(This post is part of my Small Business Startup & Survival Guide. You can catch up on the whole series here.)
If you go to work for almost any big company these days, you’re practically guaranteed some kind of retirement plan. While pensions may be fading as a perk (except in government), they’re being replaced by a host of options including 401(k) plans and Individual Retirement Arrangements (IRAs).
Retirement plans may be less common in startups and small businesses because they’re considered complicated and expensive to set up and maintain. However, starting a retirement savings plan for yourself and your employees is easier than you think - there are also tax advantages. Employer contributions may be deductible since the money that you spend on your employees will typically reduce your taxable income. In addition, small businesses may be entitled to a tax credit for the administrative costs starting certain types of plans.
To sort it all out, here’s a brief overview of some of the options:
The most common retirement plans for small businesses are Individual Retirement Arrangements (IRAs), defined contribution plans, and defined benefit plans.
When it comes to an IRA, we generally think of two different kinds: a Traditional IRA and a Roth IRA.
- With a Traditional IRA, a taxpayer makes contributions to an account; those contributions, if made with after tax-money, are typically deductible on your tax return. In addition, the money grows tax-deferred until it is withdrawn at retirement. The hope is, of course, that your taxable income will be lower at retirement which means that you’re paying tax at a later time and at a lower tax rate than you would have while you were employed.
- A Roth IRA operates a little differently. Contributions are still typically made with after-tax money. However, with a Roth, you don’t have the advantage of a tax deduction at contribution. This is because your money grows tax-free (as opposed to tax-deferred). When you make withdrawals at retirement, assuming you’ve played by the rules, those distributions are tax-free.
An employee may opt to set up a traditional or Roth IRA to supplement another retirement plan, like a 401(k). However, when it comes to small businesses, there may not be another retirement plan available. As part of a benefits plan, a small business can help its employees set up and fund their IRAs - that includes those small businesses who are self-employed. There are typically three different kinds of arrangements for small business IRAs.
- The most simple plan is the payroll deduction IRA. With a payroll deduction IRA plan, the employer does not contribute to the plan but does make it easy for employees to do so. With the payroll deduction IRA, an employee can contribute to his or her IRA with deductions made directly from a paycheck - that makes it easy to set up and maintain for the business owner. An employer only needs one employee to get started and the plan belongs to the employee, which means that there are no reporting requirements or annual reports to file on the employer side. The only real downside is that normal contributions limits apply: up to $5,500 in 2015 and $6,500 in 2015 if age 50 or older. The same tax rules apply which means that payroll deduction contributions are tax-deductible to the employee.
- With a Simplified Employee Pensions IRA (SEP IRA), the rules are quite different. A SEP IRA is easy and inexpensive to set up and maintain but unlike with a payroll deduction IRA, an employer is the one who makes the contribution to a SEP IRA. An employer only needs one employee to get started and that employee can be the owner, including an owner who is self-employed. Employers must contribute a uniform percentage of pay for each employee. That means no cherry-picking: the rate of contributions typically applies to all employees (there are some eligibility requirements). On the plus side for businesses, employers do not have to make contributions every year so if business isn’t great one year, you can choose to skip altogether. Employer contributions are limited to the lesser of 25% of wages or $53,000 for 2015. As with a payroll contribution IRA, the plan belongs to the employee, which means that there are no reporting requirements or annual reports to file on the employer side.
- A Savings Incentive Match Plan for Employees IRA (SIMPLE IRA) plan is restricted to employers with 100 or fewer employees. With a SIMPLE IRA, employees can contribute a percentage of their salary from each paycheck (as with the payroll deduction IRA) and the employer will also make a contribution. The payoff for that flexibility is that it’s a little more complicated to set up and maintain. With a SIMPLE IRA, employees can contribute up to $12,500 in 2015 ($15,500 in 2015 if age 50 or older) to the plan; in addition, the employer must either offer to match employee contributions up to 3% of employee compensation or opt make a fixed contribution of 2% of compensation for all eligible employees (the latter applies even if the employee chooses not to make any payroll contributions). And as with the payroll deduction IRA and the SEP IRA, the plan belongs to the employee, which means that there are no reporting requirements or annual reports to file on the employer side.
When we think of defined contribution plans, we typically think of profit sharing or 401(k) plans. With a defined contribution plan, employees can generally sock away higher amounts with the added bonus of employer contributions. Those higher limits come with a price: more paperwork. An annual form from the 5500 series must be filed by the employer on time. Penalties for noncompliance or late filing can be severe: a penalty of up to $1,100 a day (or higher) may apply for each day that a report is late. Defined contribution plans can vary, so here are the highlights:
- A profit sharing plan may be appealing on the small business side because employer contributions can be discretionary. Employers can generally set all of the rules, so long as they are not considered discriminatory against employees. Those rules should be detailed in writing. While an employer does not have to make contributions each year, the formula for making any such contribution must be made clear in advance. The upside to the loosey-goosey employer contribution requirements is that contributions can be quite significant: up to the lesser of 100% of compensation or $53,000 for 2015.
- With a traditional 401(k) plan, eligible employees are automatically enrolled in the plan and contributions are deducted from their paychecks at a fixed percentage, unless the employee requests a different contribution rate or opts out altogether. An employer only needs one employee to get started on the plan and may opt, as part of the plan, to offer matching contributions up to a percentage of compensation: that information has to be spelled out in writing for the employees. For 2015, an employee can contribute up to $18,000 (those age 50 or over can make additional contributions up to $6,000 for 2015). Employer contributions, together with employee contributions, cannot exceed the lesser of 100% of compensation or $53,000 for 2015.
- There are different variations on 401(k) plans depending on your circumstances: the rules can be pretty complicated. Many small businesses prefer the safe harbor 401(k) plan because it gets rid of the nondiscrimination testing requirement.
A defined benefit plan is fixed in advance based on compensation, length of service and age, as opposed to contribution plans which may ebb and flow based on the markets. The most common defined benefit plan is a pension, which as you know, has become significantly less common in today’s economy. Since employer contributions must be sufficient to pay those benefits in the future, defined benefits are typically more complicated and more expensive for small businesses - or any business, for that matter. That’s why you don’t see as many of these types of plans offered now except when dealing with the government (insert your joke of choice here).
It doesn’t really stop there. You can add in variations on many of these kinds of plans. You can mix and match where allowed: there is, for example, such a thing as a Roth 401(k) plan.
Retirement plans can be complicated. They are typically governed by more than one set of rules. For example, reporting requirements for defined contribution plans extend to the Department of Labor and the Internal Revenue Service. Penalties for not complying with the rules, as well as missing deadlines, can be severe. But don’t let that scare you away: instead, consider using a retirement plan administrator for set up and compliance purposes. A good plan administrator will flag due dates for returns, help figure limits and caps for plans, including top heavy plans, and assist with filling out annual reports.
