Best Retirement Plans For Small Business – Help small businesses choose the right employee retirement plans. A CPA can help business owners make sense of the various options available. Jimmy J. By Williams, CPA/PFS
Retirement plans offer significant tax benefits to small businesses and encourage them and their employees to save for the future. There are many types of retirement plans available to small businesses, each with their own requirements and limitations. The same plan is not necessary for companies of all sizes and ownership structures, so small business owners should do their homework before making a decision.
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As a CPA, you can help business owners choose and implement the plan that is best for them. You can base your recommendations on the unique characteristics of your client’s business, such as the owner’s retirement goals, how the business is set up (as a sole proprietorship, limited liability company, C corporation, or S corporation), number of employees, and more.. You can also help them understand the legal and compliance issues associated with each type of plan, as well as any tax benefits they may bring.
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The following is an overview of the types of plans, as well as a discussion of issues to consider to help your small business owner clients through the often confusing process of choosing a retirement plan.
There are many different types of retirement plans available to small business owners. The most important ones include the following (see the chart, “Comparison of Retirement Plans for Small Businesses,” for more details on the four most common types of plans):
A SEP can be used by businesses with any number of employees. Contributions are made only by the employer (up to 25% of each eligible employee’s compensation or $55,000 for 2018) and are tax deductible as a business expense. The primary benefit of SEP plans is how easy they are to administer. After adoption, SEPs typically require no annual IRS form filing, and administrative costs are minimal.
There are three steps to establishing an SEP. Employers must (1) execute a written agreement to provide benefits to all eligible employees; (2) give employees specific information about the contract; and (3) set up an IRA account for each employee. The IRS has a model SEP plan document, Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement. However, not all employers can use Form 5305-SEP, and some must use the prototype document instead.
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However, SEPs do not allow employees to defer income, and employees are always 100% vested in employer contributions to their SEPs. Therefore, it may not be the best choice for companies in industries with high employee turnover or who want to use a retirement plan to help retain employees. Another potential disadvantage of these plans is that they require employers to contribute the same percentage to all eligible employees. Because of this requirement, if the owner wants to make large contributions to his or her SEP, a small sole proprietorship may not have enough cash flow to support such a plan.
SIMPLE IRAs are generally available to businesses with 100 or fewer employees who earned $5,000 or more in compensation in the previous year. These plans are funded by tax-deductible employer contributions and pre-tax employee contributions.
As the name suggests, SIMPLE IRAs are easy to implement and manage. Employers can use Form 5304-Simple Savings Incentive Matching Plan for Small Employers (SIMPLE) – Not for Use with a Designated Financial Institution, or Form 5305-Simple Savings Incentive Matching Plan for Small Employers to implement this plan. (Simple) — For use with a designated financial institution. Like Form 5305-SEP, the employer is required to keep the form in its records but not file it with the IRS.
A small employer may want to implement a SIMPLE IRA plan because it allows employees to defer income by making salary-deductible contributions (subject to annual limits) to their SIMPLE IRAs. Another potential benefit to the employer of a SIMPLE IRA plan over a SEP is that it usually requires a smaller contribution from the employer. The employer must make a dollar-for-dollar contribution of each employee’s salary reduction equal to 3% of the employee’s compensation or a non-elective contribution of 2% of the eligible employee’s compensation (up to $275,000 for 2018) , regardless of whether the employee contributes the salary reduction.
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However, like SEPs, employees always have 100% of employer contributions vested in SIMPLE IRAs, so they may not be the best choice for companies in high-turnover industries.
Qualified plans are more complex than SEPs or SIMPLE IRAs and therefore have stricter reporting requirements. But they may be better suited to larger or growing businesses. Larger businesses typically have the staff and infrastructure to accommodate the required reporting of qualified plans, and usually want features such as loan provision and service withdrawals in qualified plans that are not allowed in a SEP or SIMPLE IRA. There are several types of qualified plans, which can be divided into two broad categories: defined benefit and defined contribution plans.
Defined benefit plans. Commonly referred to as pension plans, defined benefit plans promise to pay employees a steady stream of income at some point in the future. The amount each employee receives is usually based on earnings history and length of service. Employers must contribute enough to a defined benefit plan each year to meet what is known as the minimum funding requirement. Due to the complexity of the minimum fund calculation and other requirements, the administration of a defined benefit plan usually requires the professional assistance of an actuary. For this reason, very few small businesses use it.
Defined contribution schemes. With defined contribution plans, employers make contributions to individual accounts for each employee. Employees generally have the authority to invest money as they see fit in the investment options provided by the scheme. Defined contribution plans do not require employers to immediately invest the amount contributed to the plan and may allow employee loans.
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Types of defined contribution plans include profit sharing plans and money purchase plans. Under a profit-sharing plan, the employer’s contribution is discretionary, so the employer does not have to contribute to the plan every year. Under a money purchase plan, contributions are mandatory, so the employer must contribute to the plan each year, and the contribution percentage used to determine the contribution amount cannot change from year to year.
Profit-sharing plans may include a 401(k) feature (also known as a cash or deferred adjustment or CODA), whereby employees participating in the plan may choose to contribute to an individual account rather than to a receive part of their pre-tax compensation. Compensation in cash. These contributions are called “elective deferral” because the employee chooses to delay receiving the amount contributed to the account. A profit sharing plan with a 401(k) feature is commonly known as a “401(k) plan”. A “Solo 401(k) plan” is a 401(k) plan that covers only the business owner and his or her spouse.
For 2018, participants in a 401(k) plan can make elective deferrals of up to $18,500 ($24,500 for participants age 50 or older at the end of the calendar year). If the plan allows, employers can contribute a percentage of each employee’s compensation to the employee account (a non-elective contribution) or, within certain limits, match the amount of employees’ elective deferrals, or both. Total employer and employee contributions to a 401(k) plan are limited to the lesser of:
A 401 (k) plan can be designed so that employee ownership in employer matching or non-elective contributions becomes subject to a periodic vesting schedule. After completion of the vesting period for the contribution, the employee is 100% vested in the employer’s contribution and has the right to non-forfeiture of the entire amount of the contribution in his account. A provision for earmarking employer contributions to a retirement plan can help employers retain valuable employees.
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Under a graded vesting schedule, the employee increases the employer’s contribution over a period of years. Many plans use a five-year vesting schedule, in which the employee vests in 20% of the employer’s contribution each year of service, while the employee vests 100% in the contribution at the beginning of year 6. For example, a five-year vesting schedule for employer matching in the employer’s plan document and non-elective contributions to employee accounts as a plan provision. The employer makes an employer contribution in the amount of $10,000 to the employee’s retirement account in Year 1. Should the employee decide to leave the company during his second year of employment, he will be entitled to $2,000, or 20%, of retain the employer contribution.
Otherwise, some plans allow for “cliff anchoring”. With cliff vesting, the employee vests all employer contributions subject to vesting when the employee meets a certain minimum number of years of service. This vesting method reduces the amount of employer contributions retained by high-turnover employees
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