Choosing The Right Retirement Plan for Your Small Business

“Is this still the right plan for me?”

This was a recent question a business owner asked me as more employees became eligible to enter into the company’s SIMPLE IRA plan. With newly eligible employees entering your retirement plan and fluctuating annual revenue, it’s hard to know to time two things:

1. When you make the switch
2. What plan you switch to

Regarding the plan to switch or enter into, there’s a couple plan options to choose from when it comes to saving for retirement:

• Traditional IRA
• SIMPLE IRA
• SEP IRA
• Profit sharing plan
• 401k
• Cash balance plan

I like to group these plans into three phases which vary in terms of complexity and tax savings.

1. Phase 1 (start up)
2. Phase 2 (growing)
3. Phase 3 (mature)

Based on your annual profit & your interest/willingness to save will largely determine which plan is going to make the most sense for you. Profit matters because if you’re a LLC taxed as a sole proprietorship, partnership, or s-corporation, your profit is what flows through from your business tax return to your personal tax return. Then you pay tax based on your taxable income personally (including business profit).

High profit = more tax

Low profit = less tax

Your interest and willingness to save also matters because you can make a lot of profit but if you’re reinvesting all your profit back into your business or making owners distributions to satisfy personal spending desires then there won’t be any capital left over after taxes to save.

Retirement accounts are deemed qualified.

I like to think of the idea of qualified as meaning, qualified for special tax treatment.

That qualified tax treatment comes in the form of tax-deferral.

Traditionally, if you earn income from your investments (think dividends or bond interest) or sell a position for a gain, then you would pay tax on both the income and growth from your investments. What’s valuable about tax-deferral is that you don’t have to pay taxes on income earned or positions sold for a gain.

This is important because that special tax treatment boosts after-tax returns which enhances future retirement spending dollars.

So picking the right retirement plan is going to depend on how much you’re willing to save, can save, and will need into the future. The available retirement plans options fit into the retirement buckets in the following ways:

1. Phase 1 (start up)
   1. Traditional IRA
   2. SIMPLE IRA
2. Phase 2 (growing)
   1. SEP IRA
   2. Profit Sharing
   3. 401k
3. Phase 3 (mature)
   1. Cash balance plan

Each phase corresponds to a certain level of tax savings offered. Now it’s not a perfect science that at “X” profit or “X” number of employees one plan will make perfect sense. Efficiently running a business is constantly in flux and what works today – may not always continue to work.

Traditional IRAs are extremely simple because they require no work on part of the employer to get up and running – it’s actually the responsibility of the employee to contribute to their own account.

If this is your only opportunity to save for retirement (there’s no other available employer plan) then there is no income limit on how much you can earn per year and get the max into your 401k plan. The max for the 2023 tax year is $6,500 (extra $1,000 is granted if you’re over the age of 50).

SIMPLE IRAs are administered by the employer for your employees – so this requires a little more leg work on your end but you’re rewarded with the ability to contribute $15,500 in 2023 (extra $3,500 if you’re over the age of 50). Downside of the SIMPLE IRA is there’s a couple caveats that are important to note:

• Available to any small business – generally with 100 or fewer employees
• Easily established by adopting Form 5304-SIMPLEPDF, Form 5305-SIMPLEPDF, a SIMPLE IRA prototype or an individually designed plan document
• Employer cannot have any other retirement plan
• No filing requirement for the employer
• Contributions:
  • Employer is required to contribute each year either a:
    • Matching contribution up to 3% of compensation (not limited by the annual compensation limit), or
    • 2% nonelective contribution for each eligible employee
      • Under the “nonelective” contribution formula, even if an eligible employee doesn’t contribute to his or her SIMPLE IRA, that employee must still receive an employer contribution to his or her SIMPLE IRA equal to 2% of his or her compensation up to the annual limit of $330,000 for 2023; $305,000 for 2022; $290,000 for 2021; $285,000 for 2020 (subject to cost-of-living adjustments in later years)
  • Employees may elect to contribute
  • Employee is always 100% vested in (or, has ownership of) all SIMPLE IRA money

To participate in a SIMPLE IRA an employee must:

• earned at least $5,000 in compensation during any 2 years before the current calendar year and
• expects to receive at least $5,000 during the current calendar year.

