Owning your own business means you have more control over your working life, but it also means that you’re on your own when saving for retirement. Like most Americans, small business owners struggle to save enough. A 2013 TD Ameritrade study found that 7 in 10 entrepreneurs aren’t saving regularly (if it all) for retirement.
It’s tough to manage cash flow to fund life expenses, the demands of a growing business, and retirement savings simultaneously. And there are many plans available, so it’s not straightforward to determine the best way to save.
Retirement planning for entrepreneurs isn’t easy, but it’s important. Both you — and your employees — will need a nest egg in the future.
There are five types of retirement plans that small-business owners might consider:
- Savings Incentive Match Plan for Employees (SIMPLE IRA)
- Simplified Employee Pension Plan (SEP IRA)
- Self-Employed 401(k) Plan
- 401(k) Plan
- Defined Benefit Plan
We’ll focus on how these plans might benefit very small businesses with 10 or fewer employees. Keep in mind the right plan will depend on your personal preference, as well as the size and structure of your business, so you’ll want to speak with a financial planner who can help you determine the best option.
SIMPLE IRA
If you have 100 or fewer employees who expect to earn $5,000 this year, your business is eligible for a SIMPLE IRA plan. With this plan, the employer matches 1-3% of an eligible employee’s compensation, and the employee can contribute up to $12,500 per year ($15,500 for employees age 50 or older).
The Pros and Cons
There are two big benefits of a SIMPLE IRA. One, the plan is easy and cheap to both setup and maintain. It’s as simple as filling out a few forms to begin, and there’s a small amount of paperwork at the end of the year. You’re not required to have a plan administrator, so the plan is inexpensive.
Second, the SIMPLE IRA allows an employer to provide a smaller match to employees, while allowing the employee to contribute more. The matches are also tax deductible as a business expense.
There are downsides as well. Contributions to a SIMPLE IRA count against your 401(k) contributions, so it’s not a good fit if you’re running a side business and want to contribute elsewhere to a 401(k). Also, there are large penalties for withdrawing funds from the account — 25% if it’s within the first two years of participation, and 10% thereafter until retirement age.
Who’s It Good For?
SIMPLE IRAs are a great starter retirement plan for many small businesses with a few employees. This plan is easy to administrate, and it allows the employer to contribute a nominal amount while allowing employees to save more for retirement.
SEP IRA
A SEP IRA allows a business owner to put away 25% of a participant’s compensation or a maximum of $53,000, whichever is less. An employee can contribute up to $5,500 to the plan for the 2015 tax year ($6,500 for employees aged 50 or older), but this counts towards the IRS limit for SEP, Roth, and traditional IRAs every year.
Pros and Cons
Like the SIMPLE IRA, a SEP IRA is easy to setup and administrate. And depending on business profits, a SEP IRA can help a business owner tuck away a great deal for retirement.
However, a SEP IRA isn’t a great fit for a business with employees. There are rules about how long an employee has to work for the business. Employers also contribute 100% of the money to a SEP IRA. And contributions are the same for everyone, so if you want to put away a lot for yourself, you’ll also be putting away a bunch for your employees too.
There is some amount of flexibility with a SEP IRA. Contributions are not required every year. Withdrawals are permitted, but there’s a 10% penalty for those under age 59 ½ .
Who’s It Good For?
A SEP IRA is a good fit for a small business comprised of only owners and/or high-value employees.
401(k)
401(k)s are very common in companies of all sizes. Employers can contribute up to 100% of compensation to a maximum of $53,000 ($59,000 for employees age 50 or older) between employee and employer. Only 25% of compensation is tax deductible. Employees can contribute 100% of compensation, up to a maximum of $18,000 ($24,000 for employees age 50 or older).
Pros and Cons
401(k)s are great plans, and they’re widespread for a reason. Employers have flexibility around how much of an employee match they provide, but employees can contribute a large amount at any time. Early withdrawals are subject to a 10% penalty, but loans may be permitted. Employers can offer both Roth and Traditional options.
However, the plan can be cost-prohibitive for small businesses. Plan sponsors have administrative and fiduciary responsibilities.Very small businesses would probably be better served with a different plan.
Who’s It Good For?
Small to large companies will benefit from providing a 401(k) plan, but it’s too expensive and complicated for very small companies.
Solo (Individual) 401(k)
Solo 401(k)s are very similar to traditional 401(k) plans, but these plans are meant for sole proprietors or partnerships (and their spouses). The plan has the same contribution limits as regular 401(k)s. The limit is $18,000 for employee contributions ($24,000 for employees age 50 or older), and a maximum of $53,000 between employer and employee contributions ($59,000 for employees age 50 or older).
Since the plan is restricted to sole proprietorships and partnerships, it’s easy for the business owner to contribute the full $53,000 if funds are available. Like regular 401(k)s, up to 25% of compensation is tax deductible.
Pros and Cons
A solo 401(k) is a great plan for sole proprietorships and partnerships. There’s a lot of room for contribution. If you set up a solo 401(k) by December 31st, you can contribute all the way up to your tax filing deadline. Like other 401(k) plans, there’s also the possibility for withdrawals (10% penalty if before retirement) or hardship loans if necessary.
The plan is slightly more complicated to set up than the SEP IRA and SIMPLE IRA, but not much. Unlike a regular 401(k), there aren’t huge admin costs and fiduciary duties. If you have over $250,000 in your account, there is additional yearly reporting, but that’s it. The main drawback is that only some businesses qualify for this account!
Who’s It Good For?
A solo 401(k) is a great way for sole proprietors or partnerships (and their spouses) to save for retirement.
Defined Benefit Plan
Defined benefit plans are plans where the benefit is determined, but the necessary savings to generate the benefit vary. The other plans discussed above are defined contribution plans, where contribution amounts are set but a specific benefit isn’t guaranteed. These plans act like a traditional pension, and they are less common now than in the past.
Pros and Cons
The best part about a defined benefit plan is that you can sock away a large amount — over $100,000 — in a tax-advantaged account. Since defined benefit plans operate differently than the other defined contribution plans discussed above, you can also use those plans as well to put away over $150,000.
This big perk does come with some downsides. You’re required to keep funding the plan, even in down years, or else you’ll face additional taxes from the IRS. There’s also less flexibility in determining your retirement income, as you set your retirement payouts when creating the plan.
Defined benefit plans are also more expensive to run as an actuary has to run calculations every year to determine the necessary funding amounts. And since defined benefit plans are for the whole company, it can get expensive with multiple employees.
Who’s It Good For?
Defined benefit plans are a good choice for businesses with a small number of owners. The business should also be generating a large enough revenue to take advantage of the additional contribution room, especially considering the expense of the plan. It also helps if the entrepreneur is closer to retirement age — you don’t want to sign up for 30 years of unknown required pension contributions!