This article was co-written by Blake Faust, Retirement Plan Services Leader at Wipfli Financial Advisors, LLC
Setting up a retirement plan for your business comes with a wide range of benefits. It’s a great way to attract and retain employees, maximize your own retirement savings as the owner of the business and gain business tax deductions on employer contributions.
Of course, one of the biggest concerns small business owners have is selecting the right retirement plan for their company. Each of the three plans below has distinct benefits, as well as certain drawbacks — it all depends on what your ultimate goals are as a business and the owner of that business.
With that in mind, here’s our small business retirement plans comparison:
A Simplified Employee Pension (SEP) plan allows employers to contribute pre-tax money into IRA accounts for employees.
Contributions: SEP-IRAs only allow employer contributions, and all eligible employees will receive a uniform percentage of compensation as a contribution — meaning, if you as the business owner elect to contribute 25% to your own SEP IRA account, you would be required to contribute 25% of compensation to all eligible employee’s accounts.
A SEP-IRA is a good option if your goal for the plan is to serve as an added benefit, since employees don’t need to contribute their own dollars to receive the benefit. However, if the goal is to maximize savings for retirement, then it may not the best option; you’d instead want a plan that also allows employee contributions.
Flexibility: SEP-IRAs are flexible in that they allow your business to raise or lower the contribution amount from one year to the next. Considering the COVID-19 pandemic negatively impacted so many small businesses, being able to lower their SEP-IRA contribution amount to weather this impact showed why this can be a significant benefit.
Tax deductions: In years your business performs well, you can increase your contribution amount and therefore take a larger tax deduction.
SIMPLE IRAs differ from SEP-IRAs in that they not only require an employer contribution but also permit employee contributions.
Flexibility: SIMPLE IRAs are less flexible than SEP-IRAs in that the employer is required to contribute either 1) a match of up to 3% of compensation or 2) a 2% nonelective contribution for each eligible employee. This means your business cannot make additional contributions in years it performs well and so cannot increase the tax deductions it can take for those contributions.
Eligibility: Employees are eligible if they received at least $5,000 in compensation in the preceding two years, so the eligibility threshold is very low. This is also true of the SEP-IRA, where anyone over 21 years old, who earned at least $650 in 2021 and who has worked for your business for any three of the last five years, is eligible.
Vesting: In both SIMPLE and SEP-IRAs, all contributions are immediately 100% vested, meaning employees keep the full amount in their retirement plan balance (both employee and employer contributions) upon leaving the company.
401(k) plans — which allow both employer and employee contributions — offer several distinct benefits from SEP and SIMPLE IRAs.
Contributions: 401(k)s allow employees to make either traditional or Roth contributions. Roth contributions are taxed at the time of the contribution instead of at the time of distribution (aka when the employee is retired). This benefits employees who are early in their careers and/or in a lower tax bracket, as they’ll pay lower taxes on the contributions now than they would taking the distribution in retirement after they’ve presumably advanced their career and earnings.
Vesting: 401(k)s provide the ability to set a vesting schedule for employer contributions to the 401(k). These schedules are often tiered depending on the employee’s tenure. For example, at two years with the company, the employee might be 20% vested, and the vesting percentage increases at 20% every year until the employee becomes 100% vested at six years with the company.
Vesting schedules can be used as a retention tool for employers, as employees may be motivated to keep more of the employer contribution in their retirement plan by staying longer with the firm.
Eligibility: 401(k)s provide flexibility around eligibility. Employers can set a lower or higher threshold of eligibility depending on their goals. If your goal is to attract talent to your organization, setting a lower eligibility threshold makes them eligible to make and receive contributions sooner. If your industry experiences higher turnover and your goal is to retain employees, you can raise the eligibility threshold as an incentive for them to stay at your company and receive the benefit of a retirement plan. This also saves your business money in that you’re not contributing to as many employees’ 401(k)s.
Complexity: Because 401(k)s give you much more flexibility in how to design the plan, they can also be more complex. While SEP and SIMPLE IRAs are designed to be simple, cost-effective and self-administered by the employer, 401(k)s require a third-party administrator and an annual filing requirement to ensure the employer stays in compliance with the IRS and Department of Labor.
All three retirement plan options have penalties for not complying with applicable rules, so it’s important that you understand the requirements or partner with a third party administrator that can help you stay in compliance.
How business owners can maximize their personal savings
As a business owner, it’s likely most of your wealth is tied into your business. This makes building wealth outside the business a priority — and retirement plans offer a great opportunity for you to invest significant amounts of money into a tax-deductible plan.
- A SEP-IRA allows the business to contribute up to 25% of your compensation or $58,000, whichever amount is lesser.
- A SIMPLE IRA lets the employer select either a nonelective contribution of 2% of the employee’s compensation (with a max annual contribution of $5,800) or a 3% match (with a max annual contribution of $8,700). Plus, the employee can contribute up to $13,500 for the year 2021 through payroll.
- A 401(k) allows the business to contribute up to 25% of compensation to employees as matching contributions, non-elective contributions, or both. Plus, the employee can contribute up to $19,500 for the year 2021 through payroll. The total contributions to an employee cannot exceed the lesser of 100% of their compensation or $58,000 (assuming they are under the age of 50 and do not qualify for catch-up contributions).
As you can see, employer contributions can be quite rewarding for highly compensated employees. This enables you as the business owner to grow your wealth outside the business and better enables the business to attract and retain talent.
How to choose a retirement plan: Strategize with experts
When it comes to choosing a retirement plan for your small business, there is no one-size-fits-all approach. It all comes down to which plan best fits the needs and goals of you, your employees and your business.
Even small businesses that currently have a retirement plan should review it every few years to determine how the business has changed and whether it’s still meeting their goals or if the business should transition to a different type of plan or provider.
Wipfli and Wipfli Financial Advisors can help. We walk through your goals, take you through your options and help you select the right plan. Wipfli can assist with designing the plan, creating the plan document, complying with the plan provisions and providing third-party administration services for 401(k) plans. Wipfli Financial Advisors can help you develop your investment lineup, take on fiduciary responsibilities, and provide participant education so they feel comfortable enrolling in the plan.
Ready to select your retirement plan? Contact us to get started.
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