Say you’re running a small business. You’d like to start saving for retirement and take advantage of some of the tax savings opportunities out there that are associated with retirement plans, and if your business has employees, perhaps you would also like to give your employees the opportunity to save as well. A retirement savings plan can certainly be an attractive perk to potential employees.
What are your options? What are the pros and cons of the different options that are available? This can be a complex topic that can be difficult to follow. In this blog post, we will try to go through the various options for retirement plans for small businesses in plain, understandable English.
What are the key benefits of a 401(k) or IRA?
The main benefit of an IRA or 401(k) plan is that it allows you to defer recognition of income tax - both on amounts deferred and investment gains – until the amounts are distributed from the plan. Additionally, employers can take a deduction with respect to all amounts they contribute to the plan. As we will see later on in this article, small business owners who have a solo 401(k) plan can participate in the plan as both an employer and employee and thus potentially enjoy the tax benefits available in both categories.
With respect to Roth plans, employee contributions can only be made on an after-tax basis, so you can’t defer recognition of income with respect to amounts that are being contributed into the plan. On the flip side, however, the key advantage of a Roth plan is that amounts distributed from the plan upon retirement are not subject to income tax upon distribution (which is the case with respect to a standard 401(k) plan or IRA). This means that your investments would generally grow tax-free in a Roth plan.
What are the differences between an IRA and a 401(k) plan?
The main differences between IRAs and 401(k) plans are as follows:
The structure of the plan: An IRA is simply a retirement account that is established for the purpose of earning tax-deferred income that is intended to be saved until retirement. In a 401(k) plan, contributions are made to and held in a tax-exempt trust.
Contribution limits: The contribution limits for plan participants are much lower for IRAs than they are for 401(k) plans. For 2019, contributions to IRAs are capped at $6,000 ($7,000 if you are 50 years old or older), while the contribution limit for 401(k) plans is $19,000 for individuals who are under age 50, and $25,000 for individuals who are 50 years old and older.
Contribution limits for Roth plans: For Roth IRAs, the contribution limit begins to decrease when an employee’s income reaches $122,000 (for 2019; $193,000 if married filing jointly), and no contributions are permitted if income exceeds $137,000, $203,000 if married filing jointly (limits are for 2019). If a company offers a Roth 401(k), on the other hand, there is no maximum income limit.
Whether contributions can be made on a pre-tax basis: You can contribute to your 401(k) on a pre-tax or after-tax basis. IRAs do not accept pre-tax contributions, but all contributions made are tax-deductible. As stated above, contributions to Roth plans can only be made on an after-tax basis.
Investment options: The law does not allow IRA funds to be invested in life insurance or collectibles. No such limitations apply with respect to 401(k) plans.
Roth option for SIMPLE plans. A SIMPLE 401(k) plan can include a Roth feature, but a SIMPLE IRA cannot. Otherwise, 401(k) plans and IRAs can be structured as either standard or Roth plans.
Loans can be taken from a 401(k) plan, but cannot be taken from an IRA.
Prohibited Transactions: The consequences of prohibited transactions are quite different for a 401(k) plan and an IRA; a prohibited transaction completely disqualifies an IRA, resulting in a deemed distribution of the IRA assets, and a prohibited transaction involving a 401(k) plan results in an initial tax of 15% of the amount involved for each year (or part of a year) in the taxable period. If the transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved is imposed.
SEP IRAs
Differences between SEP IRAs and standard IRAs: SEP-IRAs are similar to standard IRAs, except that they are pure “profit-sharing” plans. This means that companies can make contributions to their employees’ retirement accounts, but employees cannot defer any income into their SEP accounts.
Contribution requirements and limits: Employer contributions do not need to be made by the company every year and are capped at the lesser of (a) 25% of employee compensation, or (b) $56,000 (for 2019). Note that the employer must contribute equally for all eligible employees and that all eligible employees must participate in the plan. Employees covered by union agreements and nonresident aliens with no US source compensation can be excluded from a SEP plan.
Employer eligibility: Any employer, including self-employed individuals, can establish a SEP. A SEP can be set up for a given tax year as late as the due date (including extensions) for the business’s tax returns to be filed with the IRS; conversely, other arrangements need to be established prior to calendar year-end for a given tax year. Someone can set up a SEP for the self-employment business even if they already participate in their employer’s retirement plan at a second job. Finally, unlike with respect to a SIMPLE plan, a business can maintain both a SEP plan and another retirement plan.
