As a small-business owner, figuring out retirement choices can be a little intimidating. How do you pick the most appropriate retirement plan for your business as well as your employees?
There are three main types of retirement plans for small businesses: SIMPLE-IRAs, SEP-IRAs, and 401(k)s. Read on below to learn more about each type of retirement plan.
SIMPLE stands for Savings Incentive Match Plan for Employees. A SIMPLE-IRA is a type of traditional IRA that is set up for employees and allows both employees and employers to contribute. If you’re an employer of a small business who needs to get started with a retirement plan that is easy to administer, a SIMPLE-IRA may be for you. While this plan doesn’t require an employee to contribute out of their earnings, employers must contribute 2% of their eligible employee’s salary to a retirement fund. If you do choose to offer a matching contribution to your employee’s SIMPLE-IRA plan, you can match up to 3% of your employee’s compensation. Employees can participate in a SIMPLE-IRA plan by having automatic deductions go straight from their paycheck to their SIMPLE-IRA.1,2,3
Distributions from SIMPLE-IRAs are taxed as ordinary income, and if taken before age 59½, may be subject to a 10% federal income tax penalty. Distributions before 59½ and in the first two years of participation in the plan may come with a whopping 25% penalty. However, during the 2020 calendar year, the CARES Act allows eligible participants to take an early distribution of up to $100,000 without paying the 10% penalty. Generally, once you reach age 72, you must begin taking required minimum distributions.
For a business to use a SIMPLE-IRA, it typically must have fewer than 100 employees and cannot have any other retirement plans in place. There are also no filing requirements required by the employer.2
SEP plans (also known as SEP-IRAs) are Simplified Employee Pension plans. Any business of any size can set up one of these types of retirement plans, including a self-employed business owner. This type of retirement plan may be an attractive option for a business owner because a SEP-IRA does not have the start-up and operating costs of a conventional retirement plan. It also allows for a contribution of up to 25% of each employee’s pay. This is a type of retirement plan that is contributed to only by the employer, and the contribution to each employee’s SEP-IRA must be the same percentage of earnings. Employees are not able to add their own contributions. Unlike other types of retirement plans, contributions from the employer can be flexible from year to year, which can help businesses that have fluctuations in their cash flow.4
Much like SIMPLE-IRAs, SEP-IRAs are taxed as ordinary income, and if taken before age 59½, may be subject to a 10% federal income tax penalty. The CARES Act applies to SEP-IRAs too. Generally, once you reach age 72, you must begin taking required minimum distributions.
401(k) plans are funded by employee contributions, and in some cases, with employer contributions as well. Large 401(k) plans tend to be the most labor intensive in terms of maintenance and management. They’re often more costly, as annual testing to ensure equitable administration is required. However, there are good reasons to steer toward a 401k plan, including the potential for higher contributions by owners and highly-valued employees, and the option of offering account loans to employees. In recent years, many 401k plans have added the Roth option to their plan, which allows employees to elect to make after-tax contributions that can be withdrawn tax-free in retirement.
A word about Solo 401(k)s: Businesses that are made up of only the business owner and his or her spouse are permitted to use a simplified version of the 401(k). The Solo-K is also often referred to as an individual 401k(k). Because of the limitation on who can participate, the plan is not subject to the anti-discrimination testing that is performed on the traditional 401(k), which helps reduce the cost and the complexity of the plan.
In most circumstances, you must begin taking required minimum distributions from your 401(k) or other defined contribution plan in the year you turn 72 if you have pre-tax funds in the account. Withdrawals are taxed as ordinary income, and if taken before age 59½, may be subject to a 10% federal income tax penalty. As of right now, the CARES Act exemptions apply only in the 2020 calendar year.5
Making the right choice for your specific situation is important, and can save time, money, and headaches in the long-run. Get it right with the help of your Certified Financial Planner™ Professional.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.
1 - IRS.gov, January 15, 2020
2 - IRS.gov, January 8, 2020
3 - IRS.gov, January 9, 2020
4 - IRS.gov, January 15, 2020
5 - U.S. Chamber of Commerce, February 20, 2020
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