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 small business retirement plans available to you.
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 2024 of up to $16,000 ($19,500 if age 50 or older). 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 2024, your contributions for each employee are limited to the lesser of 25% of pay or $69,000. 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 $750 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 2024 of up to $23,000 of pay ($30,500 if age 50 or older). 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 2024 can’t exceed the lesser of $69,000, (plus catch-up contributions of up to $7,500 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.
Individual 401(k)
An individual 401(k) plan, also known as a solo(k) is a regular 401(k) plan combined with a profit-sharing plan. However, unlike a regular 401(k) plan, an individual 401(k) plan can be implemented only by self-employed individuals or small business owners who have no other full-time employees (an exception applies if your full-time employee is your spouse). If you have full-time employees age 21 or older (other than your spouse) or part-time employees who work either 1,000 hours a year for one year or 500 hours a year for three consecutive years, you will typically have to include them in any plan you set up; in this case, adopting an individual 401(k) plan will not be a viable option. (Beginning in 2025, the service requirement drops to two consecutive years.)
One feature that makes an individual 401(k) plan an attractive retirement savings vehicle is that in most cases your allowable contribution to an individual 401(k) plan will be as large as or larger than you could make under most other types of retirement plans. With an individual 401(k) plan you can elect to defer up to $23,000 of your compensation to the plan for 2024 plus catch-up contributions of up to $7,500 if you’re age 50 or older, just as you could with any 401(k) plan. In addition, as with a traditional profit-sharing plan, your business can make a maximum tax-deductible contribution to the plan of up to 25% of your compensation (up to $345,000 in 2024).
An individual 401(k) may not meet your future needs. If your business grows and you hire a full-time employee who is not your spouse, that employee will generally need to be included in your plan. If that happens, you no longer have an individual 401(k) plan; you have a regular 401(k) plan and profit-sharing plan, and you lose the benefit of the individual 401(k) plan’s simplified administration rules.
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 $275,000 (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.
Remember, tax planning is a year-round endeavor. By staying proactive and seeking professional guidance, you can optimize your financial outcomes and reduce stress during tax season. If you have any questions or need assistance, our team at LittleOwl CPA is here to help.
