How to Make a Qualified Retirement Plan Work for Your Business

It makes good business sense to offer a qualified retirement plan to your employees. Learn about the different retirement plans available and the tax benefits for small businesses.

While most large companies offer retirement savings options to their staff, a significant number of small businesses don’t. They don’t understand the rules, they think they can’t afford the cost, and they may not take the time to learn how they can benefit from acting like the big businesses to help their employees...and themselves.

While federal law doesn’t mandate that small businesses have a qualified retirement plan, as you’ll see from the information that follows, it makes good business sense to do so.

Overview: What is a qualified retirement plan?

A qualified retirement plan is a savings vehicle with tax advantages.

From an employer’s perspective

Contributions by employers are tax deductible. By making deductible contributions, you are effectively sheltering your profits (reducing your current tax bill). Contributions by employers are not subject to employment taxes.

Employers can also get tax credits for setting up a qualified retirement plan. Basic credit for a small business (fewer than 100 employees who received at least $5,000 in compensation from you in the prior year) to set up a plan in 2020 or later is 50% of start-up costs -- administrative and employee education costs -- up to either:

• The greater of $500
• The lesser of (1) $250 times the number of non-highly compensated employees eligible to participate or (2) $5,000.

The credit can be claimed for three years. Before 2020, the credit was limited to no more than 50% of costs up to $500 per year for up to three years. Credit for adopting an automatic enrollment 401(k) plan or switching an existing plan to this type in 2020 is 50% of costs up to $500 per year for three years. This credit is new for 2020 and can be claimed in addition to the credit above.

From an employee’s perspective

Contributions by employees are usually made on a pre-tax basis via salary reduction contributions. The amount of compensation contributed to the plan is not subject to income taxes, although Social Security and Medicare (FICA) taxes still apply.

Some plans (e.g., designated Roth accounts added to 401(k) plans described later) allow after-tax contributions, which don’t avoid current income tax but allow for tax-free buildup of retirement savings (I’ll explain later).

Earnings on contributions invested through the plan are tax deferred, so there’s no current tax on the growth of retirement savings. Plans are allowed, but not required, to let employees take loans from their accounts up to set limits. This creates access to ready cash at reasonable interest rates.

What makes a retirement plan qualified?

Plans are qualified if they meet various requirements set by the IRS and the U.S. Department of Labor (DOL), which include:

1. Maintaining the plan for the benefit of participants.
2. Meeting nondiscrimination tests to ensure that all employees who meet certain requirements have the right to participate. For plan years beginning after December 31, 2020, certain part-timers must be allowed to participate.
3. Providing certain information to participants, such as information about the plan in general and about their accounts in particular.

Employers can offer nonqualified retirement plans, but they don’t have any of the tax benefits described above for employers or employees.

Retirement plan options for small businesses

There’s a variety of qualified retirement plans small businesses can use. The one selected depends on the company’s situation: profitability, number of employees, and other factors.

For example, some plans can be funded entirely with employee contributions, which is a benefit for companies that want to offer a plan but don’t have the financial ability to make contributions. Some plans are funded entirely by employer contributions; employees are not allowed to add their own money.

There are two basic types of qualified retirement plans available to for-profit businesses.

• Defined contribution plans, where the payout to employees depends on the investment performance of the contributions.
• Defined benefit plans, which are pension plans that target the retirement payout and then base contributions on what’s actuarially determined to be needed for the promised benefits.

1. SEPs

SEP stands for Simplified Employee Pension (SEP) plan, but don’t let the term mislead you. It isn’t a pension plan; it’s a defined contribution plan funded entirely by employer contributions. More specifically, it’s called a SEP-IRA.

A SEP can be used by any size business, including a self-employed person with no employees. Other features of a SEP:

• Setup: The plan can be set up and funded up to the extended due date of the taxpayer. All that’s required is to complete IRS Form 5305-SEP, which merely requires noting a few particulars (such as the terms for participating in the plan) and then signing it. It’s not filed with the IRS; it’s kept with your business records. Then, you must give employees information about the SEP, such as the fact that you’ve set up the plan and how allocations are made to the employee’s account. Finally, you need to set up an IRA for each employee at a financial institution (a bank, brokerage firm, mutual fund, or insurance company) into which contributions will be made.
• Information reporting: The plan does not require any annual reporting to the DOL (as do other plans listed below).
• Employer contributions: The employer must contribute the same percentage of compensation for each participant from 1% to 25%. Contributions are limited to the lesser of 25% of the employee’s compensation (effectively 20% of net earnings from self-employment if the person isn’t an employee because of how compensation is figured in this situation) or a set dollar limit each year ($56,000 in 2019; $57,000 in 2020).

2. Profit-sharing plans

This type of plan can be used by any size business and is funded entirely by the employer. Contributions are based on a business’ profits, and the amount contributed is discretionary as long as contributions are made on a nondiscriminatory basis and the plan meets other legal requirements.

Other features of a profit-sharing plan:

• Contribution limits: The same annual contribution limits for SEPs apply to profit-sharing plans.
• Information reporting: 401(k) plans require annual information reporting to the DOL (SEPs to not).

3. 401(k) plans

This is a type of profit-sharing plan funded with employee contributions on a pre-tax basis (called elective salary deferrals). Contributions go directly into each employee’s account. Employers can make certain matching contributions, or they can adopt certain automatic enrollment plans under which they must make certain matching contributions (doing this ensures that the plan meets nondiscrimination and coverage rules).