Employee eligibility: A SEP must allow all employees who have satisfied the following minimum requirements to participate in the SEP and receive employer allocations: (a) attainment of age 21, (b) performance of services for the employer during at least three of the immediately preceding five years, and (c) the employee has received compensation equal to or exceeding an inflation-adjusted minimum compensation threshold ($600 for 2019) from the employer within the last three years. Employers can provide for more flexible minimum participation requirements than the ones stated in the previous sentence if desired.
Spousal Option: Each spouse must separately meet the SEP requirements in order to receive an employer contribution.
Payroll Deduction IRA
This arrangement is the simplest type of retirement plan for small employers and simply requires the employer to set up an IRA for each eligible employee. The employer’s involvement is limited to transmitting employee payroll deductions, and no employer contributions need to be made; in fact, they are not permitted for Payroll Deduction IRAs. With respect to Payroll Deduction IRAs, employee contributions are limited to $6,000 for 2019.
SIMPLE IRA
Overview: A SIMPLE IRA permits contributions from both employers and employees but is only available to employers with 100 or fewer employees who received $5,000 or more in compensation in the preceding calendar year.
Employer Contributions: Employers can make deferral contributions of up to $13,000 for 2019. Employers must either (a) match employee contributions dollar for dollar up to 3% of compensation, or (b) make a fixed nonelective contribution of 2% of compensation (up to the annual compensation limit, which is $280,000 for 2019) for all eligible employees, even those who do not contribute. An employee must be fully vested in employer contribution.
Employee contributions: Employees may contribute to the SIMPLE IRA on a pre-tax basis.
Exclusivity: The SIMPLE plan must be the exclusive retirement plan maintained by the employer, other than with respect to employees who are permitted to be excluded from participating in the IRA (e.g., union employees).
Solo 401(k) Plans
Key advantages:
Employee/employer contributions: Solo 401(k) plans allow small business owners to contribute to their retirement plan in both their capacities as an employer and an employee.
For 2019, this means that plan owners can contribute up to 100% of compensation (or “earned income,” for self-employed individuals), capped at $19,000 for 2019 ($25,000 for individuals age 50 and older), plus employer non-elective contributions of up to 25% in “compensation.” Total contributions (not including “catch-up” contributions for those who are age 50 and older) are capped at $56,000.
No testing required: A business owner with no common-law employees doesn't need to perform nondiscrimination or top-heavy testing for their solo 401(k) plan since there are no employees who could receive disparate benefits.
Flexibility with respect to investment options: While 401(k) plans offered through a corporation generally offer very limited investment options, a solo 401(k) plan provides the plan owner with the opportunity to self-direct his investments in any manner that he or she desires. 401(k) plan assets can be invested in equities, bonds, real estate, cryptocurrencies and other types of investments, and 401(k) plans are not subject to the restrictions that IRAs are subject to (as discussed above re: collectibles and life insurance).
Applicable rules: Solo 401(k) plans have the same rules as traditional solo 401(k) plans; however, they only cover only a business owner with no employees, or that person and his or her spouse. Given the limited number of participants in the plan, many of the administrative burdens typically associated with a 401(k) plan (e.g., required nondiscrimination/top-heavy testing, employee disclosures, etc.) would not be applicable with respect to a solo 401(k) plan.
Participation in multiple plans: A business owner can maintain a solo 401(k) plan through his or her business while also participating in a 401(k) plan sponsored by his or her employer. Note, however, that the limits described above are calculated on a per-person (and not a per-plan) basis.
Elliot’s current practice involves advising clients with respect to employment, executive compensation and employee benefits issues, including self-directed IRAs and solo 401(K) plans, tax and ERISA compliance, golden parachute tax calculations, advice relating to nonqualified deferred compensation and M&A-related due diligence.
He also assists clients on day-to-day corporate matters including preparation of applicable securities filings, amendments to employment agreements and equity compensation plans, ERISA, tax and corporate governance issues, employee communications, and public announcements.
Elliot previously worked at the New York AmLaw Firm of Proskauer Rose LLP, where he advised clients on employee benefits, compensation, and corporate governance issues in connection with public and private company mergers and acquisitions, corporate reorganizations and restructurings, and various financing arrangements.
*Mainstar's role as custodian of self-directed accounts is nondiscretionary and/or administrative in nature. This information is for educational purposes only, and should not be construed as investment, legal, tax or financial advice or as a guarantee, endorsement, or certification of any investments. Mainstar encourages individuals to consult a financial or legal professional when making investment decisions.