Bakery owner checking out small business retirement plans on an iPad.

Retirement plans for small business owners to consider

Choosing the best retirement plan for your small business is important to hiring and keeping the right associates.

Offering a retirement plan is a great way for small businesses to attract and retain employees. Retirement plan options also help both employee and small business owner shelter income from taxes while promoting saving for retirement. To accommodate the varied needs of individual small businesses, the tax code offers several types of small business retirement plans. As such, it's important to compare them against each other to find the best retirement plan for everyone involved.

Retirement plans for small businesses

Simplified Employee Pension Plan (SEP) or SEP IRA

Under this plan, the employee establishes an IRA and the employer contributes up to 25% of an employee's compensation each year. There is no employee contribution in this SEP plan. It's simple, and it's popular with small family-owned businesses.

Benefits of a SEP Plan

  • Employers have the option to use less restrictive participation requirements.
  • Any investment earnings are tax-deferred until withdrawal.
  • A tax-deductible way for small-business owners to attract and retain employees while also saving for their own retirement.
  • The business owner is generally an eligible participant.

Requirements of a SEP Plan

  • A SEP IRA plan must be available to all employees who are at least 21 years old, who have performed services for the employer for at least three of the preceding five years and have received at least $600 in compensation from the employer.

Savings Incentive Match Plan for Employees (SIMPLE)

Companies with fewer than 100 employees can set up a SIMPLE IRA plan. Each employee opens an IRA account, and both the employer and employee contribute money to it. There is minimal paperwork and no separate administration fees. It's an efficient way to provide a retirement plan to a large group of people, that is, large by small-business standards.

Benefits of a Simple IRA Plan

  • Eligible employees may choose to make deferrals before taxes from their paychecks.
  • Employers may make a non-elective payment of 2% of compensation to each eligible employee on this plan or match individual contributions up to 3% of compensation.
  • Employers may change the percentage from year to year, but certain restrictions do apply.
  • Participating employees don't have to pay taxes on the income they contribute, either. However, employees generally owe taxes if they take withdrawals.
  • Investment earnings made by the employees will compound tax-deferred until they begin to make withdrawals.

Requirements of a Simple IRA Plan

  • Eligible employees may be required to have received at least $5,000 in compensation from the business during any two years before the current year and reasonably expected to earn at least $5,000 in the current year to participate. An employer can set less restrictive requirements (for example, allowing all employees to participate, even those making less than $5,000), but it can't make more restrictions.
  • This plan is for businesses with 100 or fewer employees. If the business grows and the employer hires more than 100 people, the plan can continue for two more years before expiring permanently.

Traditional 401k

A small-business traditional 401k retirement plan allows employees to set aside a portion of their salary for retirement on a pre-tax basis. Designated Roth Contributions are also an available option to provide employees the ability to contribute a portion of their salary on an after-tax basis. Companies offering a 401k need to file paperwork each year to ensure their plan complies with IRS regulations. But still, a traditional 401k plan is a good option for businesses that plan to grow and that want flexibility in how much money they contribute on behalf of eligible employees.

Benefits of a Traditional 401k Plan

  • Contributions are made with pre-tax dollars. Employee contributions may include Designated Roth Contributions.
  • Employee contributions are 100% vested.
  • Employer sponsored plan that provides employees investment option choices.
  • Taxes on matching funds are deferred until withdrawn.

Requirements of a Traditional 401k Plan

  • Annual nondiscrimination tests are required to prove the plan is operating in compliance with applicable regulations.
  • Eligible employee is defined as someone who has reached age 21, has at least one year of service and has worked at least 1,000 hours in the year beginning with the date of hire. Employer may establish less restrictive eligibility requirements.

Safe Harbor 401k

This type of 401k plan is similar to a traditional 401k plan in many respects. Under a Safe Harbor Plan, the administration is reduced because the plan includes either a matching or an automatic employer contribution that allows all employees to potentially contribute the maximum amount each year to their accounts. Although it is less flexible than a traditional 401k, it may be easier for a small business to operate and comply with IRS regulations.

