I spend a lot of time working with business owners, CFOs, and HR Directors to help them determine the right kind of retirement plan for them and their employees. There are quite a few different types of retirement plan options that cater to the particular needs of businesses of varying sizes- from the self-employed individual to large enterprises. Three retirement plan 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.
It can be complicated to wade through the “alphabet soup” of options, so let’s review some essentials before determining what may be the best fit.
The 401(k) Plan
By far the most popular retirement plan offered to employees is the 401(k) plan. Of the various options, the 401(k) plan offers the most flexibility and the highest contribution limits. The 401(k) plan is often preferred because it enables business owners and employees to make the most consistent tax deferred contributions. In 2017, employees can contribute up to $18,000 if under 50 years of age, $24,000 if 50 or older. If coupled with a profit sharing plan, the total contribution limits are even higher.
Not only do 401(k)s offer higher contribution limits than most other plan options, but they also offer more choices in terms of plan design to manage business costs and savings goals. For instance, you can institute a discretionary match on employee contributions, implement vesting parameters on match dollars, or offer a Roth 401(k) option for owners and employees that may fear higher tax rates down the road. You can also allow features such as employee loans or hardship withdrawals for increased flexibility.
But, with increased flexibility comes increased administrative and compliance oversight. Generally, 401(k) plans have higher administrative costs than IRA alternatives and require annual compliance tests and filings.
The SEP stands for Simplified Employee Pension Plan. The biggest advantage of SEP-IRAs is that they have contribution limits similar to a 401(k) without the added compliance tests and reporting. With a SEP-IRA, you can contribute up to 25% of your compensation or $54,000 (whichever is lower) into an IRA. As an added benefit, these SEP-IRA contributions are considered a deductible business expense, they do not count toward the individual IRA limit, and they do not count as yearly income for the employee. These annual contributions are also flexible and discretionary- good if cash flows are inconsistent from year to year.
Although relatively easy to set up and administer, the SEP-IRA does not have all the bells and whistles of a 401(k) plan. Generally speaking, there is no option for Roth contributions, loans, profit sharing, or catch up contributions for those over 50.
It is also very important to note that 100% of the contributions are made by the employer (no employee contributions allowed) and are 100% immediately vested. Also, if you have employees, you must generally also fund SEP-IRAs for them as well and the percentage of W-2 earnings must be uniform across all employees. So for example, if you as a business owner give yourself 25% of your W-2 earnings, your employees must receive 25% as well. For these reasons, SEP-IRAs tend to be favored by sole practitioners or firms with fewer employees.
The SIMPLE IRA
A SIMPLE stands for Savings Incentive Match Plan for Employees. Like SEP-IRAs, these plans tend to be favored by small employers as they are easy to set up and administer. Like 401(k)s, these plans also provide a single method for both the employer and employee to contribute.
Under a SIMPLE plan, each participant has their own IRA set up under the plan and employees have the choice to contribute up to $12,500 (or up to $15,500 for those 50 years old and older) in 2017. Contributions are pre-tax and taken directly out of employees’ paychecks. Additionally, employers are required to make a 3% matching contribution or 2% non-elective contribution. Like other plans, the SIMPLE IRA allows employers a tax deduction for contributions made to the plan on behalf of employees.
The biggest drawback to a SIMPLE IRA is that the employee deferral limit is $12,500 (or $15,500 for those 50 and older,) the lowest of any of these options outlined, and are generally only allowed for businesses with less than 100 employees. The employer is also beholden to making inflexible contributions on behalf of employees.
Seek Professional Advice
As you can see, each plan type has its merits as well as drawbacks; there is no “one size fits all” solution. Before you make a decision on which plan is right for you, you should seek professional counsel, preferably from a fiduciary advisor, to weigh options and determine the best fit based on your goals and objectives.
Vanessa McElwrath, CFP ® is a wealth advisor with ML&R Wealth Management a locally owned Registered Investment Advisor in Central Texas. For 20 years, ML&R Wealth Management has served individuals, families, businesses and nonprofits with wealth management services, custom retirement and 401k plans and portfolio management. ML&R Wealth Management designs and manages tailored retirement plans that benefit business owners and their employees by an investment philosophy based on a long-term outlook and full transparency in pricing with no hidden fees.