Retirement plan basics for small businesses

For many business owners, a retirement decades in the future might seem like an abstraction (and a distraction) when there’s an enterprise to run with endless day-to-day demands. “Planning for your retirement and choosing a well-thought-out plan that’s right for your situation is about taking control of your life,” says Judith Anderson, senior vice president, Retirement & Personal Wealth Solutions at Bank of America. “It’s about today, not 30 to 40 years from now.” That’s because a well-thought-out plan can help small business owners work toward better economic security that will help them focus on their businesses and might also provide them with tax advantages now.

An employer-sponsored retirement plan also can help business owners attract and retain employees — especially if they’re considering offers from other employers. Many workers place a high priority on retirement benefits when choosing an employer.

Fortunately, small business owners can choose from many attractive retirement plans under the federal tax code. The best plan for a particular business depends on factors such as the size of the company, how much employees are able to contribute each year and how many administrative duties the business owner is prepared to take on. The following discussion of options for small employers assumes that the business owner has self-employment earnings or employee compensation from the business.

Options designed for small companies with employees

The SEP IRA

The simplified employee pension (SEP) plan is an employer-sponsored retirement arrangement for companies with one or more employees, and employer contributions are made to individual retirement accounts (IRAs) established for each eligible employee.¹ Many smaller companies opt for SEP IRAs because they are cost-effective and relatively simple to run while still allowing the business owner to help their employees save for retirement. In this plan, business owners can make contributions to IRAs they set up for themselves and their employees. SEP IRAs can offer a full range of investment options, including stocks, bonds, mutual funds and exchange-traded funds (ETFs). The SEP IRA also may be a good choice or option for sole proprietors who want to maximize their retirement savings.

SEP IRAs are subject to maximum contribution limits, which are subject to change annually, so small business owners should check the IRS website for the most current information. Employer contributions generally must equal the same percentage of salary for all participating employees, including the business owner. So if a business owner makes an employer contribution equal to 10% of their salary, for example, participating employees also must receive an employer contribution equal to 10% of their compensation.

Advantages

• Simplicity: The SEP IRA potentially requires less maintenance than a 401(k).
• Flexible contributions: Annual contributions aren’t mandatory to maintain a SEP IRA.
• Tax advantages: The money a business owner contributes to the business owner’s own SEP IRA is generally tax deductible by the business and so is the cash the owner contributes to employees’ SEP IRA accounts. Any potential growth of contributions may be tax deferred. When a business owner withdraws money from a SEP IRA account, it is taxable as ordinary income, including during retirement. Starting in 2023, the business owner and employees may be able to elect for SEP IRA contributions to be made on a Roth (after-tax) basis when contributed and tax-free qualified distributions provided applicable requirements are satisfied. Small business owners should check with their tax advisors and SEP IRA providers.
• Tax credits: Small business owners may be able to take advantage of a tax credit for small employer plan startup costs. Effective January 1, 2023, up to 100% of a business’s qualified startup costs may qualify for a three-year startup credit. A 100% credit is available for employers with up to 50 employees, and a 50% credit is available for employers with between 51 and 100 employees. Qualified startup costs include expenses related to the establishment and administration of the plan or to retirement-related education of employees. An additional credit of up to $1,000 per employee may be available based on contributions made by the employer to an eligible employer plan. The full additional credit is limited to employers with up to 50 employees and is phased out for employers with between 51 and 100 employees. Certain exceptions apply to the additional credit based on employees’ wage amounts.
• Early withdrawals: Any withdrawal a plan participant receives before age 59½ is subject to an additional tax equal to 10% of the distribution unless an exception applies. For more information on taking distributions from a SEP IRA, small business owners can see IRA FAQs - Distributions (Withdrawals).

Disadvantages

• Inability to borrow against savings: As with any IRA, employees cannot take loans from their plan accounts.
• Immediate vesting: This type of plan does not allow business owners to require that employees work for a certain number of years before their contributions are vested, so it does not provide as much of an incentive to stick with the company as plans like 401(k)s do, where such requirements are allowed. With a SEP IRA, contributions become 100% vested immediately.
• No catch-up: For those age 50 and older at any time during the year, catch-up contributions are not allowed, as the employer makes all the contributions.

Deadline for contributions

Contributions are due no later than the due date for the employer’s federal tax return, including extensions.

