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Which retirement plan is best for my small business?

Choosing a retirement plan for you and your employees can be difficult. Here’s how the most popular options – SIMPLE IRAs, SEP IRAs and 401(k)s – compare.

Starting a retirement plan for your small business can be exciting – until you learn how many options are out there and the cost of setting one up.

Among the many options, there are three retirement plans that are likely the best fit for you if your business has employees: 401(k) plans, SEP IRAs or SIMPLE IRAs. Those plans are typically the easiest for small business owners to set up, maintain and customize.

Learn what the pros, cons and characteristics are for each plan so you can make the best decision for your business – and your employees.

 

Terms to know

There are lots of numbers and acronyms associated with retirement plans. Here are the common ones and what they mean.

  • Contribution: Money that goes into your retirement account
  • Distribution: Money you take out of your retirement account
  • Tax-deferred: A type of retirement account with contributions of pre-tax money
  • IRA: Individual Retirement Account, which is a type of tax-deferred retirement account
  • SEP: Simplified Employee Pension Plan, which is a type of IRA that only employers can contribute to
  • 401(k): A type of retirement account where employers and employees can both make contributions to. 401(k) refers to subsection 401(k) in the Internal Revenue Code
  • Vesting: How much an employee owns the funds in their retirement account
  • Roth: A type of retirement account with contributions of post-tax money
  • Safe harbor: A type of retirement account where employers make guaranteed and fully vested contributions to all eligible employees
  • Traditional: A type of tax-deferred retirement account

 

At a glance: SIMPLE IRAs vs. SEP IRAs vs. 401(k)s

The best retirement plan for your business depends on your cash flow, number of employees, growth and more. Here’s how some of the most popular retirement plans for small businesses compare. Plans can be customized, but these are the general rules for SIMPLE IRAs, SEP IRAs and 401(k)s.

  SIMPLE IRA   SEP IRA   401(k) 
Who can contribute?  Optional for employees to contribute; mandatory for employers to contribute  Employees cannot contribute; mandatory for employers to contribute  Optional for employees to contribute; optional for employers to contribute (unless a safe harbor option is selected) 
When are employees required to qualify? (You may offer these plans to employees before this point as well.)  When an employee has been paid more than $5,000 by your company  When an employee who is at least 21 years old has  worked for your company in three of the last five years   When an employee who is at least 21 years old has worked for your company for at least one year 
Are employer contributions tax-deductible? Yes
Are employees 100% vested? Employees are 100% vested, including employer contributions  Employees are 100% vested  Vesting amount varies depending on options selected 
Is annual IRS testing required? No No Yes
What are the annual contribution limits?*

Employee limit: 
$20,500 

Employer limit: 
25% of employee’s compensation 

Total limit: 
$61,000 

Employee limit: 
N/A 

Employer limit: 
Lesser of $61,000 or 25% of employee’s compensation 

Total limit: 
N/A 

Employee limit: 
$20,500 

Employer limit: 
Up to $61,000 

Total limit: 
$61,000 

Is there a tax credit for startup costs?

The credit is 50% of your eligible startup costs, up to the greater of: 

  • $500; or 
  • The lesser of: 
*LIMITS FOR 2022 TAX YEAR

SIMPLE IRA

What is a SIMPLE IRA?

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a retirement plan designed for businesses with up to 100 employees. Most employees would have to be part of the plan if you offer it, since the only requirement is if they’ve made at least $5,000 in the company.

Both employees and employers can make contributions. Employers are required to contribute to employees’ plans.

Who is a SIMPLE IRA best for?

A SIMPLE IRA is best for most small businesses that are looking for a low-maintenance plan but also have enough cash to make mandatory contributions. There aren’t many strict rules and regulations around SIMPLE IRAs, so they’re also relatively easy and inexpensive to set up.

SIMPLE IRAs also have a limit of 100 employees.

Pros of a SIMPLE IRA plan

A SIMPLE IRA is one of the easiest plans to set up and manage for small businesses. Here are some of its perks:

  • Employees can contribute: The burden isn’t entirely on the employer to contribute, as employees can make their own contributions.
  • Easier for employees to qualify: Employees don’t have to work for you for a certain number of years before they must qualify. They qualify if they’ve made $5,000 from you – although you can offer a plan to them sooner.

Cons of a SIMPLE IRA plan

Even though they’re easy to run and set up, they might not be good for employers who may not be able to make contributions.

  • Mandatory employer contributions: Employers must contribute 3% of the employee’s compensation through matching or 2% of the employee’s compensation if the employee doesn’t make contributions.
  • Lower contribution limits: Employees can only contribute up to $14,000 to their plan. Employers are required to make contributions as well, but that’s likely not going to near the $61,000 contribution limit of 401(k)s and SEPs.
  • Max of 100 employees: SIMPLE IRAs have a cap of 100 employees. Although it takes time to grow to 100 employees, keep this in mind if you’re a mid-sized business that’s scaling quickly.

Simplified Employee Pension (SEP)

What is a SEP?

A Simplified Employee Pension (SEP) is a type of IRA where only employers can contribute to their employees’ retirement. They may be called SEP IRAs or SEPs.

SEPs are tax-deferred accounts, which means you don't pay taxes on contributions –.

