For decades, the rhetoric around an impending retirement crisis has been building. A retirement fund should be the pot of gold at the end of the rainbow, but some Americans feel they haven’t saved enough. If you own a business, you can help alleviate these growing concerns and grow your business by offering a retirement savings account. Having the best plan for you and your employees boosts retention rates and mitigates turnover. You can attract qualified employees and save income taxes over a lifetime by setting up a plan. Although the seemingly countless number of options may make navigating through this decision daunting for you, ultimately, two major factors can be used as a benchmark in choosing your plan: the number of employees you have and your business cash flow. Today we will look at five common retirement plans using this framework to maximize savings and contributions.

Tax Benefits

To begin our explanation, it is important to note that contributions made to your and your employees’ retirement plans can be tax deductible. Additionally, investments within retirement plans grow tax free, you will not have to worry about reporting any interest, dividends, or capital gains earned in these accounts. Some of these plans have a in which contributions are not tax deductible but withdrawals and distributions are tax free. The key point here is that no matter which plan you choose, you may save a substantial amount in income taxes over the course of your lifetime. Although the tax benefits are similar, important differences exist between the plans. This article will discuss these and offer insights to help you decide which retirement plan will be best for you.

SEP IRA

So, you have just started your business and you are looking for the best way to fund your own retirement. If you have no other employees or you are only working with your spouse, family member, or just a few helpers, then the SEP IRA may be the most advantageous retirement account to open. The ease of setting up a SEP IRA is the first advantage a sole proprietor will notice. There are no startup or annual filing requirements from the IRS, and it costs very little to start and maintain the plan.

Unlike other plans, employers must contribute an equal percentage to all eligible employee accounts, including their own. Under this provision, maximizing your retirement contributions will add up with even just a few employees. Unless your profit is equal to or greater than about $345,000, the contribution limits are lower than with a 401(k) plan, and no catch-up contributions after age 50 are allowed. Nevertheless, these drawbacks may not concern a sole proprietor, but they do justify switching away from the SEP IRA as you start hiring more people.

Once you set up the plan, you are not required to make annual contributions. This flexibility allows you to set up the plan, so it is ready for when you are. Lastly, thanks to the SECURE 2.0 Act, SEP IRAs can now have a Roth option.

Luckily, terminating the SEP is as easy as it was to open it. Again, no IRS filing is necessary; you just stop contributing. Overall, the SEP should be used primarily by self-employed individuals who have only a few employees; contributing at the same rate percentage to all eligible employee accounts could be costly otherwise. As you hire employees, moving from the SEP IRA to the SIMPLE IRA may be in your best interest.

Solo 401(k)

An alternative to the SEP IRA is the solo 401(k). If you and your spouse are the only employees of your company, then a solo 401(k) may make sense for you. Under its rules, as your income rises and if you can afford to, you may contribute a maximum of (for tax year 2024) $23,000 per year ($30,500 if you are over age 50), plus a match of up to 20% of your business income, capped at a combined $69,000/year ($76,500 if you are over age 50). The nice thing about this plan is that you can set it up at most custodians without using a third-party administrator, so the setup and maintenance costs are low. You will need to file a 5500-EZ once the assets in the plan exceed $250,000. Overall, you should choose the solo 401(k) for your sole proprietorship if you can and want to contribute more annually.

SIMPLE IRA

Now imagine that your business has entered a new phase; you have grown to the point where managing everything by yourself no longer works and you have hired employees to help you with some business tasks to allow you to focus on growing your business. It is still important to maximize your contributions and savings! SIMPLE IRAs —or “Savings Incentive Match Plan for Employees IRAs” — are a great retirement account to open for yourself and your staff of 100 employees or fewer. The SIMPLE IRA is like the SEP when it comes to the ease and affordability of setting up and maintaining the plan. Specifically, there are no filing requirements with the IRS and the expenses to establish and maintain the plan are low and infrequent. The plans begin to diverge when discussing the nature of the permitted contributions. In this plan, employers must make annual contributions to at least some eligible employee accounts. Whether you must contribute to all eligible accounts or not depends on your chosen method to calculate said payments, and there are two IRS-approved equations: the 2% nonelective contribution or the 3% matching contribution. The former requires you to contribute a dollar amount equal to 2% of all eligible employees’ income, whether they contributed to the plan or not. Alternatively, you may find it more cost-effective to match contributions up to 3% of their compensation for employees who will only receive the match if they contributed that year. Choosing the latter will incentivize your employees to contribute to their own accounts. Additionally, you may reduce your matching contribution the following year to anywhere between 1% and 3%, but for no longer than two years in a row within a five-year period.