The plan can be used by any size company, including a self-employed individual working alone (a “solo 401(k)”).

Other features of a 401(k) plan:

• Roth option: The plan can include a designated Roth account feature, which allows employees to contribute after-tax dollars, and they can then take out distributions tax free.
• Information reporting: The plan must file an annual information return with the DOL, reporting on participants, contributions, etc. There is an exemption from reporting for plans covering only sole proprietors, partners, and their spouses if the amount of plan assets is small enough (find these details in the instructions to Form 5500-EZ).
• Salary deferral limits: Elective salary deferrals are limited to an annual amount: For 2019 it’s $19,000, or $25,000 if age 50 or older by the end of 2019; for 2020 it’s $19,500, or $27,000 if age 50 or older by the end of 2020.
• Employer contributions: Employer contributions can be a percentage of employee contributions or determined by some other formula as long as total contributions -- employee and employer -- don’t exceed the profit-sharing limits described earlier.

5. SIMPLE-IRAs

These are Savings Incentive Match Plans for Employees (SIMPLE), which allow for contributions to IRAs for each participant. These plans are similar to 401(k)s, but they’re limited to small businesses (those with 100 or fewer employees).

The plan is funded by elective salary deferrals if employees choose to do so, but they require certain employer contributions each year (either matching employee contributions up to 3% of compensation or 2% of compensation regardless of what employees contribute).

Other features of a SIMPLE-IRA:

• Setup: Like a SEP, the plan is easy to set up. Find details in the instructions to Form 5304-SIMPLE, where employees can choose their own financial institutions for the SIMPLE-IRA account, or Form 5305-SIMPLE, where the employer maintains the employees’ accounts.
• Information reporting: Like a SEP, there’s no annual information reporting to the DOL.
• Salary deferral limits: Elective salary deferrals are limited to an annual amount: For 2019: $13,000, plus another $3,000 if 50 or older by year end; for 2020: $13,500, plus another $3,000 if 50 or older by year end.

6. Money purchase plans

Like profit-sharing plans, money purchase plans can be used by any size business, but unlike profit-sharing plans, there are required contributions that must be made each year. The company sets a percentage of employee compensation that will be contributed, regardless of profitability. The same annual reporting required for profit-sharing plans applies to money purchase plans.

7. Defined benefit (pension) plans

These are pension plans that promise to pay a set amount upon retirement (there are some provisions for other payout options). An actuary determines what the company must contribute in order to keep this promise, factoring in the employee’s age, an assumed rate of return on investments, and the targeted retirement age.

This plan can be expensive to maintain because of actuary fees as well as required premiums to be paid to the Pension Benefit Guaranty Corporation, a government agency that will pay a minimum pension if the plan fails. However, it can be a good option for a business under the right conditions, providing sizable write-offs and good benefits to employees.

Other retirement plan options for small businesses

Even if an employer doesn’t adopt a qualified retirement plan, there are other ways to help employees save for retirement.

• Payroll deduction IRA: By using payroll software, the employer automatically withholds money from an employee’s paycheck, which is contributed to the employee’s IRA. This is an arrangement, not a plan (no plan documents are required).
• A state-run program: Some states, such as California, have instituted mandatory retirement plans for small employers that don’t have a qualified plan. These employers must withhold money from an employee’s paycheck and contribute it to the state-run plan unless the employee opts out.

Importance of retirement plans to owners and employees

Having a retirement plan helps both employers and employees. For employers, having a plan is a tool to recruit and retain employees, especially in a tight job market. It’s also a way for business owners to save for their own retirement; they often look at their company as their retirement plan and fail to set aside other funds that may be needed if the business underperforms.

Most employees face numerous claims on their paychecks, from paying for child care, paying a mortgage, savings for college, paying off student loans, or helping to support an elderly parent or adult child. Saving for retirement is often not a priority, resulting in financial insecurity later in life. A retirement plan helps to provide a dedicated measure of retirement savings, which can ease employees’ financial anxiety now and create loyalty to the company.

Employer responsibilities for qualified retirement plans

If you decide to have a qualified retirement plan for your company, be sure to do it right to avoid penalties or other problems. The company is treated as the plan sponsor. The sponsor must meet certain responsibilities, which are overseen by a fiduciary (typically in a small business, that person is the owner).

These responsibilities include:

• Setting up the plan correctly (e.g., completing forms in a timely manner).
• Providing notice to employees about the plan and their eligibility to participate.
• Administering the plan correctly, which includes adding contributions within set time limits and making distributions and/or loans according to the terms of the plan as allowed by law.
• Filing annual information returns as described earlier where applicable.

Final word on qualified retirement plans

In the next year or two, there is to be a new retirement plan option called an open Multiple Employer Plan (MEP) that could be very favorable for small businesses. These MEPs will allow two or more employers to pool together to offer 401(k)s to their employees.

By doing this, employers will lower their administrative costs, and their employees will likely gain access to a greater range of investment options. Employers will also reduce their fiduciary responsibilities because the MEP will be headed up by a pooled plan provider -- the primary fiduciary.

While MEPs are technically open for plan years beginning after December 31, 2020, they can’t start before IRS and DOL guidance is provided. In the meantime, small businesses should discuss their current retirement plan options with their CPA or other tax or business advisor to make decisions now.