Small business owners have many critical priorities, such as growing their business, making a profit, managing taxes, and attracting and rewarding valuable employees. A small business retirement plan may help them achieve these objectives. Most small business plans are easy to start up, inexpensive to run, and simple to manage.
What is a small business retirement plan? A small business plan is a tax-deferred plan that offers retirement savings for self-employed individuals and their spouses, or small business owners. Some define a small business owner as a business owner with less than 10 employees, but one of the plans we offer - a SIMPLE IRA - can be used as long as you have less than 100 employees. One of the advantages of a small business plan is that business owners can deduct contributions made to their own accounts, as well as contributions made on behalf of employees, as a business expense.
Who is eligible to set up a small business retirement plan? Anyone who has earned income from self-employment can establish a small business retirement plan. Examples include consultants, independent contractors, board members, store owners, sales representatives with 1099-MISC income, doctors, attorneys, real estate agents, people with home based businesses, and many more. Whether self-employed income is the primary income source, or an individual just has a small business on the side and continues to work for someone else, they are eligible to set up a small business retirement plan, using the income derived from being their own boss.
Four small business and self-employed retirement plans include: Individual 401(k) which offers a Roth 401(k) feature, SEP IRA, SIMPLE IRA, and a Profit Sharing plans.
An Individual 401(k) plan is designed to maximize contributions for self-employed individuals and spouses, and it’s less complex and less costly to maintain than a conventional 401(k) plan. The first thing to understand about an Individual 401(k) is that contributions can come from two sources. The first source is referred to as the owner’s salary deferral. How this works is that the business owner defers, or foregoes, a percentage or dollar amount of their salary up to a maximum of $18,500 in 2018 ($19,000 in 2019). If over age 50, they can defer an additional $6,000, for a total of $24,500 in 2018 ($25,000 in 2019) into the plan. Salary deferrals can be used to reduce income and thus tax liability now. Alternatively, they can designate all or a portion of salary deferrals as an Individual Roth 401(k) contribution. With a Roth contribution, the contribution cannot be deducted now, but the business owner can take tax-free qualified distributions later. A qualified distribution is generally a distribution that is made after a 5 year holding period and after age 59½.
The second part of the contribution is the company contribution, also called a profit sharing contribution. This piece can be as much as 25% of your income if the business is incorporated (or if the business owners receives a W-2), or 20% of income if they are a sole proprietor and file a Schedule C. The total of the two contribution pieces (salary deferral plus profit sharing) can total up to as much as $55,000 for 2018 ($56,000 for 2019). These limits are increased by $6,000 if age 50 or over. This plan allows a business owner to put away quite a large sum for retirement.
An Individual and Roth Individual 401(k) also offer a loan feature, giving the opportunity to take a loan in the event of a setback. 50% of the vested account balance, up to $50,000 can be borrowed.
This plan must be adopted by December 31 in order to make current year contributions. However, if there are any full or part-time employees other than a spouse, a small business owner is not able to establish this plan.
Another popular plan for small businesses is a SEP IRA. A SEP IRA is very similar to a Traditional IRA, except it has higher discretionary contribution limits. The contribution limits for SEP IRAs are 25% of income (or 20% of income if you are a sole proprietor and file a Schedule C) up to $55,000 for 2018 ($56,000 in 2019). The contributions made to a SEP IRA are not mandatory. Employers are able to set aside from 0 – 25% each year. Therefore, if they have a good year, they can put away the maximum amount. If on the other hand, they didn’t have as successful of a year as hoped, they can put away a small percentage or even skip a year of contributing altogether. Keep in mind that only employers can make SEP IRA contributions. So whatever percentage of salary a business owner contributes to their own SEP IRA, they must also contribute the same percentage of eligible employee’s salary into their SEP IRA accounts.
