Small Business Retirement Plans: Comparing SIMPLE, SEP-IRA and SOLO 401(k)s
As a busy small business owner myself, I know how hard it can be to find enough hours in the day to run your business, let alone to think ahead to retirement. Before you know it though, you can wake up one day and wonder where the time went and begin to feel unprepared for what's next.
It's much easier to save for retirement when you work for a company with a 401(k) or similar plan that you can sign up for when you start working there. Luckily, small companies don't have to forgo retirement savings just because a 401(k) plan can be time-consuming and expensive to set up and maintain. There are options specifically for smaller businesses: a Savings Incentive Match Plan for Employees (SIMPLE) plan, a Simplified Employee Pension (SEP) plan and a SOLO 401(k).
If your company has more employees than just you and your spouse, you may want to consider either a SIMPLE IRA or a SEP-IRA. The plans have similarities and a few differences that must be considered when deciding between the two. Knowing the details of each type can help you decide which is the best choice for you, or which to offer your employees if you own a small business.
They’re Called SIMPLE Plans for a Reason
The SIMPLE IRA enables employees and employers to contribute to Traditional IRAs—they cannot be Roth IRAs—expressly set up for employees. The plan is more cost-effective for a small company (typically 100 or fewer employees) to set up than a 401(k), which requires both set-up and ongoing administrative costs.
Setting up a SIMPLE IRA comes down to completing a form, and there are no filing requirements. However, the company cannot have any other retirement plan. The plan must be set up by and for each eligible employee. To qualify, a worker must have earned at least $5,000 from the company in each of the past two years and plans to receive compensation of at least that much in the current year.
All contributions must be invested in the IRA account. Contributions are not subject to federal income tax withholding. SIMPLE IRAs can be set up at banks, savings and loan associations, insurance companies, regulated investment companies, federally insured credit unions, and brokerage firms.
Contributions can be invested in stocks, mutual funds, ETFs and other similar types of investments. The available investment options depend on what's provided by the financial company maintaining the account.
The SIMPLE IRA Employer Contribution
The employer has a choice about contributing annual funds to the plan:
Non-elective contributions: The employer contributes 2% of each employee’s salary into the plan each year, even if the employee does not contribute.
Elective contributions: Dollar-for-dollar matching contribution, up to 3% of the employee’s salary.
The employee is always 100% vested in all the SIMPLE IRA funds.
This Simplicity Comes with a Cost Compared to Other Plans
This plan is easy and inexpensive to set up and maintain, and employees share responsibility for saving for retirement. However, the plan has inflexible contributions and lower contributions limits than other retirement plans. An employee can salt away more money each year in a 401(k) plan or SEP-IRA.
Participants cannot take out loans from these plans because the assets may not be used as collateral. An employee can withdraw funds, but the loan would be added to income and the IRA adds 10% to the tax bill for employees younger than 59.1/2. If the employee withdraws funds within the first two years of participating in the SIMPLE plan, the IRS bumps up the 10% additional tax to 25%.
Comparing the SEP-IRA Plan
Simplified Employee Pension (SEP) plans can provide a significant source of retirement income by allowing employers to save money in retirement accounts for themselves and their employees. Like SIMPLE IRAs, SEPs lack the start-up and operating costs of a conventional retirement plan. Unlike it, they allow for a contribution of up to 25% of each employee's pay.
How they're different from other retirement plans is that employees enrolled in a SEP-IRA do not deposit funds directly to their savings plan. Instead, the employer makes the contributions on their behalf. One key benefit: SEP-IRAs permit employers to omit contributions during years that the company is not generating a profit or is experiencing declining sales.
Most SEPs require that company owners make allocations proportional to employees' salaries. As a result, all the contributions for the employees should be the same percentage of salary. Employees can start contributing after working three years at the company and must make at least $650 per year. Annual contribution limits are higher than standard IRAs, and those contributions are vested right away.
How to Establish a SEP-IRA Plan
Setting up a SEP is different than establishing a SIMPLE. The employer first has to choose a financial institution to serve as trustee of the SEP-IRAs that will hold each employee's retirement plan assets. These accounts will receive the contributions made to the plan.
There are three steps to establish a SEP:
Execute a written agreement to provide benefits to all eligible employees.
Give employees specific information about the agreement.
Set up an IRA account for each employee.
There’s a Plan for One-Man Shops Too: The Solo 401(k)
Self-employment has many advantages and perks, but one benefit that's typically not available to many small business owners or entrepreneurs is an employer-sponsored retirement plan like a 401(k). To provide retirement options for solo business owners, the IRS allows for a solo 401(k), which is a one-participant 401(k), shares in many of the aspects of an employer-sponsored 401(k) plan.
To describe these plans, the IRS states that the business owner wears two hats in a Solo 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can contribute both:
Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit of $20,500 in 2022 or $27,000 in 2022 for those age 50 and older.
Employer nonelective contributions are up to:
As the employer, you can contribute additional profit-sharing funds of up to 25% of your compensation or net self-employment income—i.e., your net profit less half your self-employment tax and the plan contributions you made for yourself.
The limit on compensation used to factor in your contribution is $305,000 this year.
Total contributions to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed $61,000 this year. The one exemption to a solo 401(k) is your spouse – they can contribute too, if they work in the business.
The Bottom Line
There are a lot of options to consider when making a decision about which type of plan to roll out for your small business. If you'd like more detail, take a look at this handout with a table that shows the options available under each type of plan.
If you'd rather get some guidance on which plan makes the most sense for your personal and professional situation, working with a financial planner like me can help.
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