July 14, 2017. By Matthew Okaty:

If you are a small business owner, whether a sole proprietor or one with employees, it is important to understand your retirement plan options.  Without such a plan, you could be missing out on tax-deferred growth that could impact your future retirement as well as have trouble attracting and keeping good employees.

When most people think of retirement plans they only think of 401(k)’s and IRA’s, but as a business owner there are additional options available that you should be aware of:

  • Simplified Employee Pension Plan (SEP IRA),
  • Savings Incentive Match Plan for Employees (SIMPLE IRA), and
  • Self-Employed 401(k) plans.

Each has different benefits and/or drawbacks depending on the size of your business, the number of employees you have, and what you want to achieve. Therefore, you will want to consider several factors when making your decision. The biggest question is whether you are a sole proprietor or whether you have (or anticipate having) employees.

1) Sole Proprietors

  • If you are a sole proprietor (or have no employees other than a spouse), the most commonly used plans are either SEP IRA’s or Self-Employed 401(k) plans. While SIMPLE IRA’s can also be used by sole proprietors, they have a much lower contribution limit than the other two options which reduces the amount you are allowed to save each year.
  • Between the SEP IRA and the Self-Employed 401(k), the Self-Employed 401(k) probably has more overall benefits, including but not limited to:
    • Self-Employed 401(k)’s allow for additional “catch up” contributions for people over the age of 50, whereas SEP IRA’s do not. This translates to an additional $6,000.00 per year in contributions.
    • Contributions to Self-Employed 401(k)’s can be made through a combination of salary deferrals and profit sharing, whereas contributions to SEP IRA’s can only come from profit sharing. This can have a significant impact on your ability to max out your annual contributions. While both plans have a maximum contribution limit of $54,000.00 in 2017 (not including “catch up” contributions as discussed above), the profit sharing portion can be no more than 25% of compensation. So if you earned $100,000 in self-employment income and had a SEP IRA, you would only be able to contribute a maximum of $25,000. With a Self-Employed 401(k), however, you could also contribute an additional $18,000 through salary deferrals (and an additional $6,000 if you are over the age of 50). For high-income earners (over $200,000 approximately) this would be a moot point, though, because you would be able to max out your contributions through the profit sharing contribution alone.
    • With Self-Employed 401(k)’s, you also have the ability to take out loans and borrow against your account value, which is not permitted in SEP IRA’s. This is not necessarily a recommended course of action, however, and should always be done with caution.

2) Small Businesses with Employees

  • If you have employees (less than 100), then the most commonly used plans are either SIMPLE IRA’s or 401(k) plans. SIMPLE IRA’s are easier and less costly to administer. However, unlike 401(k) plans, they also require the employer to make matching contributions (up to 3% of compensation) which could potentially be greater than the cost of administering a 401(k) plan.
  • If time is a big issue for you, though, make sure you understand the administrative responsibilities involved in operating a 401(k) plan, which require annual filings and special IRS compliance testing. These services can generally be outsourced to a third-party administrator, but it still requires a level of involvement from you as the plan sponsor.
  • One trade off to the administrative complexity of 401(k) plans, however, is that they do have a higher contribution limit. For SIMPLE IRA’s, the total combined employer/employee contributions cannot exceed $25,000 for those under 50. With a 401(k) plan, the combined limit for 2017 is $54,000, which is significantly higher.
  • SEP IRA’s are also available to businesses with employees, but be aware that with a SEP IRA, employees are not able to contribute to their own accounts; all SEP contributions must come from the employer (employees are still allowed to make regular IRA contributions to SEP accounts, but the contributions would be subject to regular IRA contribution rules which have an annual contribution limit of only $5,500 per year for people under 50).

Please be aware that the information provided here is only meant to be an overview and there are additional details not listed that you may want to consider. Therefore, it is strongly recommended that you speak to a financial professional when deciding on the type of plan that’s right for you and your business.  There are also important tax consequences to consider, and while employer contributions are generally tax deductible, you should also speak to a CPA or other tax professional to ensure that any qualifying deductions are done correctly.

Here is a helpful summary of some of the key differences between the various retirement plan options for small businesses: Compare Small Business Retirement Plans Chart

As usual, do not hesitate to contact us with any questions.