Do you own a small business or earn income as a self-employed individual?
Are you looking to make higher annual contributions to a retirement account?
Are you looking for additional tax deductions?
If you’ve answered “yes” to one or more of these questions, a small business retirement account might be a good fit for you.
As a small business owner, you’re responsible for setting aside funds for your own retirement. You can even establish a plan if you’re self-employed. And if you have employees, you have the power to help them put away money for their retirement. Offering a retirement account can help you attract and retain top talent, especially if you’re in a competitive field.
Starting a retirement savings plan is easier than you might think. What’s more, retirement plans offer significant tax advantages to both employers and employees.
In this article, we’ll cover IRA and Defined Contribution plans that you can take advantage of, as well as the benefits of setting up a retirement plan.
Table of Contents
Keep in mind that all these accounts can be self-directed into a wide array of alternative assets. You can use these accounts to invest in assets like…
- Residential, commercial, and industrial real estate
- Private mortgages
- Trustees
- Private lending
- Private equity
- Real estate investment partnerships
- Precious metals
- And much more
Here’s a quick overview so you can understand which business retirement account is right for you.
IRA-Based Plans
Payroll Deduction IRA
The Payroll Deduction IRA is the simplest retirement arrangement option. It’s popular among small business owners because it’s “no fuss, no muss”—employees set up their own Traditional or Roth IRA, then authorize a payroll deduction for their IRA. All that you, the employer, must do is transmit each employee’s authorized deduction to their financial institution.
For instance, let’s say your company, Linzo Nursery, offers employees the chance to deduct a portion of their paychecks to contribute to their IRAs.
Rebecca, a Linzo employee, signs up for the program and has $200 of her $2,000 bi-weekly paycheck deposited into her IRA for a yearly total of $5,200. At year-end, Linzo reports the full $52,000 she earned on her Form W-2. Rebecca would add the $5,200 to any other IRA contributions she made during the year in calculating her maximum contribution and Form 1040 IRA deduction.
- Key advantage. Easy to set up and maintain; no plan document needs to be adopted.
- Employer eligibility. Any employer with one or more employees.
- Employer’s role. Arrange for employees to make payroll deduction contributions, then transmit contributions for employees to the IRA. Employers don’t have an annual filing requirement.
- Contributors to the plan. Employee contributions are remitted through payroll deduction.
- Maximum annual contribution (per participant). $6,000 in 2020. Participants over the age of 50 can make additional contributions, up to $1,000.
- Contributor’s options. Employees can decide how much to contribute at any time.
- Minimum employee coverage requirements. There is no requirement. Coverage can be made available to any employee.
- Withdrawals, loans, and payments. Withdrawals are subject to federal income taxes. Early withdrawals are subject to an additional 10 percent tax, but special rules apply to Roth IRAs. Participant loans aren’t permitted. The assets may not be used as collateral.
- Vesting. All contributions are immediately 100 percent vested.
SEP IRA
Almost any small business can establish a Simplified Employee Pension, or SEP IRA. There are no requirements for the number of employees, nor are there any restrictions on structure—regardless of whether your business is a sole proprietorship, partnership, corporation, or nonprofit.
It’s a great option for small businesses because it allows for larger contributions and greater flexibility.
As a small business owner, you can choose whether to make tax-deductible contributions on behalf of eligible employees. Employees enjoy tax-free growth until taking distributions in retirement. The elective contribution limits are high—as of 2020, you can contribute up to 25 percent of an employee’s compensation, but no more than $57,000.
For instance, let’s say you have an employee Jordan, who works at your real estate brokerage, Verde Commercial Group. Verde decides to establish a SEP for its employees, primarily because the real estate industry is cyclical in nature, with good times and down times. In good years, Verde can make larger contributions for its employees. In down times it can reduce the amount.
Verde’s contribution rate, whether large or small, must be uniform for all employees.
The financial institution that Verde has chosen for its SEP has several investment funds from which to choose; Jordan decides to divide the contribution to his SEP among four of the available funds. Because he’s an employee, he can’t contribute to his SEP because SEPs only allow for employer contributions.