Business owners can let all employees participate in the SEP IRA or they can specify that a certain age and length of employment has to be met before contributions are made to employee accounts. The age limit cannot exceed 21 years old, and the employment requirement is limited to 3 of the past 5 years. Once the employees exceed these requirements, business owners are obligated to contribute the same percentage of salary to their SEP IRAs as they contribute to their own account. This plan must be adopted by the business tax filing deadline, plus extensions.
For employers who want employees to help fund their own retirement plan, they may be interested in a SIMPLE IRA. A SIMPLE IRA is sometimes described as a mini- 401(k) plan, but it is only available for businesses with less than 100 employees. Contributions are made both by the employer and the employee. Employees defer a percentage of their salary into the SIMPLE IRA, up to $12,500 in 2018 and $13,000 in 2019 (or $15,500 in 2018 and $16,000 in 2019 if over age 50). The salary deferral contributions are typically deducted from the paychecks of each participant during normal payroll. Then the employer either matches contributions of employees that are participating in the plan, up to 3% of salary, or can choose to provide a 2% non-elective contribution to all eligible employees, whether the employees participate in the salary deferral portion of the plan or not. One advantage of providing a 3% matching contribution is that the employer only contributes to those employees who make a contribution for themselves. An advantage of the 2% non-elective contribution is that these contributions are capped at $5,500 in 2018 ($5,600 in 2018) -- however they’ll have to contribute for all eligible employees even if they don’t participate in the salary deferral portion of the plan. Two important things to know about SIMPLE IRAs are, first, a vesting schedule cannot be imposed on the employer contribution, meaning that even if an employee leaves the company soon after an employer contribution is made to their account, the money is still theirs to keep. Also, if the employees need to tap into their account within the first 2 years of funding, any withdrawals carry a hefty 25% IRS penalty if the employees are under age 59 ½. This plan must be adopted by October 1 in order to make current year contributions.
Profit Sharing Plan
A profit sharing plan has the same contribution limits as a SEP IRA and is popular with employers whose profits tend to fluctuate from year to year. The contribution limit is the lesser of $55,000 for 2018 ($56,000 for 2019) or 25% of income (20% of income if you are a sole proprietor and file a Schedule C). There are a few differences between a profit sharing plan and a SEP IRA. First, vesting is permitted on profit sharing contributions. Generally, the employee must complete a certain amount of time before he or she has rights to the employer contributions in the plan. Plan benefits are said to "vest" at the end of that time period. The employer has a choice of vesting schedules when the plan is set up. For example, they can require employees to work three years before they are fully vested, or give them a certain percentage of ownership each year until they are fully vested at the end of six years. If the employee leaves before the contributions are fully vested, they effectively forfeit the funds. These funds may be used to make future contributions to other employee accounts.
Another difference between a profit sharing plan and a SEP IRA is that the employer can set up a profit sharing plan to require your employees to have at least 1,000 hours of service per year before they are eligible for a contribution. This means that if there are part-time, seasonal, or temporary employees that do not work at least 20 hours a work, the employer would not need to make a contribution into their accounts. A final advantage of a profit sharing plan over a SEP IRA is that loans are permitted to any employees. 50% of an employee’s vested account balance up to $50,000 can be borrowed.
This plan must be adopted by December 31 in order to make a current year contribution.
Many business owners are too busy with the day to day details of running their business to think about planning for retirement. However, these plans are a way to help grow businesses and help employers retain and attract valuable employees. An employer sponsored retirement plan is often one of the crucial benefits individuals ask about when considering a new employment offer. Additionally, some plans have loan features, giving the opportunity to make a loan in the event of a setback. Also, tax credits exist for small business owners who establish new plans. Another big benefit is that contributions made to the employer’s account, or to employee accounts, are tax-advantaged. These contributions reduce the business’ taxable income and offer tax-deferred growth. Plus, contribution limits to these plans are much higher than the standard Traditional and Roth IRA contribution limits. A small business employer can control how much they contribute to their own account and employee’s accounts, and in most situations, employers are able to skip funding one year if the business didn’t do as well as hoped.
The chart below may help determine which plan may make sense.