Employer sponsored retirement plans are typically the single most valuable tool for business owners when attempting to:
- Reduce their current tax liability
- Attract and retain employees
- Accumulate wealth for retirement
But with all of the different types of plans to choose from which one is the right one for your business? Most business owners are familiar with how 401(k) plans work but that might not be the right fit given variables such as:
- # of Employees
- Cash flows of the business
- Goals of the business owner
There are four main stream employer sponsored retirement plans that business owners have to choose from:
- SEP IRA
- Single(k) Plan
- Simple IRA
- 401(k) Plan
Since there are a lot of differences between these four types of plans we have included a comparison chart at the conclusion of this newsletter but we will touch on the highlights of each type of plan.
SEP IRA PLAN
This is the only employer sponsored retirement plan that can be setup after 12/31 for the previous tax year. So when you are sitting with your accountant in the spring and they deliver the bad news that you are going to have a big tax liability for the previous tax year, you can establish a SEP IRA up until your tax filing deadline plus extension, fund it, and take a deduction for that year.
However, if the company has employees that meet the plan’s eligibility requirement, these plans become very expensive very quickly if the owner(s) want to make contributions to their own accounts. The reason being, these plans are 100% employer funded which means there are no employee contributions allowed and the employer contribution is uniform for all plan participants. For example, if the owner contributes 15% of their income to the SEP IRA, they have to make an employer contribution equal to 15% of compensation for each employee that has met the plans eligibility requirement. If the 5305-SEP Form, which serves as the plan document, is setup correctly a company can keep new employees out of the plan for up to 3 years but often times it is either not setup correctly or the employer cannot find the document.
Single(k) Plan or “Solo(k)”
These plans are for owner only entities. As soon as you have an employee that works more than 1000 hours in a 12 month period, you cannot sponsor a Single(k) plan.
The plans are often times the most advantageous for self-employed individuals that have no employees and want to have access to higher pre-tax contribution levels. For all intents and purposes it is a 401(k) plan, same contributions limits, ERISA protected, they allow loans and Roth contributions, etc. However, they can be sponsored at a much lower cost than traditional 401(k) plans because there are no non-owner employees. So there is no year-end testing, it’s typically a boiler plate plan document, and the administration costs to establish and maintain these plans are typically under $400 per year compared to traditional 401(k) plans which may cost $1,500+ per year to administer.
The beauty of these plans is the “employee contribution” of the plan which gives it an advantage over SEP IRA plans. With SEP IRA plans you are limited to contributions up to 25% of your income. So if you make $24,000 in self-employment income you are limited to a $6,000 pre-tax contribution.
With a Single(k) plan, for 2016, I can contribute $18,000 per year (another $6,000 if I’m over 50) up to 100% of my self-employment income and in addition to that amount I can make an employer contribution up to 25% of my income. In the previous example, if you make $24,000 in self-employment income, you would be able to make a salary deferral contribution of $18,000 and an employer contribution of $6,000, effectively wiping out all of your taxable income for that tax year.
Simple IRA’s are the JV version of 401(k) plans. Smaller companies that have 1 – 30 employees that are looking to start are retirement plan will often times start with implementing a Simple IRA plan and eventually graduate to a 401(k) plan as the company grows. The primary advantage of Simple IRA Plans over 401(k) Plans is the cost. Simple IRA’s do not require a TPA firm since they are self-administered by the employer and they do not require annual 5500 filings so the cost to setup and maintain the plan is usually much less than a 401(k) plan.
What causes companies to choose a 401(k) plan over a Simple IRA plan?
- Owners want access to higher pre-tax contribution limits
- They want to limit to the plan to just full time employees
- The company wants flexibility with regard to the employer contribution
- The company wants a vesting schedule tied to the employer contributions
- The company wants to expand investment menu beyond just a single fund family
These are probably the most well recognized employer sponsored plans since at one time or another each of us has worked for a company that has sponsored this type of plan. So we will not spend a lot of time going over the ins and outs of these types of plan. These plans offer a lot of flexibility with regard to the plan features and the plan design.
We will issue a special note about the 401(k) market. For small business with 1 -50 employees, you have a lot of options regarding which type of plan you should sponsor but it’s our personal experience that most investment advisors only have a strong understanding of 401(k) plans so they push 401(k) plans as the answer for everyone because it’s what they know and it’s what they are comfortable talking about. When establishing a retirement plan for your company, make sure you consult with an advisor that has a working knowledge of all these different types of retirement plans and can clearly articulate the pros and cons of each type of plan. This will assist you in establishing the right type of plan for your company.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.