However, since you wear two hats—employer and employee—you can choose to contribute up to 25 percent or compensation, up to $57,000, to your own SEP IRA.
- Key advantage. Easy to set up and maintain.
- Employer eligibility. Any employer with more than one employee may set up a SEP IRA.
- Employer’s role. Each year, you can decide how much to contribute on behalf of your employees. If your business has had a bad year, this can be $0. Employers aren’t required to file annually.
- Contributors to the plan. Only employers can contribute to a SEP IRA.
- Maximum annual contribution (per participant). As a business owner, you can contribute as both an employer and an employee. You can contribute up to 25 percent of an employee’s compensation, but no more than $57,000 in 2020.
- Contributor’s options. Employers can decide whether to make contributions year-to-year.
- Minimum employee coverage requirements. SEP IRAs must be offered to all employees who are at least 21 years old, employed by the employer for 3 of the last 5 years, and had compensation of $600 in 2020.
- Withdrawals, loans, and payments. Withdrawals are subject to federal income taxes. Early withdrawals are subject to an additional tax. Participant loans aren’t permitted. The assets may not be used as collateral.
- Vesting. Contributions are immediately 100 percent vested.
SIMPLE IRA
The Savings Incentive Match Plan for Employees, or SIMPLE IRA, is another retirement savings account. Like its name implies, a SIMPLE IRA is easier to set up and administer than is a 401(k). This makes it an attractive option for companies who want to offer retirement benefits at a low price point.
To qualify, you must have fewer than 100 employees who have received at least $5,000 in compensation in the previous year. Employees are eligible if they’ve earned at least $5,000 during any two preceding calendar years, and are expecting to earn $5,000 in the current year.
Employees can choose whether to contribute to their SIMPLE IRA.
Employers are required to contribute in one of two ways:
- 2 percent nonelective contribution. You contribute a flat 2 percent of each eligible employee’s pay regardless of whether or how much your employee deferred.
- 3 percent matching contribution. You match each employee’s elective deferrals, dollar-for-dollar, up to 3 percent of your employee’s pay.
- You must match between 1 to 3 percent of your employee’s compensation.
- You must not contribute less than 3 percent for more than 2 calendar years out of the 5-year period ending with the calendar year the reduction is effective.
- Even if an eligible employee doesn’t contribute to his or her SIMPLE IRA, that employee must still receive an employer contribution to their SIMPLE IRA equal to 2 percent of their compensation up to the annual limit of $285,000 for 2020 (subject to cost-of-living adjustments in later years).
For instance, let’s say you own Brainboost Learning Center, a small business with 30 employees. Brainboost decides to establish a SIMPLE IRA plan for its employees and will match its employees’ contributions, dollar-for-dollar, up to 3 percent of each employee’s compensation. That means that if your employee doesn’t contribute to their SIMPLE IRA, you don’t need to pay a matching employer contribution.
Your head tutor, Robin, has a yearly compensation of $50,000 and contributes 5 percent of his compensation ($2,500) to his SIMPLE IRA. The Brainboost matching contribution is $1,500 (3 percent of $50,000). Therefore, the total contribution to Robin’s SIMPLE IRA that year is $4,000 (his $2,500 contribution plus Robin’s $1,500 contribution). The financial institution holding Robin’s SIMPLE IRA has several investment choices and he can choose the options he likes most.
Under this option, if a Brainboost employee does not contribute to their SIMPLE IRA, then that employee does not receive any matching employer contribution.
In another example, let’s say you own Brainfood Juicery next door, your other small business with 20 employees. Brainfood has a SIMPLE IRA plan for its employees and will make a 2 percent nonelective contribution for each of them.
Under this option, even if your Brainfood employee, Alexa, doesn’t contribute to her SIMPLE IRA, she would still receive Brainfood’s employer contribution to her SIMPLE IRA that equals 2 percent of her compensation.
