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As a small business owner, you have a lot on your plate. From managing day-to-day operations to keeping up with the latest industry trends, it can be difficult to find time to think about your long-term financial future. However, retirement planning is an important part of being a responsible business owner, and there are a number of different retirement plans available to small businesses.
Small business retirement plans
Among the different business retirement plans out there, it can be tough to decide which one is right for your company. The answers to these questions can help you find the right fit for your business:
- How much money do you want to contribute?
- What are the tax benefits you want?
- How much control do you want over the investment choices?
- What are the fees and expenses associated with the plan?
- Do you want a plan that allows for employee contributions?
- Do you want to offer a Roth option?
- Do you want the flexibility to adjust employer contributions?
- How many employees do you have and how many do you plan on hiring?
The answers to these questions will determine what type of plan you choose. Retirement plans fall under three main categories: IRA-based plans, defined contribution plans, and defined benefit plans. Each has their pros and cons so choosing the right one is important. If you are unsure how to answer some of these questions, talking to a financial or tax advisor can help you choose the best retirement plan for your business.
SEP IRA
A Simplified Employee Pension (SEP) IRA is an IRA-based plan and is a great choice if you're self-employed or have a small business with only a few employees. SEPs are rarely used for small businesses that have more than 20 employees. A SEP must be offered to all employees who are at least 21 years old, employed by the employer for three of the last five years, and have had compensation of $650 for 2022.
Contributors
Only the employer can contribute.
Maximum contribution limit
Up to 25% of compensation but no more than $61,000 for 2022.
Pros
- It's easy to set up and maintain
- Low setup and maintenance costs
- As an employer, you can decide whether to make contributions year to year
- The contribution limits for SEP IRAs are also higher than most other retirement plans
Cons
- You're not able to take advantage of catch-up contributions if you're over 50
- Your employees are not able to contribute to their own SEP IRA
- No Roth option
SIMPLE IRA
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is similar to a SEP IRA, but it's designed for small businesses with 100 or fewer employees. A SIMPLE IRA must be offered to all employees who have compensation of at least $5,000 in any prior two years and are reasonably expected to earn at least $5,000 in the current year.
Contributors
Employees can decide how much to contribute. The employer must either make matching contributions or contribute 2% of each employee's compensation.
Maximum contribution limit
Employees can contribute up to $14,000 for 2022. Participants aged 50 or over can make additional contributions up to $3,000 for 2022. Employers can decide to either match employee contributions 100% of the first 3% of compensation (can be reduced to as low as 1% in any two out of five years) or contribute 2% of each eligible employee's compensation. In other words, as an employer you can decide to only contribute if an employee contributes, or contribute 2% to all employees regardless of whether they contribute.
Pros
- It is a salary reduction plan, which allows employees to reduce their taxable income by investing for retirement
- It requires little administrative paperwork
- Low setup and maintenance costs
Cons
- Required to make matching or nonelective contributions for your employees, which can be costly if your business is not doing well
- Maximum contribution limits are lower
- Employers cannot maintain any other type of retirement plan
- No Roth option
401(k)
A 401(k) is a defined contribution plan, which is a type of retirement plan in which the employer, employee, or both make contributions. It is a great choice for businesses of all sizes. Generally, a 401(k) must be offered to all employees at least 21 years old who worked at least 1,000 hours in a previous year. If you have no employees, then you can set up a Solo 401(k) plan.
Contributors
Employees can decide how much to contribute and the employer can make additional contributions, including matching contributions. With a Solo 401(k) plan, you as the business owner can make contributions to the account as both an employer and an employee.
Maximum contribution limit
Employees can contribute up to $20,500 for 2022. Participants aged 50 or over can make additional contributions up to $6,500 for 2022. The maximum employer/employee combined contribution is either 100% of compensation or $61,000 for 2022, whichever is less.
Pros
- Contribution limits for an individual 401(k) are higher than most other retirement plans, allowing a high level of salary deferrals by employees
- Roth 401(k) option available
- Employer contributions are optional
- The vesting schedule is set by the employer
- A 401(k) plan may permit loans
Cons
- High setup and maintenance costs, as well as administrative requirements
- Plan fees can be high, especially for small businesses
Profit-sharing plan
A profit-sharing plan (PSP) is a defined contribution plan and a good choice for businesses that are profitable and want to offer employees a retirement benefit. Generally, a PSP must be offered to all employees at least 21 years old who worked at least 1,000 hours in a previous year.
Contributors
Employers make contributions as set by plan terms.
Maximum contribution limit
The maximum contribution is either 100% of compensation or $61,000 for 2022, whichever is less.
Pros
- Allows an employer to make large contributions for employees
- Employer contributions are optional
- Can motivate employees to perform well so the small business makes a profit
- Can motivate employees to stay with the small business (retention)
Cons
- High setup and maintenance costs, as well as administrative requirements
- There are limits on how much you can contribute if you have highly compensated employees
Defined benefit plan
A defined benefit plan, also known as a pension, is a good choice for businesses that want to provide a guaranteed retirement benefit to their employees. These types of plans are rare for small businesses and usually offered by large organizations and government agencies. Generally, a defined benefit plan must be offered to all employees at least 21 years old who worked at least 1,000 hours in a previous year. Many have a vesting schedule where employees have to work a certain number of years before they can qualify.
Contributors
Employers make contributions as set by plan terms. Employee contributions may sometimes be required or voluntary.
Maximum contribution limit
The maximum contribution is set by the terms of the plan.
Pros
- Provides a fixed guaranteed benefit for employees
- The benefit amount is typically known in advance
- May offer cost-of-living adjustments
- Can motivate employees to stay with the small business (retention)
- Survivor/beneficiary benefits may be available
- Vesting schedule set by employer
Cons
- It is the most costly retirement plan
- It is the most administratively complex plan
- There is less flexibility when accessing the funds
- Benefits are not dependent on investment returns
- An excise tax applies if the minimum contribution requirement is not satisfied or excess contributions are made to the plan
Which one is right for you?
As a small business owner, it is important to think about your long-term financial future and plan accordingly. There are a number of different retirement plans available to small businesses, each with its own benefits and drawbacks. The best retirement plan for your business will depend on your specific circumstances and needs.
If you are looking for a retirement plan that is simple to set up with low costs and want to contribute as much as possible, then a SEP IRA may be right for you. If you want a Roth option, then a 401(k) may be right for you. If you want to share your small business profits, then a profit-sharing plan may be the best route. One thing to note is that you can choose to have multiple plans, such as a 401(k) and PSP. You can even contribute to both a 401(k) and SEP IRA (as long as the contribution amount isn't over the maximum amount allowed). The only exception is a SIMPLE IRA.
All of the retirement plans listed above are good options for small businesses looking to provide their employees with a retirement savings plan or save for their own retirement. Ultimately, you'll need to decide what's best for your business based on your budget, your workforce, and your long-term goals. If you have any questions about setting up a retirement plan for your small business, work with a financial professional to find guidance for choosing the right one.
Our Small Business Expert
David S. Chang, ChFC®, CLU® is an award-winning entrepreneur, keynote speaker, author, and consultant. He has over two decades of experience in the wealth management space and has been featured in dozens of news, radio, and podcast programs nationwide. He currently works as Head of IoT for the West Region of a Fortune 200 company. He is a graduate of the United States Military Academy at West Point and currently a Lieutenant Colonel in the California Army National Guard. He is an East-West Graduate Degree Fellow and has an MBA from the UCLA Anderson School of Management.
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