Who is a SEP plan best for?

A SEP is best for small businesses with less than 10 employees. Since the employer is solely responsible for making contributions, it can get expensive – which is why it’s not ideal for businesses with dozens of employees.

This type of plan may also work best for you if your cash flow varies throughout the year. One of the perks of having a SEP is that there aren’t hard contribution deadlines throughout the year, so you can make your required contributions whenever is best for you – as long as they’re made by the earlier of your tax return’s due date (including extensions), or when it’s filed.

This plan is also popular among small business owners who are the only employee of their business.

Pros of a SEP plan

A SEP plan does require you to make all contributions to your employees’ plans, but there are upsides that come with that.

  • Flexible contribution schedule: There’s no rigid schedule for making employer contributions. You just have to make sure your required amount is contributed by the due date of the company’s federal income tax return.
  • Less maintenance required: Some retirement plans have stringent IRS filing and testing requirements. SEP IRAs don’t have those – so you don’t have that added stress.

Cons of a SEP plan

Despite their flexibility and low-maintenance requirements, SEP IRAs have downsides you should be aware of.

  • Entirely based on employer contributions: Your employees can’t make contributions to a SEP IRA, only employers can. This can be a huge relief to employees, but expensive to employers.
  • Higher thresholds for employees to qualify: Employees must be allowed to participate in a SEP IRA if they have worked for the business in at least three of the last five years – so newer employees might be left out. But like with any plan, you can offer the plan sooner to eligible employees.

401(k) plan

What is a 401(k) plan?

A 401(k) plan is the most flexible plan for small business owners. Many retirement plan providers can customize a 401(k) to fit your business’ needs. You can choose to go through the traditional 401(k) route, which allows your employees to make tax-free contributions – or choose a Roth 401(k) and take tax-free distributions. You can offer both options to employees.

It’s also flexible because you can decide, as the employer, whether you want to contribute to employees’ plans (if you’re not using a safe harbor option). Some retirement plans, like SEP IRAs and SIMPLE IRAs require employers to make contributions.

There’s also a safe harbor 401(k) plan, which does require you to make contributions to your employees’ plans – but gives you some wiggle room on how you can do that.

Who is a 401(k) plan best for?

A 401(k) plan is best for businesses that are scaling quickly since there’s no limit on the number of employees needed to qualify for one.

It may also be a good fit for any size employer who wants to offer employees a retirement plan, but doesn’t necessarily have the cash flow to make their own contributions. Unlike SEP IRAs and SIMPLE IRAs, employer contributions aren’t mandatory for most 401(k) plans.

Pros of a 401(k) plan

A 401(k) is one of the easiest plans to customize for businesses with employees. Here’s why they’re a great fit for some businesses:

  • Employer contributions aren’t required: Traditional and Roth 401(k)s allow you to provide a retirement plan your employees can contribute to – but doesn’t require you to match or even contribute to them. This is perfect for small business owners who want to offer retirement plans, but don’t necessarily have the budget to make contributions or matches for everyone.
  • No minimum or maximum number of employees needed to qualify: Whether your business is one employee or 100, you can sign up for a 401(k) plan. This can be great for businesses that are growing quickly because your plan can grow with you.
  • Several different types to choose from: You can choose a traditional, Roth or safe harbor 401(k) plan for your business. There are several reasons why your business might want to go with one plan over another, so having different options to choose from can help both you and your employees.

Cons of a 401(k) plan

A 401(k) plan may be best for your business – but it comes with some administrative burdens.

  • Annual nondiscrimination testing: Your 401(k) plans must pass at least two tests from the IRS to make sure that highly compensated employees aren’t being favored over non-highly compensated employees. Learn more about these tests from the small business 401(k) provider Guideline.
  • IRS filing requirements: On top of annual testing, 401(k)s also require you to file the Form 5500 Series. Although this sounds complicated or scary, most 401(k) providers will handle this part for you and help you navigate these complex rules.
  • More expensive: Because 401(k)s require more maintenance and filings, they’re typically more expensive to have – costs of employer contributions aside.

How to create a retirement plan

The best way to create a retirement plan for your employees is using a third-party account provider. The right provider for you depends on what type of plan you want and how much you’re willing to spend.

Here are some of the most popular retirement plan providers:

There are ways to set up a retirement plan on your own, but no small business owner should go that route. Retirement plans are complicated and wrapped with rules and regulations no matter which plan you go with. There are also hefty penalties and fines if you make a mistake.

Each of the reputable providers mentioned above offer plans designed for small businesses. Compare their prices and services or talk to your CPA about which provider and plan is best for you.

The bottom line

Researching retirement plans for your employees for the first time can be confusing and overwhelming. There’s a slew of acronyms like IRAs and numbers like 401(k) that can make the process much harder.

But as a small business owner, the three best choices for retirement plans are typically SIMPLE IRAs, SEP IRAs and 401(k) plans. Although there are several differences in their contribution limits, IRS regulations, and employer contribution rules, those plans are typically the easiest to set up and maintain.

If you’re not sure which plan your small business should opt for – or what the tax implications of the plan you’re currently on are– schedule a free call with a DiMercurio Advisors team member today. You don’t have to make sense of your business’ taxes alone.

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