You should also note that your employees will have immediate and full rights over the contributions made by themselves and you; in other words, the account is 100% vested to the employee, regardless of their resignation date. Fortunately, there are eligibility requirements that must be met by the employee before enrolling.

In a nutshell, the benefits of the SIMPLE IRA outweigh the costs when a business has some employees yet is not generating sufficient cash flows that allow for a greater net benefit by enrolling in a costlier plan, like a 401(k). This plan is optimal for employers willing to accept lower contribution limits to save on administration and maintenance costs. This makes the SIMPLE appealing to small-business owners, as they will not spend laborious hours managing the plan or filing with the IRS and can still make contributions that align with their goals.

As your business continues to grow, you will reach a point in time where you will want to contribute more to your retirement plan. Before you are ready to take on a third-party administrator, as well as all the other costs associated with a traditional 401(k), we opt for adding a safe harbor provision to allow for lower costs and higher contributions.

Safe Harbor 401(k)

Two typical company milestones will either force or prompt you to switch from your SIMPLE plan to a 401(k): you now have more than 100 employees on your payroll, or you are generating enough income where the higher contribution limits of the regular 401(k) outweigh the administrative costs. While similar, a few key features distinguish the safe harbor 401(k) from the traditional format. The employer must make annual contributions to at least some eligible employee accounts, selecting one of the two formulas discussed under SIMPLE plans, above. In addition, vesting schedules are not allowed. The trade-off is that the business can forgo the complex annual nondiscrimination tests that regular 401(k) plans must pass. Skipping these tests allows for highly compensated employees to disproportionately benefit from the plan. If your business is comprised of many lower-paid employees, your rate of savings may be limited if you opt for a traditional 401(k), as it is likely your savings rate is greater than your employees’.

Safe harbor 401(k) plans can also allow participants to take loans against their accounts.

Overall, you can contribute more to your safe harbor 401(k) account compared to the SEP and SIMPLE, without the complication of annual nondiscrimination testing. You will need a third-party administrator (TPA) to assist with certain annual filing requirements and other tasks.

Traditional 401(k)

Congratulations, your business and employees are profitable enough to maximize retirement savings by establishing a traditional 401(k) — your business can handle the additional administration and setup costs, and your employees are saving enough to allow you, the owner, to increase your personal contributions. This plan is one of the most flexible retirement plans offered and allows for much higher contribution limits than SEP plans and SIMPLE IRAs. Under a traditional 401(k), employers are not required to make annual contributions, but if they decide to, they can mitigate risk by setting up a vesting schedule that stipulates that the employees do not have rights to their employer contributions until a certain number of years. This plan also allows participants to take loans.

A TPA is required for the setup and maintenance of your 401(k) plan, and its fees can add up as the plan grows. While expensive, these administrators can be very helpful in managing accounts and helping your plans stay within regulations. Since employer contributions are optional, your company is subject to nondiscrimination tests, barring highly compensated employees from disproportionately benefiting from the plan. Once the tests are complete for the year, auditors will require highly compensated employees to withdraw any contributions made over the limit of the year. As the average income and savings of your employees grow, so do the contribution limits, and the costs of contributing. Settling on the traditional 401(k) depends greatly on not only the number of employees you have, but also their average salaries.

Tax Credit for Retirement Plans

If your business has fewer than 100 employees, there is a startup tax credit of $500 to $5,000 for three years after starting a plan. The tax credit is for setup costs (of which there are usually none with a SEP, SIMPLE or solo 401(k)) and educating your employees about the plan, and has important limitations.

Conclusion

While establishing retirement accounts is a powerful way to attract employees and bolster their confidence toward a fulfilling retirement, we do appreciate the uniqueness behind each business. These decisions are not to be taken lightly. While this article is intended to make the choice clearer, for advice best suited to you and your business, please reach out to our team.

To read more:

2023 Tax-Planning Strategies: Essential Last-Minute Tips to Maximize Your Savings (milestonefinancialplanning.com)

The Importance of Retirement Tax Planning – Why Tax Planning in Retirement Is Just as Important as When You’re Working | Milestone Financial Planning

Secure Your Retirement: Investing for Your Future | Milestone Financial Planning