Last Updated on February 5, 2020
If you are a self-employed individual or own a small business, you have a number of retirement plan options available to you. Here is a list of four retirement plans for small businesses, along with each plan’s pros and cons:
The Savings Incentive Match Plan for Employees (SIMPLE) IRA is suitable for many small business owners. If you have 100 or fewer employees who have earned $5,000 or more on payroll, this plan may be right for you.
Pros of a SIMPLE IRA
- Easy setup: To set up a SIMPLE IRA plan, you can use forms provided by the IRS. Use form 5304-SIMPLE if you’ll allow your employees to choose where to invest their SIMPLE IRA contributions. Use form 5305-SIMPLE if you plan to choose the financial institution for everyone on the plan. Once you’ve set up the plan, notify your employees about the changes, and you’re ready to get started.
- Affordable setup: It may not cost you a dime to set up a SIMPLE IRA plan. If it does, you may be able to write off the cost as a business expense on your taxes.
- Affordable maintenance: While your employees may incur some small costs for an investment adviser, you probably won’t have to pay anything for this plan, because there’s no administrator.
- Easy maintenance: Year-end paperwork for the SIMPLE IRA is surprisingly easy to understand and complete, so maintaining this type of plan is simple.
- Higher limits: A SIMPLE IRA offers higher contribution limits than a traditional or Roth IRA. Employees can contribute up to $13,000 to their account, plus a $3,000 catch-up contribution for employees older than 50. Employers are required to contribute either 3 percent of an employee’s total compensation.
- Matches are deductible: Money that you put into an account for your employees is tax deductible as a business expense.
Cons of a SIMPLE IRA
- Limited to small companies: This plan is formatted for very small businesses. So if you plan to grow your business beyond 100 employees, you’ll have to change plans down the road.
- Contributions count against your 401(k) contributions: If you’re running a side business and contribute elsewhere to an employer’s 401(k) program, this isn’t the best option for you. Contributions to a SIMPLE IRA count against the $18,500 limit for your 401(k), seriously limiting your overall retirement savings options.
- Big penalties may apply: With most other retirement accounts, you’ll pay a 10 percent penalty if you withdraw early. But with the SIMPLE IRA, the penalty can be as high as 25 percent of the account’s balance. Plus, within the first two years, you can’t roll your money into a new account without incurring this steep penalty.
- Accounts have to be open by Oct. 1: If you’re looking for a way to cut your tax bill this year, the SIMPLE IRA won’t do the trick. You must open an account by Oct. 1 to make contributions for that tax year.
- Mandatory contributions: As an employer, you’ll have to make certain contributions to your employees’ accounts, even if your business year isn’t going well.
- Low contribution limits: In contrast to other options for small businesses and the self-employed, the SIMPLE IRA has very low contribution limits. This can hurt you if you’re trying to save big for retirement.
The Simplified Employee Pension is as easy to work with as a SIMPLE IRA, but it could cost your business a lot more if you have more than one or two employees. In my case, I don’t have any employees, so the SEP IRA was ideal.
Pros of a SEP IRA
- Easy setup: Setting up a SEP IRA is as easy as setting up a SIMPLE IRA. Fill out form 5305-SEP, let your employees know, and get started.
- Affordable setup: Again, because setting up a SEP IRA is easy, there aren’t many administrative costs. And you may be able to write off the setup costs as a business expense.
- Easy maintenance: As with the SIMPLE IRA, administration for a SEP IRA account is simple.
- Non-mandatory contributions: Employers make all the contributions to a SEP account, but employees don’t have to make contributions, and contributions don’t have to be a set amount or percentage.
- Tax-deductible contributions: Any contributions you make to your IRA or your employees’ SEP IRAs are tax deductible as business expenses.
- Contributions don’t affect other accounts: Contributions that you make to an employee’s SEP IRA don’t affect your ability to contribute to another IRA account. Employees who also work for another business where they have a separate retirement account can still have a SEP IRA with your company.
- Good motivation: Many businesses run a SEP IRA so that the more a business profits, the more the employer contributes. This can be good motivation for employees to help boost the company’s bottom line.
