22 Aug Small Business Retirement Plans – Updated for 2019!
There are many advantages to owning your own business. You are your own boss and in control of your business: how it grows, your brand, who you serve, the direction is takes. Small business owners also often have more freedom having their own business than if they worked for someone else.
The one thing lacking is an employer sponsored retirement program and the human resource team to set up one up. Therefore, in many cases, small business owners are missing out on ways to maximize tax benefits and automate savings for retirement.
Small business owners have a variety of options to choose from to save for retirement which can make it complicated. There is no one size fits all solution and making the wrong choice can have consequences. You and your business are unique and your retirement plan should fit your budget, your profile and your goals.
Although not an employer sponsored plan, opening an IRA is the simplest route to retirement savings and may be a great first step for a new small business owner. There are two options for IRA to choose from with the biggest difference being the tax benefits.
Traditional – With a traditional IRA the contributions are pre-tax meaning it reduces your taxable income for that year. Earnings will accumulate tax deferred in the account until you begin taking distributions. The disadvantage of an IRA is that the contribution amounts are low- only $6,000 for 2019 with an additional $1,000 catch up contribution available if you are over age 50. IRAs also have income phase-outs if you have access to an employer sponsored retirement plan, even if you don’t participate. If you do not have access to a retirement plan through an employer then you can contribute to an IRA no matter what your income is. An IRA would be a good choice for a business owner who is only able to contribute a limited amount, has a relatively low income, is not ready to contribute for employees and thinks that their income tax rate will be lower in retirement than it is currently.
Side note: Keep in mind that an IRA is a good option if you have a 401(k) from a previous employer. You can roll the old 401(k) into an IRA penalty and tax free if done as a direct rollover.
Roth – Personal Roth IRA contributions are made after-tax, so you do not receive an immediate tax benefit on the contributions but the account grows tax free and distributions (after age 59-1/2) are not taxed. Furthermore, there are no Required Minimum Distributions from a Roth. This can be a very powerful retirement planning tool if you think that you will be in a higher tax bracket in retirement or don’t need the current tax deduction. Annual deductible contribution limits are the same as a Traditional IRA ($6000 and $7000) with income phaseouts of $120,000-135,000 for single tax filers and $$189,000-199,000 if you are married filing jointly.
A personal Roth IRA is the great option for someone early on in their business that does not want to contribute a large amount yet but anticipates higher income in the future and will benefit from tax free withdrawals and growth.
Employer Sponsored IRA Plans
SEP IRA – Simplified Employee Pension (SEP) IRA is an employer funded plan with significantly higher contribution limits than a traditional IRA. This makes it a great option for small business owners that do not have employees and would like to make larger contributions, such as real estate agents. The 2019 contribution limits are the lesser of 25% of compensation or $56,000. SEP’s can also be an option for small businesses with a stable employee workforce who want a plan with low administrative costs.
SEP IRAs only allow for employer contributions; employees may not contribute to their SEP IRA account. Employees are 100% vested once a contribution is made with a SEP and all plan contributions must be at the same percentage rate.
The SEP IRA does allow from flexibility with contribution amounts and timing. Contributions do not have to be made every year and the amounts can vary. The timing of the contribution is also flexible allowing the small business owner to contribute any time before the taxes are filed for the business. This allows the employer to evaluate the finances, calculate the current tax situation and then determine the contribution. Your CERTIFIED FINANCIAL PLANNER™ and accountant can work together to make sure you make the right contribution amount to maximize yours goals.
SIMPLE IRA – Savings Incentive Match Plan for Employees (SIMPLE) IRAs are retirement plans that allow for both employer and employee contributions. All contributions are 100% vested from the time that they are contributed. Small businesses with up to 100 employees can qualify for a SIMPLE plan making them an excellent low-cost choice for a growing business.
As the name implies, the employer must offer a matching contribution in this plan of 1%, 2% or 3% or they can simply contribute a fixed 2% (non-matching) to all employees, regardless of participation.
The SIMPLE employee contribution limits are higher than traditional IRA’s but less than other corporate retirement plans like 401(k)’s. For 2019, they are limited to $13,000 if under age 50 and $16,000 for those who are 50+.
SIMPLEs are easy to set up, flexible and inexpensive to administer.
401(k) – For a small business owner with employees who wants to maximize their retirement plan contributions the 401(k) remains the plan of choice. Most businesses come to a 401(k) plan through an evolution – growing their business, hiring employees, developing sufficient cash flow and having a need for a solid retirement plan. 401(k) plans are more expensive than SEP’s, SIMPLE’s or solo 401(k) because a Third-Party Administrator is needed to conduct the annual qualifying tests including discrimination testing and file the form 5500 required by the IRS.
Business owners and their employees will be able to contribute more income to these plans than most of the other options that have been covered. The deductible contribution limits for 401(k) plans in 2019 is $19,000 for employees. If an employee is 50 or older they can contribute an additional $6,000 per year as a catch-up provision for a total deductible contribution of $25,000 for 2019.
Employer contributions are tax-deductible up to 25% of the employee’s compensation but are not required. There are tax benefits for the employer who chooses to contribute and a good retirement plan can attract and help retain great talent. The most common practice is for the employer to match the employees’ contribution up to a percentage (generally 3-5%) of compensation. This can a be a 100% match or a partial match (for example 50% of the first 6%).
Vesting schedules can be set by the employer in the plan document when the plan is established. The employee’s contributions are always 100% vested, but the contributions made by employer can follow graded vesting schedules or a cliff vesting schedule – both of which are meant to reward years of service.
Defined Benefit Plan
The most powerful savings vehicle for small business owners is the Defined Benefit Plan, more commonly known as a pension plan. Although many large businesses have discontinued pension plans for their employees because the high ongoing costs they can be an excellent retirement plan for small, high-income professional businesses such as law firms or dental practices. Unlike defined contribution plans, Defined Benefit Plans are funded by the employer with the goal of providing a fixed retirement income stream to the employees in retirement (i.e. “pension”).
The risk falls on the employer with a Defined Benefit plan and depending on the market, the level of contributions to the plan can be high. An actuary determines how much will need to be contributed to the plan annually in order to meet the income objectives set by the plan. This means that different amount will need to be contributed to the account every year and is dependent on factors such as the age of your employees, their salaries, how large of a benefit will be provided and market conditions. Defined Benefit plans are more expensive to administer than other retirement plans because of these actuary requirements.
That being said they can be excellent retirement savings vehicles for high earning small business owners because the annual limits far exceed those in any other retirement plan. In fact, the limits are not on the contributions per se, but on the benefit; the maximum annual retirement benefit is $225,000 per year (in 2019); to achieve this, contributions will be high. All contributions are pre-tax, which allows for a potentially huge tax savings for the small business owner.
Which Plan is Right for Your Business?
This is of course a complicated and difficult question that requires a lot of different factors to be considered, including the number of employees, type of employees (salary, age), your personal retirement goals, etc. If you are not sure which plan to choose it is a good idea to talk to a fee-only CERTIFIED FINANCIAL PLANNER™. A CFP® will help you weigh your options and pick the plan that helps you achieve your goals and that is right for your business.