two years assuming you are younger than 59 ½. 
• No Roth contributions: A SIMPLE IRA does not allow for Roth contributions so all money put into a participant’s account, from you or the employee, must be on a before-tax basis.
• Mandatory matching contributions: If your employees contribute to their accounts, you are required to match their contributions. All contributions you make on behalf of the business are 100% vested as soon as they are made.
• Lower contribution limits: Relative to other plans, the maximum allowable contribution for any given year is lower so it may not be a great fit if you are looking to maximize your retirement savings.

Contribution limits and deadlines

For participants under 50, the SIMPLE IRA annual contribution limit is $16,000 for 2024. For participants over 50, the catch-up contribution limit is $3,500 for a total of $19,500. These limits are for employee contributions only and do not include matching contributions. 

When it comes to the employer contributions, you can make either a 3% matching contribution or a 2% non-elective contribution. A non-elective contribution means you have to make a 2% contribution to all eligible employees even if they do not contribute on their own.

Who should establish a SIMPLE IRA?

SIMPLE IRAs are great solutions for small businesses that have more than a few employees and that aren’t ready to commit to the high costs and administrative hassle of a 401(k) but still want to allow employees to contribute to a retirement plan. Even if your goal is to eventually set up a 401(k) plan for your business, the SIMPLE IRA can be a great solution until you are ready to make the larger commitment.

Solo 401(k)

Solo 401(k)s were designed for businesses with no employees other than the business owner or the business owner and their spouse. They allow for both the business owner to contribute a portion of their salary and for the business to make a matching or profit sharing contribution to the plan. It allows for higher contribution limits without the stringent reporting requirements of a more traditional 401(k).

Advantages

• Easier to maximize plan contributions: A solo 401(k) may allow business owners to maximize plan contributions at lower income levels. For example, if you made $100,000 in a given year, you could only contribute $25,000 to a SEP IRA (25% of $100,000) but you could potentially contribute $23,000 of your own money (if under 50) plus an additional $25,000 of employer money (25% of $100,000) for a total of $48,000 to a solo 401(k).
• Ease of administration: Unlike traditional 401(k) plans, solo 401(k)s are not subject to testing requirements which are designed to ensure employees receive equitable benefits under the plan. Since there are no other employees, the testing is unnecessary. There may be an annual filing requirement once the plan reaches $250,000 in assets, but it’s still a relatively simple process to complete.
• Roth contributions are allowed: Unlike with SEPs and SIMPLEs, you can make Roth contributions to your solo 401(k) account. This gives you greater flexibility to manage your taxes as your business income fluctuates and as tax policy changes over time.
• After-tax contributions are allowed: If the plan is designed properly, you can make after-tax contributions to the plan and eventually roll them over within the same plan to a Roth account or to a separate Roth IRA. This is known as a mega backdoor Roth IRA strategy. Currently, Congress is considering eliminating this option so you need to stay up to date with legislative changes.

Disadvantages

• Susceptible to legislative changes: While annual reporting requirements are fairly light, there is always a chance that retirement plan legislation changes over time. It’s important to stay on top of any legislative changes and adjust your plan and plan documents accordingly.
• It can’t grow with your business: If you hire an employee and they are eligible for a retirement plan, you cannot keep your solo 401(k). You will have to set up a new plan for your business and move your plan assets to another account.

Contribution limits and deadlines 

For 2024, Solo 401(k) participant contributions are limited to the lesser of (1) 100% of compensation, or (2) $23,000 for those under 50 and $30,500 for those 50 or older. Employers can contribute an additional $46,000, via matching or profit share contributions. Total contributions, including both employee and employer, are limited to $69,000 for those under 50 and $76,500 for workers 50 or older. Employee contributions must be made by the end of the tax year (12/31). Employer contributions can be made up to the business tax filing deadline, with extensions.

Who should establish a Solo 401(k)?

Businesses that have no employees other than the owner (and a spouse) are eligible to set up a solo 401(k). If the business owner is capable of saving more than would be possible under other retirement plans, a solo 401(k) could be a great choice to maximize retirement savings.

Traditional 401(k)

A traditional 401(k) is often associated with much larger companies like Walmart, Amazon, and others. However, a 401(k) can still be a great plan for small businesses if you have the revenue and income to support higher contributions, are comfortable with higher administrative costs, and are committed to making larger contributions.

Advantages

• Flexible plan design: 401(k)s allow you to customize your retirement plan to achieve specific retirement savings and business goals. You can elect to make a matching contribution for your employees, contribute based on the profit of your business, or both.
• Employee contributions are allowed: Employees may elect to save, or defer, a portion of their salary into the plan. 401(k)s also let you contribute more to the plan at lower income levels than SEP or SIMPLE IRAs.
• Loans are available: This can be seen as an advantage and a disadvantage, but the fact remains that 401(k)s can allow for plan loans and access to your money (that must always be repaid). It’s generally not advisable to take a loan from a 401(k), but the option does exist.
• After-tax contributions are allowed: If the plan is designed properly, you can make after-tax contributions to the plan and eventually roll them over within the same plan to a Roth account or to a separate Roth IRA. This is known as a mega backdoor Roth strategy. 

Disadvantages

• Complexity and cost: 401(k)s require a lot of paperwork, plan design, and administrative upkeep. In most cases, it makes sense to hire a third party plan administrator to handle the reporting and accounting requirements. All of this adds to greater plan complexity and cost.
• Testing rules: 401(k)s are subject to annual testing requirements to ensure that businesses are contributing fairly to all employees regardless of their income. As a result, contributions for highly compensated employees (including owners) may be limited to ensure more equitable distribution of retirement plan assets.
• Limited investment options: Depending on how you set up the 401(k), you may have to select from a limited number of investment options. You may be able to choose what is available, but it will still be more restrictive than a traditional brokerage account that can give you access to thousands of stocks, mutual funds, and exchange-traded funds (ETFs).

Contribution limits and deadlines

For 2024, participant contributions are limited to the lesser of (1) 100% of compensation, or (2) $23,000 for those under 50 and $30,500 for those 50 or older. Employers can contribute an additional $46,000, via matching or profit share contributions, regardless of the age of the employee contributing. Total contributions, including both employee and employer, are limited to $69,000 for those under 50 and $76,500 for workers 50 or older. Employee contributions must be made by the end of the tax year (12/31). Employer contributions can be made up to the business tax filing deadline, with extensions.

Who should establish a traditional 401(k)?

These plans are typically reserved for larger organizations with many employees. However, they can make sense for small businesses that have at least one or more employees, consistent and recurring revenue, and the ability to make significant contributions. 

A traditional 401(k) plan is a level up from both SEPs and SIMPLEs for business owners that want to maximize their retirement savings.

Final word

Choosing the right retirement plan for your small business is a big decision. The right plan for your business will depend on your personal financial goals, the size of your business and number of employees, the predictability of your business income, your ability to consistently contribute, and your desire to support your employees with their retirement savings.

While it’s an important decision to make, you can always change your retirement planning strategy in the future to meet your evolving needs which is why it’s important to consistently review your personal financial plan and your plan for your business. With a dynamic strategy, you can make a smart, informed decision for your business, supercharge your retirement savings, and put yourself one step closer to financial independence.