Alexa’s annual compensation is $20,000. Even if Alexa doesn’t contribute this year, Brainfood must still make a contribution of $400 (2 percent of $20,000).
- Key advantage. The SIMPLE IRA is a salary reduction plan with little administrative paperwork.
- Employer eligibility. Any employer with 100 or fewer employees—who does not currently maintain another retirement plan. There is a two-year grace period if you exceed 100 employees, to allow for growing businesses.
- Employer’s role. Employers aren’t required to file annually. Financial institutions handle most of the paperwork.
- Contributors to the plan. Employees can make pre-tax contributions, and employers can make tax-deductible contributions.
- Maximum annual contribution (per participant). Employees can contribute up to $13,500, with catch-up contributions of $3,000, in 2020. Employers can contribute a dollar-for-dollar match up to 3 percent of pay, or a 2 percent non-elective contribution for each eligible employee.
- Contributor’s options. Employees decide how much to contribute. Employers must make matching contributions or contribute 2 percent of each employee’s compensation.
- Minimum employee coverage requirements. Employers must offer any employee who has earned at least $5,000 in any prior 2 years, and are reasonably expected to earn at least $5,000 in the current year.
- Withdrawals, loans, and payments. Withdrawals are subject to federal income taxes. Early withdrawals are subject to an additional tax Participant loans aren’t permitted from SIMPLE IRAs.
- Vesting. Contributions are immediately 100 percent vested.
Defined Contribution Plans
SIMPLE 401(k)
The SIMPLE 401(k) is a simplified version of the 401(k) plan. SIMPLE IRAs and SIMPLE 401(k) plans share a lot of commonalities. Only small businesses with fewer than 100 employees are allowed to participate, employers make pre-tax contributions, and reporting requirements are minimal. Employee contributions are optional, and both plans feature the same contribution limits.
Employers are required to contribute in one of two ways:
- 2 percent nonelective contribution. You contribute a flat 2 percent of each eligible employee’s pay regardless of whether or how much your employee deferred.
- 3 percent matching contribution. You match each employee’s elective deferrals, dollar-for-dollar, up to 3 percent of your employee’s pay.
To qualify, you must have fewer than 100 employees, and you cannot have any other retirement plans. Employees are eligible if they’ve earned at least $5,000 during any two preceding calendar years, and are expecting to earn $5,000 in the current year.
- Key advantage. Attract and retain talented people in today’s challenging job market with less regulatory scrutiny.
- Employer eligibility. Small business employers with 100 or fewer employees may open a SIMPLE 401(k). Just as with the SIMPLE IRA plan, there is a two-year grace period if you exceed 100 employees, to allow for growing businesses.
- Employer’s role. Establish this plan with the help of a financial institution. File annual Form 5500.
- Contributors to the plan. Employees can make pre-tax contributions, and employers must make tax-deductible contributions.
- Maximum annual contribution (per participant). Employees can contribute up to $13,500, with a catch-up contribution of $3,000, in 2020. Employers can contribute a dollar-for-dollar match up to 3 percent of pay, or a 2 percent non-elective contribution for each eligible employee.
- Contributor’s options. Depending on the plan you select, employers may be required to make contributions.
- Withdrawals, loans, and payments. The SIMPLE 401(k) offers optional participant loans and hardship withdrawals for employees. Withdrawals are subject to a 10 percent early penalty.
- Vesting. Employee contributions vest immediately.
As your business grows and your workforce exceeds 100 employees, it then becomes time to switch to a regular 401(k).
Traditional 401(k)
For a retirement plan that’s more robust than an IRA-based plan, consider the Traditional 401(k).
The Traditional 401(k) offers high contribution limits, as well as the potential for an employer match and profit-sharing contributions, making it a great tool to attract and retain high-quality talent.
However, these plans require considerable attention in the plan design phase and regular annual upkeep thereafter. That’s why we’d recommend bringing a third-party administrator onboard.
- Key advantage. A Traditional 401(k) permits a high level of salary deferrals by employees.
