Setting up a retirement plan is an important process to conquer. There are different types of retirement plans to set up and it can be overwhelming to some, so today’s article will simplify 3 types of retirement plans to choose between and get moving. The right plan for your business depends on how much you want to save, how many employees you have, how much time you want to dedicate to it, and so on. There is no “one-size-fits-all” plan, but this is also not a one-time decision for the lifespan of your business. Take all the information you have now and make an educated guess on the best plan for you.
Individual Retirement Accounts
Individual retirement accounts (IRAs) are arguably the easiest retirement plan to set up. Even though they are “individual” accounts, they are excellent accounts to set up through a business. The two main types of IRAs to set up on the business side are SEP IRAs (Simplified Employee Pension) and Simple IRAs (Savings Incentive Match Plans for Employees). The employee owns either account, and the business will periodically help fund the account. Let’s break both of them down.
Setting up a SEP IRA is a great option if you have a small business with few or no employees. Business owners can save up to 25% of compensation each year with “employer-only” contributions, which means employees cannot contribute themselves. For the self-employed owners who can’t cleanly define compensation, take your net earnings and subtract half of your self-employment tax and any SEP contributions you already made. The contribution rate must apply to all SEP accounts in the plan, including employees. Saving 10% to your SEP requires you to save 10% into each employee’s SEP as well. If that is not a concern, then the IRS generally allows contributions up to $69,000 for 2024, assuming that is no more than 25% of your income. Fortunately, SEP IRA contributions are not required each year. If you have a smaller cash flow year in the business, you can skip contributions to the SEPs and pick it back up the following year.
If you are concerned about funding your employees too much in a SEP IRA, then a SIMPLE IRA could be a better route. Similarly, every employee receives an account, but the contribution rates are different. Instead of employer-only contributions, employees can elect to contribute to their Simple IRA (up to $16,000 in 2024, and $19,500 if over 50). Then employers contribute 2% or 3% of compensation each year. You can select to contribute 2% to every employee regardless of whether they contribute themselves or you can match up to 3% of the employee contributions. Simple IRA employer contributions must occur each year and may not have quite the saving power as the SEP IRA ($16,000 + 3% of your comp vs. $69,000).
401(k)-Style Retirement Plans
The most recognizable plan by far is the 401(k) account. 34% of working adults have a 401k-style account1, so one in three people have some experience with what the IRS calls a Defined Contribution Plan. 401ks are great retirement plans for companies with many employees, but small business owners could find value in them as well. Importantly, as employees enter the business, they must have appropriate access to the retirement plan. You cannot create a 401k plan and only offer it to yourself or your top staff. To properly administer a 401k plan, there are rules and tests that must verify the plan is compliant. As a result, the time and cost to have a 401k can be higher than the IRA-style alternatives. However, the added costs can be worth the expense if in return you provide you and your employees with a generous retirement plan while enjoying a nice tax deduction for your business.
The traditional 401k allows employees to contribute $23,000 ($30,500 if over 50) and a maximum contribution of $69,000 for 2024 (so employers can contribute another $46,000 on top of a maxed 401k). Some 401k plans are considered Safe Harbor plans, where employers will match the contributions of employees up to a certain percentage. This looks similar to the Simple IRA plan, where all 401k accounts in the plan (even the owners) are treated equally. If you have no employees, you have an advantage in the 401(k) space because you have access to a Solo or Individual 401k. Since there are no employees in the business (not including your spouse as an employee), you are not bound by the testing requirements of a traditional 401k. As a result, you can save both $23,000 on the employee side and $46,000 on the employer side into your Solo 401k without much trouble. If you want to contribute more than 25% of compensation through the SEP IRA, then the Solo 401k can be a great option. One of the best features of a 401k plan is the access to Roth 401k’s. SEP and Simple IRAs cannot be created as a Roth IRA (at least not yet), so opting for a 401k plan with a Roth component can let you contribute tens of thousands of after-tax dollars each year. Most business owners are already in a higher tax bracket, so forgoing the deduction and contributing to a Roth each year may not be wise. But in certain years if income is unexpectedly lower, it could be. If an owner is normally in the 35% tax bracket but this year looks closer to 20%, it could be wise to “buy” Roth contributions at 20% instead of 35%.
One of the best features of a 401k plan is the access to Roth 401k’s. SEP and Simple IRAs cannot be created as a Roth IRA (at least not yet), so opting for a 401k plan with a Roth component can let you contribute tens of thousands of after-tax dollars each year. Most business owners are already in a higher tax bracket, so forgoing the deduction and contributing to a Roth each year may not be wise. But in certain years if income is unexpectedly lower, it could be. If an owner is normally in the 35% tax bracket but this year looks closer to 20%, it could be wise to “buy” Roth contributions at 20% instead of 35%. Check out my article on tax planning to learn more about the tax side of this conversation.
Applying Your Options to Your Situation
Things start to get slightly complicated when one of two things happens. First, you have a previous retirement account and don’t know what to do with it. Second, you have a retirement account that is active at another company (even another company you own). For the old account, you generally have 3 options: leave it at the old company, transfer it into your new retirement plan, or transfer it to an independent firm. Most people don’t want to leave it, so the question is mainly whether to roll it into the new plan or not. If you decide to roll it into your new plan, make sure you design the new plan to accept rollovers. Rolling the account to an independent company (into an IRA or similar account) could give you more flexibility, but ensure you are aware of the costs. The right answer is going to be specific to your situation, so make sure you understand the pros and cons of each choice before deciding.
For those with multiple retirement plans, the IRS does not allow multiple active retirement plans at the same company (for the most part, there are a few common exceptions like equity compensation plus a 401k or a 457). One business cannot have an active SEP IRA and a 401k plan, but you can at different unrelated businesses. The number of active accounts is less important than the contributions for each. As an extreme example, I cannot fund 10 different 401ks with $23,000 and expect to get a $230,000 deduction. All employee 401k contributions are combined and must be under the annual limit. Fortunately, employer contributions are specific to each business. For example, if someone has a 401k at one employer and a Solo 401k at their own company, it is possible to contribute $23,000 to the first 401k and contribute $69,000 to the solo 401k (as a full employer contribution assuming their income was high enough).
There are a lot of rules and nuances to multiple retirement plans, so check with your accountant and financial planner to make sure you are compliant. The interaction between multiple 401ks, 401k and IRAs, or between IRAs all have different limits and thresholds to adhere to. Make sure you have a solid understanding of your plan for retirement. There is nothing wrong with having money in multiple different account types, just be diligent when you start contributing between them.
Three Choices
There are many other types of retirement plans that could apply to you. For the vast majority of business owners, opting for one of these retirement plans can do the job. If you are focused on simplicity and ease of use, the SEP and SIMPLE IRAs can be a great route. If you have more employees and/or want to contribute more towards retirement, then look at the 401k options. There are many factors to consider, between taxes, benefits to the owner and the employees, IRS limits, and your overall goals and objectives. Focus less on finding the perfect plan and select one that will work for your business now. There is always the possibility to change and improve it in the future.
Sources: 1Census Bureau
TC Falkner 