The SIMPLE IRA

Designed for sole proprietors and businesses with 100 or fewer employees, the employer-sponsored SIMPLE IRA can be a cost-efficient way for small business owners to contribute to their retirement and their employees’ retirements. SIMPLE IRAs are subject to maximum contribution limits, which are subject to change annually, so business owners should check the IRS website for the most current information. Annual employer contributions are mandatory.

Employers must make either a 100% matching contribution up to 3% of employee compensation or a nonelective contribution equal to 2% of compensation (up to an annual limit), but they cannot provide both. Investment choices vary by IRA provider, but generally include individual stocks, bonds, ETFs and mutual funds.

Advantages

• Cost: Plan setup or administrative fees for a SIMPLE IRA vary by provider, though some companies don’t charge for this. Costs also may include whatever fees the brokerage or investment company charges for maintaining an account.
• Ease of setup: SIMPLE IRAs generally require less administrative upkeep than plans such as 401(k)s.
• Tax advantages: Salary reduction contributions are made on a pre-tax basis. Generally, employer contributions made by the business (match or nonelective) are considered tax deductible for the employer. Any investment growth contributions might be tax-free as well, although distributions are taxable as ordinary income in the year of distribution. Starting in 2023, business owners and their employees may be able to elect for SIMPLE IRA contributions to be made on a Roth (after-tax) basis when contributed and tax-free qualified distributions provided applicable requirements are satisfied.
• Tax credits: Business owners may be able to take advantage of a tax credit for small employer plan startup costs. Effective January 1, 2023, up to 100% of qualified start-up costs may qualify for a three-year startup credit. A 100% credit is available for employers with up to 50 employees, and a 50% credit is available for employers with between 51 and 100 employees. Qualified start-up costs include expenses related to the establishment and administration of the plan or to retirement-related education of employees. An additional credit of up to $1,000 per employee may be available based on contributions made by the employer to an eligible employer plan. The full additional credit is limited to employers with up to 50 employees and is phased out for employers with between 51 and 100 employees. Certain exceptions apply to the additional credit based on employees’ wage amounts. Small business owners should check with their tax advisor and their SIMPLE IRA provider.
• Early withdrawals: Any withdrawal received before age 59½ is subject to an additional tax equal to 10% of the distribution unless an exception applies (in SIMPLE IRAs, the tax is increased to 25% for withdrawals taken within two years of the first employer contribution). For more information on taking distributions from a SIMPLE IRA, small business owners can see IRA FAQs - Distributions (Withdrawals).

Disadvantages

• Relatively lower contribution limit than a 401(k): If a business owner and their employees wish to maximize the money they save for retirement and potentially reduce their tax benefits, other plan options may be more beneficial for the business. The pre-tax salary deferral limits in a 401(k) are higher.
• Inability to borrow against savings: As with any IRA, employees cannot take loans from their plan accounts.
• Eligibility requirements: Generally, small business owners will not be permitted to make contributions to a SIMPLE IRA plan if they made contributions to any other qualified plan in the same year. An employer generally cannot maintain a SIMPLE IRA if it has more than 100 employees with $5,000 or more in compensation during the preceding calendar year. Business owners should work with a tax advisor to plan ahead if they wish to switch to this type of plan. For more information, business owners can see the IRS page SIMPLE IRA Plan.

Deadline for contributions

Salary reduction contributions must be deposited in an employee’s SIMPLE IRA as soon as they can reasonably be segregated from the employer’s general assets but no later than 30 days after the end of the month for which the contributions are made. Matching and nonelective contributions are due no later than the deadline for the employer’s federal tax return, including extensions.

Small business 401(k)

A 401(k) plan can be established and maintained by most companies, including for-profit corporations, nonprofit corporations or partnerships.

Individual plan participants may elect to defer on a pre-tax basis or, depending on how business owners have set up the plan, as Roth contributions on an after-tax basis. A 401(k) plan also may be designed to permit participants to make after-tax contributions. Employers may make matching contributions, profit sharing contributions or other special types of contributions.

Total contributions, including those from the employer and plan participant, are limited to the lesser of 100% of compensation or a specific dollar amount set out in the federal tax code and adjusted annually by the IRS. For the most up-to-date contribution limits, see the IRS page 401(k) and Profit-Sharing Plan Contribution Limits.

