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Choosing the Right Retirement Plan for a Small Business
Most small-business owners share a variety of critical priorities, such as managing taxes, attracting and rewarding valued employees, and establishing a long-term strategy to ensure their own financial security. Fortunately, small-business owners also share an option that could help address all of those goals: sponsoring a workplace retirement plan.
Among small employers (5 to 100 workers) who decide to sponsor a plan, the strategy is generally expected to enhance the overall business by increasing their ability to attract and retain employees and by improving employee morale. In addition, retirement plans offer valuable tax deductions and allow for tax-deferred compounding of investment earnings.
A Look at Your Options
There are three broad categories of retirement plans available to small businesses. The one you choose should reflect your company's size, financial situation, and ability to comply with regulatory oversight and administrative responsibilities. You may want to consult a financial professional to help you choose a plan that's right for you.
A Simplified Employee Pension plan (SEP-IRA) may be ideal for a one-person business or a business with just a few employees. It is relatively inexpensive and easy to start and administer.
The employer - not the employees - contributes to a SEP-IRA. Employees are immediately vested, and each employee decides how his or her money is to be invested.
Although there are some exceptions, in general, a SEP-IRA must cover any employee who is 21 or older, earned at least $550 from the business, and has worked there during at least three of the preceding five years. In 2015, the annual contribution limit for each employee is 25% of compensation (or, for the self-employed, net earnings) or $53,000, whichever is less.
SEP-IRAs also offer small-business owners flexibility regarding both the amount and timing of contributions. As a result, a SEP-IRA may make sense for a business with profits that tend to fluctuate from year to year.
The Savings Incentive Match Plan for Employees (SIMPLE IRA) is also valued for its ease of administration and is available to businesses with 100 or fewer employees. A so-called "matching" SIMPLE IRA plan allows employees to contribute up to $12,500 of salary in 2015. The employer must then make a matching contribution of up to 3% of each worker's annual compensation, but the employer has the right to match as little as 1% in two out of any five consecutive years.
The other method for funding a SIMPLE IRA requires the employer to make nonelective contributions equal to 2% of compensation for each worker who has earned at least $5,000 during the year, whether or not a worker has elected to contribute income. For 2015, the maximum compensation amount that can be used to determine the contribution amount is $265,000.
Qualified plans, also known as Keogh plans, are more complex than SEP-IRAs or SIMPLE IRAs and, therefore, have more stringent reporting requirements. Employees must be covered if they are 21 or older and have at least one year of service (or two years if the plan is not a 401(k) plan and provides for full vesting within two years). There are several types of qualified plans, which can be broken down into two broad categories: defined benefit and defined contribution plans.
- Defined Benefit Plans - Defined benefit (DB) plans are more commonly referred to as traditional pension plans. They promise to pay employees a steady income stream in retirement. The amount each employee receives is generally based on earnings history and length of service. Employers must contribute enough to the DB plan each year to satisfy what's known as a minimum funding requirement. Actuarial assumptions and computations are necessary to calculate benefit and minimum funding amounts. For this reason, administration of a DB plan usually requires professional assistance.
- Defined Contribution Plans - With defined contribution (DC) plans, employers make contributions into individual accounts for each employee. Employees may then be given the authority to invest the money as they see fit. DC plans do not require immediate vesting and may allow employee loans.
- Profit-Sharing Plan - Employers can vary the amount and frequency of contributions based on fluctuating profits.
- Money Purchase Pension Plan - Contributions are mandatory, and the percentage amount may not vary.
- Paired Plans - Paired plans allow annual contributions to vary, but guarantee a minimum percentage. For 2015, employers can contribute the lesser of 25% of earned income or $53,000 to each participant's profit-sharing plan, money purchase pension, or paired plan account.
- 401(k) Plans - These popular DC plans allow employee contributions (or "elective deferrals"). In recent years, 401(k)-style plans have become less complex and less expensive for smaller businesses.
However, nondiscrimination testing, filing, and administration costs can make 401(k) and Roth 401(k) plans more difficult to manage than other types of plans. (Note that SIMPLE 401(k) plans allow employers to avoid some tests.) Participants may contribute up to $18,000 for 2015, and employers may also make contributions. Total contributions to an individual's account cannot exceed $53,000 or 100% of compensation, whichever is less.
|SEP-IRAs||SIMPLE PLANS||QUALIFIED PLANS|
|Funding Responsibility||Employer||Employer and employee||Employer (or, for 401(k)-style plans, employer and employee)|
|Level of Complexity/Reporting Requirements||Low||Low||High|
|Contribution Limits||25% of compensation or $53,000||$12,500 for employees; up to 3% of compensation for employers||Varies by plan type|
Making the Right Choice
As you review these retirement plan options, keep in mind there are many points to consider. For example, employers may take a limited tax credit during the first three years they maintain a plan. Other considerations include evaluating your business's unique needs and goals, protecting your plan from creditors, and limiting your own fiduciary responsibility. For these reasons, it is generally advisable to speak with a retirement plan expert before making any decisions.
Points to Remember
- By sponsoring a workplace retirement plan, small-business owners may be able to better pursue a wide range of important goals, such as managing taxes, attracting and retaining employees, and preparing for a financially secure future.
- The vast majority of small-business owners who sponsor a retirement plan believe that it has a positive effect on their ability to retain employees and on workers' attitudes and performance.
- Of the three main types of retirement plans, SEP-IRAs and SIMPLE IRAs are the least expensive and most convenient to administer. Qualified plans are more complex, but 401(k) and Roth 401(k) plans are typically the most expensive and time consuming to manage.
- Before deciding on a plan, small-business owners should reflect on the goals they hope to achieve and their financial and managerial ability to pursue those goals in light of each plan's unique requirements.
- It is also widely recommended that small-business owners consult an experienced retirement plan professional in order to arrive at and implement the right decision.
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