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 businesses, keeping in mind what is best 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 — making it complicated to answer questions like, “What is the best retirement plan for small business owners and sole proprietors?” or “What is the best retirement plan for large enterprises?”
Fortunately, when it comes to the types of retirement plans offered by employers, three options stand out. The best plan for your business will depend on what you want to accomplish and how much flexibility you need. These are 401(k) plans, SEP IRAs, and SIMPLE IRAs.
By far the most popular retirement plan option offered to employees is the 401(k) plan. Of the various plan models, 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 2020, employees can contribute up to $19,500 if under 50 years of age, $26,000 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 types of retirement plans offered by employers, 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 who may fear higher tax rates down the road. You can also allow features such as employee loans or hardship withdrawals for increased flexibility.
However, 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. This makes a 401(k) plan less attractive to those who are wondering what the best retirement plan is for a small business.
The SEP stands for Simplified Employee Pension Plan. Compared to other retirement plan options, 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 $57,000 (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 — this is 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 retirement plan options like a 401(k). 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.
If you have employees, you must generally 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 more desirable retirement plan options for sole practitioners and firms that are asking the question, “What is the best retirement plan for a small business?”
SIMPLE stands for Savings Incentive Match Plan for Employees. Like SEP-IRAs, these types of retirement plans offered by employers 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 $13,500 (or up to $16,500 for those 50 years old and older) in 2020. 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 retirement plan options, 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 compared to other retirement plan options is that the employee deferral limit is $13,500 (or $16,500 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.
As you can see, each one of the retirement plan options has its merits as well as drawbacks; there is no “one size fits all” solution. Before you make a decision about which plan is right for you, you should seek professional counsel — preferably from a fiduciary advisor — to weigh the different options and determine the best fit based on your goals and objectives.
Are you responsible for administering your company’s 401(k) plan? Are you wondering what the best retirement plan for a small business is? Would you like more insight and resources regarding the types of retirement plans offered by employers?