If a business owner has opted for a traditional 401(k), where employee contributions are made on a pre-tax basis, participants do not pay federal income taxes on contributions or potential earnings until they are withdrawn. If a business owner has opted under the plan to allow participants to make Roth contributions, distributions of earnings on those contributions will be federal tax-free if they are qualified distributions.

Advantages

• Tax advantages: Employer contributions to a 401(k) plan are deductible up to 25% of aggregate employee compensation for the tax year, considering only a capped amount of compensation per employee. The capped amount is specified in the federal tax code and adjusted annually by the IRS. In addition, certain administrative costs and other plan expenses may be deductible.
• Borrowing: If a plan allows for this option, participants may be able to borrow from their plan account. For more information on retirement plan loans, participants can see the IRS page Retirement Plan FAQs regarding Loans.
• Tax credits: Small business owners may be able to take advantage of a tax credit for small employer plan startup costs. Effective January 1, 2023, up to 100% of qualified startup costs may qualify for a three-year startup credit. A 100% credit is available for employers with up to 50 employees, and a 50% credit is available for employers with between 51 and 100 employees. Qualified startup costs include expenses related to the establishment and administration of the plan or to retirement-related education of employees. An additional credit of up to $1,000 per employee may be available based on contributions made by the employer to an eligible employer plan. The full additional credit is limited to employers with up to 50 employees and is phased out for employers with between 51 and 100 employees. Certain exceptions apply to the additional credit based on employees’ wage amounts.

Disadvantages

• Paperwork: The potential downside of a 401(k) is that it does require some administrative work. For instance, plans must perform certain annual tests to make sure the contributions made and benefits under the plan do not discriminate in favor of highly compensated employees. Many small businesses hire a third-party administrator to help keep up with IRS requirements, which adds to the cost of managing the plan. Retirement planning for small business owners requires business owners to look at the total financial picture for themselves and their business. Speaking with a tax advisor and financial planner can help business owners determine which plan best aligns with their financial situation, retirement goals and business considerations. For more information, business owners can see IRS Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).

Deadline for contributions

If a plan meets the requirements for a traditional 401(k) (see Retirement Plans for Small Entities and Self-Employed on the IRS website for more information), participant contributions must be deposited as soon as they can reasonably be segregated from the employer’s general assets but in no event later than the 15th business day of the following month. If plans with fewer than 100 participants make deposits within seven business days of the participant salary deferral, they will have satisfied a safe harbor rule covering the timely deposit of participant contributions.

Employer contributions are generally due no later than the deadline for the employer’s federal tax return, including extensions.

Options available to sole proprietors

The IRA

Sole proprietors may find that an individual retirement account, or traditional IRA, is one of the simplest ways to save money for retirement. It’s possible for sole proprietors to invest their contributions in stocks, mutual funds, ETFs and bonds, as well as certificates of deposit (CDs) and money market funds. Contributions are subject to limits, so sole proprietors should check the IRA Contribution Limits on the IRS website for the most up-to-date information on contribution limits.

Contributions to a traditional IRA may be tax deductible depending on the contributor’s modified adjusted gross income and federal tax filing status, but the earnings will always be tax deferred until distribution. A business owner also may make nondeductible contributions if they are above traditional IRA deductibility limits. The age at which one must start taking required minimum distributions (RMDs) is age 73. Plan participants are required to take an RMD by December 31 each year. A participant may delay their first RMD until April 1 in the year after they turn 73, but then they will be required to take two RMDs in that year. One may be subject to additional taxes if RMDs are missed. RMD rules can be complex, so business owners should consult their tax advisor regarding their specific situation.

Deductible contributions and all earnings are generally taxed as ordinary income when distributed, while nondeductible contributions are not because plan participants already paid taxes on them. An additional federal tax for early withdrawals applies to the taxable portion of distributions before age 59½ unless an exception applies.

With a Roth IRA, the same contribution limits apply, but contributions are not deductible. One’s ability to contribute directly to a Roth IRA depends on their modified adjusted gross income and filing status. When one makes qualified distributions from a Roth IRA, the distributions are not subject to federal income taxes and may be exempt from state taxes. Small business owners should consult their tax advisor about any state or local taxes that may apply.

