Choosing a Retirement Plan when you own a Small Business

This article is a continuation of our previous article “Choosing a Retirement Plan when you are Self-Employed,” expanding our discussion on retirement plans to cover companies which have employees.

Labor markets are tight and as a small business owner you often have to compete with larger organizations for talent. Pay is only a part of the equation. Other benefits – like health insurance or a retirement plan – are also key differentiators.

Pay yourself first – The opportunity for tax-advantaged savings

The best way to save is to put money away before you see it and live within your budget on what remains. American workers are aware of this and seek employers who can help them save efficiently.

On their own, working individuals have the option to contribute to Roth or Traditional IRAs, but many don’t do it.

• A key advantage to employer-sponsored plans is that savings are drawn from employees’ paychecks before they are deposited into their accounts. Savings happen more consistently without the temptation to spend the funds.

• Employer-sponsored plans permit a higher level of savings than is allowed through an IRA. In fact, contributions to employer sponsored retirement plans can often be made in addition to IRA contributions.

Because employee contributions are funded by the employees themselves, the only cost for this element of a plan is the administrative cost. And as the employer, you also benefit from the ability to make tax-advantaged savings into your own accounts.

Employer Contributions – Additional tax-advantaged compensation

In addition to the opportunity for tax-advantaged savings, many plans offer additional employer funded contributions through matching or profit sharing by the employer. These contributions effectively increase employees’ total compensation. Of course, the larger the contributions an employer makes to employee retirement plans, the larger the expense to the firm. Some examples of employer contributions are outlined in a later section.

Types of Retirement plans

Retirement accounts are tax-advantaged in one of two ways.

• Traditional accounts – These are funded with pre-tax dollars, reducing your current taxes. The funds will be taxable when you (or your heirs) take the funds out later.

• Roth accounts – These are funded with after-tax dollars. The assets grow tax-free, for your lifetime, and up to 10 years thereafter (or longer, under certain circumstances).

Some states have programs which facilitate retirement saving. For example, in Illinois, the most basic retirement plan option is to participate in Illinois Secure Choice, which is a state-run program by which employers can facilitate IRA saving through payroll deduction. This program is mandatory for Illinois employers with 5 or more employees that have been in business for more than two years, who do not have an employer sponsored retirement plan. Failure to enroll results in penalties, assessed annually based on the number of employees.

Traditional and Roth IRA contributions are limited to $7,000 per year, and as an IRA based program, the Illinois Secure Choice program is also subject to these limits.

As a state-run plan, Illinois Secure Choice has little to no overhead or compliance costs beyond setting employees up to participate. Other states may have similar programs.

For firms with less than 100 employees, who earned more than $5,000 in the preceding year and want to provide a benefit above and beyond the minimum, the next level of plan is a SIMPLE Plan. This plan provides higher saving limits for employees than IRAs, and mandatory employer contributions as follows:

• In 2023, employees can contribute up to $15,500 to a SIMPLE IRA account, unless they are 50 or older, in which case they can contribute an extra $3,500.

• Employers must either provide a 100% match on the first 3% of employees’ contributions or contribute 2% of employees’ annual salaries.

The administration of a SIMPLE plan is relatively straightforward, which includes the following: setting up an account for each employee, notifying the employees, implementing the employee’s elected withholding, and making the employer contributions in a timely manner.

The most advanced defined contribution plan is a 401(k)/profit sharing plan, which allows even higher employee contributions and the option of making profit sharing contributions.

• For 2023, 401(k) plans allow employees to contribute up to $22,500 per year, plus $7,500 catch up contributions for employees 50 or over. These can be made to traditional or Roth accounts in 2023.

•  As an incentive for employees to use the plan, employers can make matching contributions.

• In addition, employers may make profit sharing contributions. These are normally allocated based on the employee’s base salary and are limited to $66,000 for combined employee and employer contributions ($73,500 for employees over 50, including the $7,500 employee catch up contributions).

In addition to the administrative costs of running a 401(k) plan, there are compliance tests which need to be run to ensure the plan is not unduly benefiting a subset of employees. As a result, it is customary for a plan to hire a benefits consultant to manage its compliance with these rules, which represents an additional cost not borne by SIMPLE Plan sponsors.

An option to reduce compliance costs is to establish the plan as a “safe harbor plan,” which eliminates the need for the normal compliance testing so long as it makes fully vested contributions that meet certain criteria. Examples of this are as follows:

• Basic matching: The company matches 100% of all employee 401(k) contributions, up to 3% of their compensation, plus a 50% match of the next 2% of their compensation.

• Enhanced matching: The company matches at least 100% of all employee 401(k) contributions, up to 4% of their compensation (not to exceed 6% of compensation).

• Non-elective contribution: The company contributes at least 3% of each employee’s compensation, regardless of whether employees make contributions.

In a limited set of circumstances, employers may want to implement a defined benefit plan. These plans allow the company to set aside substantial funds to support a target distribution level for select employees. The number of employees you are required to cover is not as great as 401(k) plans. At least 40% of employees must be covered.

The cost to the firm depends on the demographics of the employees covered, with older, more tenured, and more highly compensated employees requiring larger contributions from the firm. With an older owner and younger employees, these plans can allow significant pre-tax contributions for the owner with only small contributions required for the young employees. Employees do not contribute to defined contribution plans.

Defined contribution plans are the most complex and expensive type of plan and require an actuary to determine the required contribution each year based on the plan assumptions and company demographics, in addition to a plan administrator.

Working through the details

For many small businesses, offering an employer-sponsored retirement plan can be a way to benefit both the owner and the employees. In turn, these plans can provide a competitive advantage – or at least maintain parity – when competing for talent.

If you, or someone you know, has a small business and is interested in setting up or updating a retirement plan, please reach out to your JMG advisor for counsel. We will gladly help you sort through the pros and cons of your various options and to implement the plan which is right for you!

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