- Can be terminated at any time: If your business grows beyond the point where a SEP IRA plan is a great idea, or if you let an employee go, the plan — and contributions to it — can be easily terminated.
- Larger contributions are possible: Unlike a traditional or Roth IRA, a SEP IRA lets you make fairly large contributions: $56,000 for 2019, or 25 percent of your net income.
Cons of a SEP IRA
- Employers contribute everything: With a SIMPLE IRA, part of the contributions can be taken out of the employee’s salary. With this plan, the employer makes 100 percent of the contributions.
- Contribution percentages must be the same: You can’t pay yourself a higher contribution percentage than your employees, which means this can become an expensive option if you add employees and want to keep your own contributions high.
- All employees must be included: Every employee who is eligible for this plan has to be included, which, again, can make it expensive if you start growing your business.
Solo (Individual) 401(k)
The Solo 401(k) retirement plan, also known as the Individual 401(k) or self-directed 401(k), is a type of 401(k) account for self-employed individuals or the owner of a very small business. It can be a great way to boost your retirement savings.
Pros of a Solo 401(k)
- More contribution possibilities: By using a Solo 401(k) for yourself and your spouse, if he or she works as your employee, you can contribute as an employee and as an employer. Therefore, you can cap your contributions as an employee and then have your business contribute up to 25 percent of your total earnings.
- Flexible contributions: You don’t have to contribute a set amount to a Solo 401(k) each year, so you can contribute less if you have a tough year or more if you have a good year.
- Tax-deductible employer contribution: If you make a contribution to this account as an employer, the contribution will be deductible as a business expense.
- Contribute in the next calendar year: You can set up a Solo 401(k) by Dec. 31 to make contributions for that tax year all the way up to the April 15 filing deadline (plus extensions). This makes it a good way to shelter some of your income if you need to reduce your tax bill.
Cons of a Solo 401(k)
- More complicated: A Solo 401(k) isn’t as complex as some plans, but it is more complicated than the IRA plans for small business owners. You’ll have to find a plan administrator to set up your plan.
- More expensive: The Solo 401(k) isn’t incredibly expensive, but it will cost you some money to set up and maintain, especially because you have to pay administrator fees.
- Required reporting: Once there is at least $250,000 in your account, you must report your benefits through form 5500 annually.
Defined Benefit Plan
Defined benefit plans, like pensions, are becoming much less common with big businesses. But they can be a great way for small-business owners and the self-employed to save more for retirement than they would otherwise be able to save.
Pros of Defined Benefit Plans
- You can contribute a lot of money: This expensive plan is best for business owners who are looking to save a lot of money for retirement and who consistently have money available to save. You can use it to save more than $224,000 a year for retirement.
- Can be combined with other options: Because a defined benefit plan is so different from other retirement savings accounts, you can combine it with a Solo 401(k) or a SEP IRA to save more.
- Reduce tax liability: Defined benefit plan contributions can be written off as business expenses, reducing your business income and personal income, which can decrease your tax rate and your tax bill.
Cons of Defined Benefit Plans
- Costs are high: With this plan, an actuary needs to run calculations to determine minimum funding levels for each employee every year, which can be very costly.
- You have to make the minimum funding: When you set up Defined Benefit Plans, you’re committed to funding it at a certain level to meet the eventual payout, even if your business has a bad year. It’s important to ensure your business can handle the minimums, regardless of cash flow.
- Payouts are limited when you set up the plan: When you set up Defined Benefit Plans, you define your payouts at the start. You can withdraw only a set amount per year during retirement, unless you roll the money into another retirement account.
- They’re not great for more employees: Defined benefit plans are created for your entire company, so payouts depend on how long someone works for you, etc. If you use this plan for your retirement, you’ll have to offer it for your employees as well, which can get expensive. This is why defined benefit plans have become less popular for larger businesses but may still be a good option for a solo operation or if you plan to only ever have one or two employees.
Get in Touch
If you want to learn more about the retirement plans for small businesses and the self-employed, contact IRA Financial by calling us at 800-472-0646. You can also fill out the form on this page or on our contact page.
We look forward to hearing from you.