Advantages

• Cost: Business owners can open a traditional IRA or Roth IRA with most brokerage or investment companies, and fees — though likely to be small — may vary. Although the IRS doesn’t require a minimum investment, some companies do.
• Ease of setup: It is possible to open an IRA online within minutes. However, plan participants must make annual contributions by the federal tax return deadline, usually by April 15, not including extensions. If April 15 falls on a weekend or a holiday, the deadline is typically the next business day.
• Tax advantages: Traditional IRAs and Roth IRAs both offer potential tax benefits but at different times. For a traditional IRA for which one has made a tax-deductible contribution, the advantages are generally immediate; with a Roth IRA, they may be in the future. When you make a Roth IRA contribution, it is not tax deductible, and the accountholder will not receive any immediate tax benefit, but qualified distributions will not be subject to federal tax. This may help the accountholder save on taxes if they are in a lower tax bracket at that point.²

Disadvantages

• Relatively low contribution limit: If a sole proprietor is a high earner and wishes to save more money for retirement and to potentially help maximize tax benefits, other options may be more beneficial. However, while the contribution limits in an IRA are less than in other plan types, if a small business owner has a retirement plan like a 401(k) with their company, they can supplement their plan savings with an IRA.

The individual 401(k) plan

For sole proprietors with no employees other than themselves (and a spouse), the individual 401(k) — also known as a solo 401(k) — potentially could let them put away more retirement savings than an IRA or a SEP IRA.

In an individual 401(k), a sole proprietor can contribute as both an employee and through their business. As an employee, they can make elective deferrals on a pre-tax basis up to 100% of earned income up to a certain dollar amount specified in the federal tax code and adjusted annually by the IRS. Maximum contribution limits are subject to change, so for the most current contribution limits, business owners should check out one-participant 401(k) plans on the IRS website.

Meanwhile, the company can contribute up to 25% of the sole proprietor’s compensation (or 20% of net earnings from self-employment) as an employer contribution. Total contributions, including those from the sole proprietor and the company, are limited to the lesser of 100% of earned income up to a certain dollar amount specified in the federal tax code and adjusted annually by the IRS. The sole proprietor’s spouse (if employed by the business) is also eligible to contribute to the company’s individual 401(k) plan.

With an individual 401(k), withdrawals taken before age 59½ are subject to regular income tax as well as an additional federal tax equal to 10% of the distribution unless an exception applies; withdrawals after that age are taxed as regular income. If a sole proprietor turned age 73 on or after January 1, 2023, the required beginning date for RMDs is April 1 of the year after they turn age 73. They would be required to take an RMD by December 31 each year after that. If they delay their first RMD until April 1 in the year after they turn 73, they will be required to take two RMDs in that year. They may be subject to additional taxes if RMDs are missed. RMD rules can be complex, so business owners should consult their tax advisors regarding their specific situation.

Advantages

• Tax advantages: Elective deferrals up to the annual limit can be made on a pre-tax basis, potentially reducing a sole proprietor’s and their company’s taxable income. Any potential investment growth of their savings would be tax deferred. They also can set up their solo 401(k) with a Roth 401(k) option. In this case, employee contributions would be made on an after-tax basis, but earnings are not subject to federal income tax if withdrawals are made when they are at least 59½, or disabled or deceased and at least five years have elapsed between the first contribution to a Roth 401(k) account and the first withdrawal.
• Borrowing: If the plan allows for this option, they may be able to borrow from their plan account. For more information on retirement plan loans, see the IRS page Retirement Plan FAQs regarding Loans.
• Early withdrawals for certain exceptions: It is possible to take an early withdrawal from an individual 401(k) plan account without owing any additional tax in certain situations, such as a qualified birth or adoption or as a qualified disaster distribution. However, sole proprietors will have to pay taxes at their current tax rate to do so.

Disadvantages

• Paperwork: Over time, administering a plan can require a fair amount of paperwork, including filing Form 5500 annually with the IRS and Department of Labor when the plan’s total assets and the assets of other one-participant plans at the end of the plan year are more than $250,000. Additionally, “every few years, the law changes and you may need to amend your plan,” notes Anderson.

Deadline for contributions

Sole proprietors or single-owner LLCs must make certain contributions by the individual federal tax filing deadline, including extensions. If a business is an S corporation, the business owner must make certain contributions by the S corporation federal tax filing deadline, including extensions.

Source: IRS, Retirement Plans for Small Business (SEP, SIMPLE and Qualified Plans).