Small companies shouldn't forgo retirement savings just because a 401(k) plan can be expensive to set up and maintain. There are options specifically for smaller businesses: a Savings Incentive Match Plan for Employees (SIMPLE) plan, a Simplified Employee Pension (SEP) plan, and a SOLO 401 (k).
If your company has more employees than you and your spouse, you may want to consider a SIMPLE IRA or a SEP-IRA. The plans have similarities and a few differences that must be considered when deciding between the two. Knowing the details of each type can help you decide which is the best choice for you or which to offer your employees if you own a small business.
They're Called SIMPLE Plans for a Reason
The SIMPLE IRA enables employees and employers to contribute to Traditional IRAs—they cannot be Roth IRAs—expressly set up for employees. The plan is more cost-effective for a small company (typically 100 or fewer employees) to set up than a 401(k), which requires both set-up and ongoing administrative costs.
Setting up a SIMPLE IRA comes down to completing a form, and there are no filing requirements. However, the company cannot have any other retirement plan. The plan must be set up by and for each eligible employee. To qualify, a worker must have earned at least $5,000 from the company in each of the past two years and plans to receive compensation of at least that much in the current year.
All contributions must be invested in the IRA account. Contributions are not subject to federal income tax withholding, meaning all contributions are taxed deferred and can be tax deductible. Employers can set up SIMPLE IRAs at banks, savings and loan associations, insurance companies, regulated investment companies, federally insured credit unions, and brokerage firms. Contributions can be invested in stocks, mutual funds, and other similar investments. Investment options depend on the choices provided by the financial company maintaining the account.
The SIMPLE IRA Employer Contribution
The employer has a choice about contributing annual funds to the plan:
1) Nonelective contributions: The employer contributes 2% of each employee's salary into the plan each year, even if the employee does not contribute.
2) Elective contributions: Dollar-for-dollar matching contribution, up to 3% of the employee's salary.
3) An employer may choose to make a matching contribution of less than 3%, but it must be at least 1% for no more than 2 out of 5 years.
4) Employees may contribute up to $15,000 for the 2023 tax year ($19,000 if age 50 and up).
The employee is always 100% vested in all the SIMPLE IRA funds.
The Simplicity Comes with A Cost Compared to Other Plans
This plan is easy and inexpensive to set up and maintain, and employees share responsibility for saving for retirement. However, the plan has inflexible contributions and lower contribution limits than other retirement plans. Employees can contribute more yearly to a 401(k) plan or SEP-IRA.
Participants cannot take out loans from these plans because the assets may not be used as collateral. An employee can withdraw funds, but the funds would be added to income, and the IRA adds 10% to the tax bill for employees younger than 59.1/2. If the employee withdraws funds within the first two years of participating in the SIMPLE plan, the IRS bumps up the 10% additional tax to 25%.
Choosing a SEP-IRA Plan
Simplified Employee Pension (SEP) plans can provide a significant source of retirement income by allowing employers to save money in retirement accounts for themselves and their employees. SEPs lack a conventional retirement plan's start-up and operating costs and allow for a contribution of up to 25% of each employee's pay.
Unlike other retirement plans, employees enrolled in a SEP-IRA do not deposit funds directly into their savings plan. Instead, the employer makes the contributions on their behalf. One key benefit: SEP-IRAs permit employers to omit contributions during years when the company is not generating a profit or is experiencing declining sales.
Most SEPs require that company owners make allocations proportional to employees' salaries. As a result, all the contributions for the employees should be the same percentage of salary. Employees can start contributing after working three years at the company and must make at least $650 per year. Annual contribution limits are higher than standard IRAs, and those contributions are vested immediately.
The contribution limit is the lesser of 25% of compensation or $66,000 for 2023
Establishing a SEP
Setting up a SEP is different than establishing a SIMPLE. The employer first has to choose a financial institution to serve as trustee of the SEP-IRAs that will hold each employee's retirement plan assets. These accounts will receive the contributions made to the plan.
There are three steps to establishing a SEP:
Execute a written agreement to provide benefits to all eligible employees.
Give employees specific information about the agreement.
Set up an IRA account for each employee.
There's a Plan for One-Man Shops Too: The Solo 401(k)
Self-employment has many advantages and perks, but one benefit that is not available to most small business owners or entrepreneurs is an employer-sponsored retirement plan like a 401(k). To provide retirement options for solo business owners, the IRS allows the solo 401(k) or a one-participant 401(k), which has many aspects of an employer-sponsored plan.
To describe these plans, the IRS states that the business owner wears two hats in a Solo 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can contribute both:
1) Elective deferrals up to 100% of compensation ("earned income" in the case of a self-employed individual) up to the annual contribution limit:
Annual salary deferral of up to $22,500 in 2023 ($20,500 in 2022) or $30,000 in 2023 ($27,000 in 2022) if age 50 and up.
Your combined annual contributions cannot exceed $66,000 for 2023 ($61,000 for 2022) or $73,500 for 2023 ($67,500 for 2022) if age 50 and up.
2) Employer nonelective contributions up to:
As the employer, you can contribute additional profit-sharing funds of up to 25% of your compensation or net self-employment income—i.e., your net profit of less than half your self-employment tax and the plan contributions you made for yourself.
The limit on compensation used to factor in your contribution is $305,000 this year.
Total contributions to a participant's account, not counting catch-up contributions for those age 50 and over, cannot exceed $61,000 this year. The one exemption to a solo 401(k) is your spouse – they can contribute too if they work in the business.
3) Other Benefits of a Solo 401(k)
You may take a loan out on your solo 401(k). (Certain rules do apply)
Your spouse can contribute, too, if they work in the business.
The Bottom Line
Small business owners may not have the budget to set up a 401(k) plan for themselves and their workers. However, if you want a way to save for retirement, there are a few options. Owners can choose between a SIMPLE IRA or SEP-IRA. Both plans provide an alternative and more affordable method to encourage retirement savings.
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