If you’re self-employed or own a small business, you’ve probably considered establishing a retirement plan. If you’ve done your homework, you likely know about simplified employee pensions (SEPs) and savings incentive match plans for employees (SIMPLE) IRA plans. These plans typically appeal to small business owners because they’re relatively straightforward and inexpensive to administer. Read on to learn more about the different types of retirement plans available to your small business.
Savings Incentive Match Plan for Employees (SIMPLE) IRA
The SIMPLE IRA plan is available if you have 100 or fewer employees. Employees can elect to make pre-tax contributions in 2021 of up to $13,500 ($16,500 if age 50 or older; both unchanged from 2020). You must either match your employees’ contributions dollar for dollar — up to 3% of each employee’s compensation — or make a fixed contribution of 2% of compensation for each eligible employee. (The 3% match can be reduced to 1% in any two of five years.) Each employee who earned $5,000 or more in any two prior years, and who is expected to earn at least $5,000 in the current year, must be allowed to participate in the plan.
SIMPLE IRA plans are easy to set up. You fill out a short form to establish a plan and ensure that SIMPLE IRAs are set up for each employee. A financial institution can do much of the paperwork. Additionally, administrative costs are low.
Simplified Employee Pension (SEP)
A SEP allows you to set up an IRA (a “SEP-IRA”) for yourself and each of your eligible employees. You contribute a uniform percentage of pay for each employee, although you don’t have to make contributions every year, offering you some flexibility when business conditions vary. For 2021, your contributions for each employee are limited to the lesser of 25% of pay or $58,000 (up from $57,000 in 2020). Most employers, including those who are self-employed, can establish a SEP.
SEPs have low start-up and operating costs and can be established using an easy two-page form. The plan must cover any employee aged 21 or older who has worked for you for three of the last five years and who earns $650 or more.
401(k) Plan
The 401(k) plan (technically, a qualified profit-sharing plan with a cash or deferred feature) is a popular retirement savings vehicle for small businesses. With a 401(k) plan, employees can make pre-tax and/or Roth contributions in 2021 of up to $19,500 of pay ($26,000 if age 50 or older; both unchanged from 2020). These deferrals go into a separate account for each employee and aren’t taxed until distributed. Generally, each employee with a year of service must be allowed to contribute to the plan.
You can also make employer contributions to your 401(k) plan — either matching contributions or discretionary profit-sharing contributions. Combined employer and employee contributions for any employee in 2021 can’t exceed the lesser of $58,000, up from $57,000 in 2020 (plus catch-up contributions of up to $6,500 if your employee is age 50 or older; ) or 100% of the employee’s compensation. In general, each employee with a year of service is eligible to receive employer contributions, but you can require two years of service if your contributions are immediately vested.
401(k) plans are required to perform somewhat complicated testing each year to make sure benefits aren’t disproportionately weighted toward higher paid employees. However, you don’t have to perform discrimination testing if you adopt a “safe harbor” 401(k) plan. With a safe harbor 401(k) plan, you generally have to either match your employees’ contributions (100% of employee deferrals up to 3% of compensation, and 50% of deferrals between 3% and 5% of compensation), or make a fixed contribution of 3% of compensation for all eligible employees, regardless of whether they contribute to the plan. Your contributions must be fully vested.
Another way to avoid discrimination testing is by adopting a SIMPLE 401(k) plan. These plans are similar to SIMPLE IRAs, but can also allow loans and Roth contributions. Because they’re still qualified plans (and therefore more complicated than SIMPLE IRAs), and allow less deferrals than traditional 401(k)s, SIMPLE 401(k)s haven’t become popular.
Defined Benefit Plan
A defined benefit plan is a qualified retirement plan that guarantees your employees a specified level of benefits at retirement (for example, an annual benefit equal to 30% of final average pay). As the name suggests, it’s the retirement benefit that’s defined, not the level of contributions to the plan. In 2021, a defined benefit plan can provide an annual benefit of up to $230,000 (or 100% of pay if less), unchanged from 2020. The services of an actuary are generally needed to determine the annual contributions that you must make to the plan to fund the promised benefit. Your contributions may vary from year to year, depending on the performance of plan investments and other factors.
In general, defined benefit plans are too costly and too complex for most small businesses. However, because they can provide the largest benefit of any retirement plan, and therefore allow the largest deductible employer contribution, defined benefit plans can be attractive to businesses that have a small group of highly compensated owners who are seeking to contribute as much money as possible on a tax-deferred basis.