- Employer eligibility. Any employer with one or more employees.
- Employer’s role. Establish this plan with the help of a financial institution. It may require annual nondiscrimination testing to ensure that the plan doesn’t discriminate in favor of highly compensated employees. File Form 5500 every year.
- Contributors to the plan. Employees can make pre-tax contributions, and employers can make tax-deductible contributions.
- Maximum annual contribution (per participant). The general limit on total employer and employee contributions for 2020 is the lesser between $57,000, or 100 percent of employee compensation, up to $285,000. Employees over age 50 receive a $6,500 catch-up contribution.
- Contributor’s options. Employees can decide how much to contribute based on a salary reduction agreement. Employers can make additional contributions, such as matching contributions, as set by the terms of the plan.
- Minimum employee coverage requirements. A Traditional 401(k) must be offered to all employees who are at least 21 years old, and who worked at least 1,000 hours in a previous year. The plan cannot exclude any employees who have reached a specified age.
- Withdrawals, loans, and payments. Withdrawals are allowed after a specified event (e.g., retirement, plan termination), subject to federal income taxes. Plans may permit loans and hardship withdrawals. Early withdrawals are subject to an additional tax.
- Vesting. Employee salary reduction contributions are immediately 100 percent vested. Employer contributions may vest over time, according to individual plan terms.
Safe Harbor 401(k)
401(k) plans exist to prepare more Americans for retirement, and the government wants to make sure that all workers—not just highly compensated employees—get to participate in a meaningful way. To ensure that all eligible employees have the chance to benefit from their company’s 401(k) plan, the IRS has set up a series of “nondiscrimination” tests to measure whether a 401(k) favors highly compensated employees. If your plan fails nondiscrimination testing, it generally translates to making expensive corrections, a lot of administrative work, and potentially even refunding 401(k) contributions.
The Safe Harbor 401(k) helps companies avoid nondiscrimination testing. It has unique built-in provisions that help all employees save by requiring companies to contribute to their employees’ 401(k) accounts. As such, more employees are encouraged to participate. In return, the IRS offers companies “safe harbor” from both the nondiscrimination testing process and the consequences of failure.
In short, Safe Harbor 401(k)s require that you offer contributions or an employer match in order to encourage your employees to participate. Those contributions must vest immediately.
- Key advantage. The Safe Harbor 401(k) allows for employees to defer high amounts without annual nondiscrimination testing.
- Employer eligibility. Any employer with one or more employees.
- Employer’s role. Establish this plan with the help of a financial institution. File annual Form 5500.
- Contributors to the plan. Employees can make pre-tax contributions, and employers can make tax-deductible contributions.
- Maximum annual contribution (per participant). Employees can contribute up to $19,500, with catch-up contributions of up to $6,000, in 2020. Employers and employees combined may contribute up to 100 percent of compensation, or $57,000, whichever is less, in 2020. Employers can deduct up to 25 percent of aggregate compensation for all participants, as well as all salary reduction contributions.
- Contributor’s options. Employees can decide how much to contribute based on a salary reduction agreement. Employers must make either specified matching contributions, or a 3 percent contribution to all participants.
- Minimum employee coverage requirements. A Safe Harbor 401(k) must be offered to all employees who are at least 21 years old, and who worked at least 1,000 hours in a previous year.
- Withdrawals, loans, and payments. Withdrawals are allowed after a specified event (e.g., retirement, plan termination), subject to federal income taxes. Plans may permit loans and hardship withdrawals. Early withdrawals are subject to an additional tax.
- Vesting. Employee salary reduction contributions and all Safe Harbor employer contributions are immediately 100 percent vested. Some employer contributions may vest over time, according to the terms of the plan.
Automatic Enrollment 401(k)
Auto Enrollment 401(k) plans are popular for many reasons: The “automatic enrollment” feature encourages higher participation among both rank-and-file employees and owners/managers, thus decreasing your risk for failing nondiscrimination tests. It allows for salary deferrals into certain plan investments if employees don’t select their own investments. Finally, it simplifies the selection of investments that are appropriate for long-term retirement savings.