Which means that many of your employees could become eligible for the SIMPLE IRA – which may make this plan become more expensive quickly. Further, if we consider how much profit you have coming into your business, you may want to consider opening a SEP IRA. With a SEP IRA, you can contribute up to 25% of your net schedule C income (if LLC) or 25% of your W2 (if s-corp). Criteria is as follows:

• Available to any size business
• Easily established by adopting Form 5305-SEPPDF, a SEP prototype or an individually designed plan document
  • If Form 5305-SEP is used, cannot have any other retirement plan (except another SEP)
• No filing requirement for the employer
• Only the employer contributes
  • To traditional IRAs (SEP-IRAs) set up for each eligible employee
  • Employee is always 100% vested in (or, has ownership of) all SEP-IRA money

Downside of a SEP is that you need a fair amount of salary to get the max into your SEP. If you contribute 25%, that means you need to pay yourself $264,000 in 2023 to get the max of $66,000 into a SEP IRA.

Further:

If you’re paying yourself 25%, that means that your eligible employees also get to receive up to 25% of their pay towards their SEP (& it’s employer contributions only).

As you can imagine:

SEPs become pretty disadvantageous once you start gaining more eligible employees.

Employee eligibility for a SEP is as follows:

• Has reached age 21
• Has worked for the employer in at least 3 of the last 5 years
• Received at least $750 in compensation for 2023 ($650 in compensation for 2021 and for 2022 from the employer during the year and $600 for 2019 and for 2020)

Profit sharing plans start to become more valuable because they’re discretionary and based on your company’s ability to generate a profit. It’s pretty straightforward:

Either you have profit & you make a contribution.

Or:

You don’t have a profit & you don’t make a contribution.

As for how that contribution is determined, you can make that as simple or as complex as you want. There is a bit more of an administrative burden here as you will need to file a form 5500 and determine how the contribution of profit is distributed amongst your eligible employees.

There is discrimination testing here to ensure that you’re not giving all the profit to highly compensated employees/owners and that the contribution is allocated appropriately. There is some wiggle here with regards to who gets what & of what amount so you can have some say but that plan needs to remain compliant. 401ks are becoming more common and one of the more attractive features is that it allows for the largest contribution amount and allows for a 100% salary deferral rate.

Meaning:

The first $22,500 (extra $6,500 if over 50) that you earn, can be 100% deferred into your 401k. Unlike a SEP, where if you earned $22,500, you’d only be able to contribute $5,625. While you can defer 100% of your salary to a SIMPLE, you’re limited in the max you’re able to defer relative to the 401k.

401k begins to shine when it comes to employer matching contributions. If you’re in a position to max out a retirement plan, there is no plan that allows for less out of pocket costs to employees than a 401k.

On top of that (assuming you’re plan isn’t top heavy and requires a safe harbor provision to avoid failing discrimination test) employer contributions are subject to a vesting schedule, this could be at worst:

• Three year cliff = after 3 years employer contributions are 100% vested and treated as employees
• 2-6 year graded vesting = 20% of your contribution becomes eligible starting in year 2 all the way up until 100% in year 6.

Generally, employee eligibility in a 401k is limited to:

• Has reached age 21
• Has at least 1 year of service
  • (A traditional 401(k) plan may require 2 years of service for eligibility to receive an employer contribution if the plan provides that after not more than 2 years of service the participant is 100% vested in all plan account balances. However, the plan must allow the employee to participate by making elective deferral contributions after no more than 1 year of service.)

This would largely be specified in your 401k plan document that would be created to serve as the guidebook for what rules your plan abides by.  This would specify other provisions such as participation loans, how distributions from the plan are handled, nondiscrimination testing, hardship withdrawals, plan amendments, etc.

Cash balance plans are really the last line of defense for business owners who are showing large amounts of profit. Typically, I find 401ks and profit sharing satisfies the majority of successful small businesses but every once in a while you’ll run into a company that has high profits that are expected to continue into the future.

A cash balance plan is actually a defined benefit plan (all the plans we discussed prior to a cash balance plan are called defined contribution plans). Meaning, the plan is meant to provide a specific benefit at retirement for a specific individual (expected to provide a future pension/annuity benefit).

Cash balance plans are governed by a plan document that is credited each year based on contributions made and the underlying performance of the securities to fund the specified future benefit promised to employees. Cash balance plan contributions are age dependent so the older the participant the higher the contribution amount becomes.

In 2023, some participants will be able to contribute up to $265,000/yr (which is why it’s so attractive).

Downsides (as you might imagine) is the capital expense required to get the plan up and running as there is a fair amount of actuarial testing requirements to keep the plan compliant and properly funded – the plan must also remain funded for a minimum of three years before it’s closed. The right retirement plan is the one that makes the most sense for you.

Getting this right not just today – but ensuring it’s the best plan each year – could help you easily save thousands if not hundreds of thousands of dollars over your lifetime.