Benefits of a Safe Harbor 401k Plan

  • Generally it allows participants, including the business owners, to set more money aside than other types of retirement plans, which may have lower limits on allowed annual contributions.
  • Internal Revenue Code, and related regulations, allows for a Safe Harbor 401k plan not to discriminate against employees regardless of their income, even if the owner is the only employee contributing.
  • Employers can make the plan more inclusive, for example, by covering younger employees or allowing employees with less than one year of service to participate.
  • Contributions are made with pre-tax dollars. Employee contributions may include Designated Roth Contributions.
  • Employee contributions and employer Safe Harbor contributions are 100% vested.

Safe Harbor 401k Plan requirements

  • Eligible employee is defined as someone who has reached age 21, has at least one year of service and has worked at least 1,000 hours in the year beginning with the date of hire. The employer may establish less restrictive eligibility requirements.
  • Employer contributions - An employer is required to make a contribution to Safe Harbor 401k plans. The employer can do this by:
    • Contributing a minimum of 3% of the compensation for eligible employees.
    • Or, the employer can match the salary deferral contributions of all eligible employees. An example of this would be, if an eligible employee defers 5% of their wages (i.e., compensation), then the employer is required to make a matching contribution of 4% of the employee's compensation. This is built from the basic formula where:
      • The employer contributes 100% of the salary deferral contributions that represent the first 3% of compensation.
      • Plus an additional 50% of the salary deferral contributions that represent the next 2% of compensation is added.
  • 100% vesting of the required employer contribution - The required Safe Harbor employer contribution is 100% vested immediately. Employees may take that money when they leave the business, no matter how long they have worked there.
  • Annual notice to participants - Each year, the employer must provide a notice that explains Safe Harbor contributions and how the employer will satisfy those requirements.
  • Establishment deadline - A new plan must be established by October 1 of the applicable year (assuming a calendar year plan).

Individual 401k

This 401k plan is for a company that only has an owner(s) and their spouse, if applicable, with no common law employees. An individual 401k plan may allow the owner(s) to set aside more income than other types of retirement plans.

Benefits of an Individual 401k

  • May allow the owner and their spouse to shelter more income from taxes than other types of retirement plans.
  • Business owner may be allowed to contribute greater amounts of their income to this type of plan versus other business retirement plan options.
  • Contributions to the plan may be tax-deductible by the business.
  • Business owner may borrow a portion of the account balance through a loan provision in the event of a hardship situation.
  • Contributions to the plan are flexible and may include pre-tax elective deferrals, after-tax Designated Roth Contributions, discretionary or profit sharing and rollover contributions.
  • Owner may contribute up to 25% of their eligible income to the plan as a discretionary or profit sharing contribution. If self-employed, see IRS publication number 560 for figuring your allowable contribution.
  • Elective deferral limits are adjusted periodically by the Internal Revenue Service (IRS), including the additional elective deferral amount for participants aged 50 or older.

Individual 401k requirements

  • An Individual 401k plan is available for businesses established as a sole proprietorship, partnership, limited liability company (LLC) or incorporated, including a Subchapter S corporation.
  • Businesses determined to be part of a controlled group of businesses are not eligible.
  • Deadline to establish a plan is by the last day of the fiscal year. For a calendar year business, this deadline is December 31st.

Neither State Farm nor its agents provide tax or legal advice.

The information in this article was obtained from various sources not associated with State Farm® (including State Farm Mutual Automobile Insurance Company and its subsidiaries and affiliates). While we believe it to be reliable and accurate, we do not warrant the accuracy or reliability of the information. State Farm is not responsible for, and does not endorse or approve, either implicitly or explicitly, the content of any third party sites that might be hyperlinked from this page. The information is not intended to replace manuals, instructions or information provided by a manufacturer or the advice of a qualified professional, or to affect coverage under any applicable insurance policy. These suggestions are not a complete list of every loss control measure. State Farm makes no guarantees of results from use of this information.

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