- Key advantage. Auto Enrollment 401(k) plans ensure high participation and permit employees to defer high amounts. Additionally, they afford safe harbor relief for default investments.
- Employer eligibility. Any employer with one or more employees.
- Employer’s role. Establish this plan with the help of a financial institution. It may require annual nondiscrimination testing to ensure that the plan doesn’t discriminate in favor of highly compensated employees. File annual Form 5500.
- Contributors to the plan. Employees can make pre-tax contributions, and employers can make tax-deductible contributions.
- Maximum annual contribution (per participant). Employees can contribute up to $19,500, with a catch-up contribution of $6,500, in 2020. Employers and employees can contribute the lesser of 100 percent of contributions or $57,000, in 2020. Employers can deduct up to 25 percent of aggregate compensation for all participants, as well as all salary reduction contributions.
- Contributor’s options. Unless they opt out, employees must make salary reduction contributions as specified by the employer. Employers can make additional contributions, including matching contributions as set by plan terms.
- Minimum employee coverage requirements. An Auto Enrollment 401(k) must be offered to all employees who are at least 21 years old, and who worked at least 1,000 hours in a previous year.
- Withdrawals, loans, and payments. Withdrawals are allowed after a specified event (e.g., retirement, plan termination), subject to federal income taxes. Plans may permit loans and hardship withdrawals. Early withdrawals are subject to an additional tax.
- Vesting. Employee salary reduction contributions are immediately 100 percent vested. Employer contributions may vest over time, according to individual plan terms.
Solo 401(k)
If your small business has no eligible employees other than your spouse, you might be a good fit for a Solo 401(k), also known as an Individual 401(k), One-Participant 401(k), or Uni-401(k). They’re versatile and popular among small business owners and independent contractors thanks to their low fees and ease of customization.
- Key advantage. Since there are no employees other than your spouse who work for the business, you get to bypass discrimination testing.
- Employer eligibility. Any business owner—self-employed, corporation, or LLC—with no employees aside from their spouse.
- Employer’s role. Determine whether a domestic relations order is qualified. Maintain plan records for at least 6 years.
- Contributors to the plan. Employees can make pre-tax contributions, and employers can make tax-deductible contributions.
- Maximum annual contribution (per participant). The business owner wears two hats: employee and employer. The owner can contribute both elective deferrals and nonelective contributions. Elective deferrals can be up to 100 percent of compensation, and up to $19,500 (or $26,00 if over age 50), in 2020. Nonelective contributions can be up to 25 percent of compensation, but cannot exceed $57,000.
- Contributor’s options. The business owner can decide their maximum annual contribution. However, if you’re employed by a second company and participate in its 401(k) plan, understand that your limits on elective deferrals are by person, not by plan. Consider the limit for all elective deferrals that you make during a year.
- Withdrawals, loans, and payments. The Solo 401(k) loan option, which is not available with an IRA, allows you to borrow from your own retirement funds, up to 50% of the plan value or $50,000, whichever is less. The loan has a five-year payback period. If you can’t pay off the loan within that five-year period, the unpaid portion will be treated as a withdrawal. Withdrawals are subject to expensive federal taxes and an early withdrawal penalty.
- Vesting. Employee and employer contributions are 100 percent vested immediately.
Profit Sharing
A profit-sharing plan is yet another type of defined contribution plan to help your employees save for retirement. You can establish one alongside other retirement plans. It’s a great option for small businesses for two major reasons.
First, it’s a powerful motivational tool for employees to perform well. When employees feel like their hard work will directly benefit them, they feel incentivized to do their best.
Second, it’s a good plan if cash flow is an issue. All contributions are discretionary, so employers get to decide whether and how much to contribute to each employee’s plan. There’s no set amount that you’re legally required to contribute. If you can afford to make some amount of contributions to the plan for a particular year, you can do so. Other years, you don’t need to make contributions.
