On a recent business trip, I had a lively conversation with a small business owner who was on a mission to start a retirement plan. He wanted a good place to save some money tax deferred and to take care of his key employees. Great idea!! You know I’m a big fan of putting some money away for down the road.
Just get a 401(k) and go, right? Well, maybe. You may not know this, but there are quite a few different retirement options out there and many specifically designed for small businesses. Let’s go over the essentials so you too can make a great decision for your company.
Three options stand-out depending on what you want to accomplish with your plan and how much flexibility you need. These are: 401(k) plans, SEP IRAs and SIMPLE IRAs. Now for a quick quiz. Simply answer these questions and you’ll start honing in on the best fit for your business:
- Can I afford a match for my employees?
- Do I want to allow employees to contribute to the plan?
- If so, will some want to save more than $11,500 a year?
- Do I need flexibility to access the funds prior to retirement for emergencies?
- How important are managing future taxes (a Roth option) versus my tax needs today?
Other things to consider include whether you want a profit sharing option or not, and do you have a business that experiences high employee turnover. If you expect high turnover, a vesting schedule for profit sharing and/or matching contributions can be a great way to go.
Are you ready to wade a little deeper into the retirement plan pool? I hope so. Here’s the plain English overview of each of the three plan types including a side-by-side comparison chart to help you sort it out.
The 401(k) Offers the Most Flexibility and High Contribution Limits
The traditional 401(k) is probably the most widely known retirement product on the market. It’s the fully loaded, high performance SUV of retirement plans. It’s generally defined as one that enables a business owner and employees to make consistent, tax-deferred contributions during the length of their careers.
But 401(k) plans offer a lot more versatility than that. 401(k)s not only offer higher contribution limits than most other plan options, but also offer more choices in design to manage business costs and program saving goals. You can choose to match or not, provide a vesting schedule, or enable penalty-free access to funds via a loan if an emergency arises. 401(k) plans also allow for “catch-up” contributions after reaching the age of 50. In 2011, employees can contribute up to $16,500 if under 50 years of age, $22,000 if over.
For small businesses and employees that may fear higher tax rates down the road, the Roth 401(k) enables participants to have their contributions taxed up-front, but withdrawals in retirement are tax-free, earnings and all. This can be a big help in managing your tax situation and money over time.
SEP IRAs are Pretty Easy to Start and 100% Funded by the Employer
Simplified Employee Pensions, more commonly referred to as SEPs, are also a popular retirement plan choice as they offer a contribution limit that’s similar to a 401(k). It doesn’t have all the bells and whistles of a 401(k) plan, but it’s got a good engine under the hood. One of the most important things to understand about SEPs is that 100 percent of the contributions made are by the employer (no employee contributions allowed) and these dollars are immediately vested for the employee. There is no Roth option, no loan option, no profit sharing option, and no catch-up contributions for those over 50 years of age like there are with a 401(k). But it also doesn’t generally have the added IRS tests and reporting that 401(k)s plans do.
The SIMPLE IRA is a Solid, Affordable Third Option
I’m going to move off the car comparison for this one. I compare a SIMPLE IRA to having the middle seat on the airplane. Flying is a much faster way to travel long distances than driving, but it’s just not as good as having the window seat and definitely not as nice as flying first class. The SIMPLE IRA’s name is a bit misleading (it actually stands for Savings Incentive Match Plan for Employees). While both employer and employee can contribute to the plan, the employer must match and matching is vested immediately. Also, the employee contribution limit is set at $11,500 for 2011, a full $5,000 less than a 401(k). The catch-up for those over 50 is also less at $2,500 versus $5,500 for a 401(k). It also doesn’t have Roth or loan options, but like the SEP, avoids those pesky IRS tests and reporting requirements of a 401(k).
A summary of important differences outlined here below:
|2011||401(k)||SIMPLE IRA||SEP IRA|
|Who can contribute||Employee; Employer optional||Employee & Employer||Employer only; must contribute for all eligible employees|
|Max Employee Contribution||$16,500 w/$5,500 catch-up if over 50 years old||$11,500 w/$2,500 catch-up if over 50 years old||Not applicable|
|Employer Contributions||Optional, up to 100% of an employee’s compensation with a $49K cap via match, profit share, or other employer contribution||Required match of 100% on the first 3% of participating employee contributions or 2% of all eligible employee salaries||Optional, but only way to fund; up to 25% of an employee’s pay with a $49K cap|
|Vesting Timing for Employer Contributions||Multi-year options or immediate||Immediate||Immediate|
|Access to Funds before age 59 ½||Penalty-free loans or 10% penalty for early withdrawal||25% penalty for withdrawing within first 2 years of participating; 10% thereafter||10% penalty for withdrawal before age 59 ½|
Now you have the scoop on what I consider the best retirement plan options for businesses with less than 25 employees.