Employers need to test that benefits don’t discriminate in favor of your highly compensated employees. One common method for determining each employee’s allocation is the comp-to-comp method.
- First, calculate the total “comp,” or the sum of all your employees’ compensation.
- Then, to determine each employee’s “comp,” divide their compensation by the total comp.
- Finally, multiply each employee’s fraction by the amount of the employer contribution.
You’ll also need to track contributions, investments, distributions, and more, and file an annual return with the government.
- Key advantage. Employers can make very large contributions for employees, which is a great incentive for high performance.
- Employer eligibility. Any employer with one or more employees.
- Employer’s role. Establish this plan with the help of a financial institution. File annual Form 5500.
- Contributors to the plan. Employers may make discretionary contributions.
- Maximum annual contribution (per participant). Up to the lesser of 100 percent of compensation, or $57,000 in 2020. Employers can deduct up to 25 percent of aggregate compensation for all participants.
- Contributor’s options. Employers make contributions according to the terms of the plan.
- Minimum employee coverage requirements. A profit sharing plan must be offered to all employees who are at least 21 years old, and who worked at least 1,000 hours in a previous year.
- Withdrawals, loans, and payments. Withdrawals are allowed after a specified event (e.g., retirement, plan termination), subject to federal income taxes. Plans may permit loans and hardship withdrawals. Early withdrawals are subject to an additional tax.
- Vesting. Contributions may vest over time according to plan terms.
Benefits of Setting Up a Retirement Plan
If you’re self-employed or run your own small business, you likely don’t have many hours in a day to plan out your retirement. It can feel like a juggling act when you’re trying to balance income-producing activities, debt-reduction activities, and running day-to-day business operations in between. Still, it’s crucial not to let retirement planning fall by the wayside. Not only do retirement accounts offer tax-sheltered earnings—you’re also able to save a higher dollar amount than you could otherwise.
Here are some significant advantages to consider:
- Greater security. The sooner you start a plan, the more financial security that you and your employees will have in later years. Even small contributions can make a significant difference over time. Some plans, like the SEP IRA, have generous contribution limits so you can set aside large amounts for retirement.
- “Catch-up” rules. Employees over age 50, including yourself, benefit from higher contribution limits.
- Lower taxable income. Employer contributions are deductible from the employer’s income. Employee contributions aren’t taxed until distribution, unless they’re going into a Roth.
- Faster growth. Retirement savings enjoy faster compound growth in a tax-free environment.
- Distributions may be eligible for tax-favored rollovers or transfers into other retirement programs.
- Tax credits for the ordinary and necessary costs of starting a SEP, SIMPLE, or certain other types of retirement plans. The credit equals 50 percent of the cost to set up and administer the plan, up to $500 per year for the first 3 years of the plan.
- Saver’s credit. Certain low- and moderate-income individuals, including those who are self-employed, get a credit for making contributions to their plans.
Selling Your Business
Chances are, that small business you’ve poured your heart and soul into might actually be one of your largest assets. If you’re ready to exit your business, you can find a buyer and liquidate your business.
Long before retirement, consider researching your potential sale price early, and update it often. Consider the sum that you’ll need for a comfortable retirement—this will give you a rough valuation goal to work towards.
Market conditions will affect your business’s value. We’d recommend building flexibility into your market plan so you can sell your stake during high times. Alternatively, you can opt to work a while longer if a recession hits. The most important thing is avoiding a distress sale. If you wait until the last minute to sell your business, potential buyers may perceive a distress sale, and you may have a lower chance of selling your company at a premium.
We Can Help
If you need help setting up a retirement plan for your small business, we’re happy to help you get started.
DISCLAIMER: Advisory Services offered through Prosperity Financial Group, Inc., an Independent Registered Investment Advisor. Securities offered through Fortune Financial Services, Inc. Member FINRA/SIPC. Prosperity Financial Group, Inc. and Fortune Financial Services, Inc. are separate entities.
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