Businesses of all sizes prosper by offering their people the opportunity to save for retirement and defer taxes.
Small businesses have nearly as many options as large enterprises. Digital technology can help make implementing and managing a plan very efficient and cost-effective.
Financial advisors, like PivotPoint Advisors, offer tools and services to unlock benefits for business owners and their businesses. In many cases, the possibilities are much more attractive than owners realize. After all, you’re focusing on running and growing your business. However, in only a week or two, it’s possible to take a census of your business, consider retirement plan options, and make excellent choices, with the help of financial planners and portfolio managers that specialize in servicing small businesses.
There are several ways to categorize company retirement plans. The very first differentiator is between “defined benefit” plans and “defined contribution” plans. If you’re a small business, it’s very unlikely you have (or want) a defined benefit plan–which makes all the contributions the responsibility of the company. These are also known by another name: pensions. These days, it’s just about unheard of for a small business to take on the burden of a pension. Enough said, let’s talk about defined contribution plans…
As a whole, the financial industry refers to defined contribution as “profit sharing” plans. 401(k) is one of the seven (7) types of profit sharing plans.
Why Should My Business Implement a Plan?
Your best employees need a retirement savings plan. It’s true that they can save, tax-deferred, by opening their own IRA account. At some point, your best people are probably going to be recruited by another business. A 401(k) with a company match could mean many thousands of dollars later in life, and your smart employees will realize that. Your small business can do just as good a job helping employees save as a large business! The playing field is more level than you may think.
An owner’s thoughts might turn to your own savings situation and that of other owners. “Qualified” retirement plans (like 401k) have rules to make sure rank-and-file employees aren’t left out. But they also have rules that make it so that owners can receive far more benefits than employees. It’s critical that you and your financial advisor are aware of these options. At first, the rules can be difficult to understand. But when understood, you and your business stand to benefit. Greatly. Among the tools available to benefit owners especially are 1) Social Security integration 2) age-weighted plans and 3) New comparability plans.
The right plan, well-implemented, saves your business two types of tax: 1) payroll tax and 2) income tax. If you offer a 401k with a company match, that match gives the business an above-the-line (the best kind!) tax deduction. Separately, you’ll save on payroll taxes every check run. With a 401K, the employees’ salaries are lower because of the deferral—and no payroll taxes are due on the deferred part of salary.
My Business Has a Plan, But I’m Not Sure About It
In our work, we see many long-established IRAs and 401(k) plans. Too many of them have performed too poorly for too many years.
Why? Because sponsoring a plan and opening accounts are relatively easy. Investing it properly is not. For example, we see too many accounts where the employee accepts the default investment option—often a money market fund—and never changes it. Such a “portfolio” will yield something like 2% year after year which doesn’t even keep up with normal 3% inflation. A company’s head of HR or benefits manager is generally NOT an investment professional! For their role, they’re right to play it super safe and not take any chances.
But the point of investing over the long-term is for GROWTH—not only safety. You have to put your money at risk to make returns. Small businesses should engage with experienced investment professionals to do right by their employees’ retirement income. Ultimately, that’s what we’re doing here—making retirements more comfortable!!
Can I Offer Retirement Plans to Independent Contractors?
Yes! Employers can contribute to a 1099 employee’s SEP or SIMPLE IRA. With a SIMPLE IRA, employers can contribute 2% of their employee’s compensation up to $305,000 or match employee contributions up to 3% of their compensation.
Most Small Businesses Will Choose from These Three (3) Plan Types
These three tax-advantaged retirement plans are similar in operation in most ways. The biggest difference to understand is in the contribution rules. How much can be contributed each year? Where do the contributions come from; the employer, the employee, or a combination of both?
SEP (Simplified Employee Pension)
First thing—pension is in the name, but these plans are not nearly as burdensome as a traditional pension. These are designed for your small business.
A SEP can be established for any size of business. They are unique in that you can establish a plan as late as the fall of the following year (with income tax filing extension). As of this writing (May 2023) you could establish a plan for calendar year 2022—as long as you haven’t finalized and filed your business income tax return. Other types of plan must be established by the end of the year in question.
The funding vehicle is an IRA account—easily opened without much hassle at all. The account is called a SEP-IRA.
SEPs are established using Form 5305-SEP or an equivalent form provided by the brokerage company. A good financial advisor will have expertise with this form and can guide you. If this form is used, the company cannot have another type of retirement plan (but could have another SEP).
The employer is obligated to make all contributions to the plan—but these contributions are flexible. The amount can vary year to year, based on the profits of the business. The funding vehicle is an Individual Retirement Account (IRA) held at custodian like Charles Schwab & Co (PivotPoint’s custodian of choice)
And perhaps best of all, contribution limits can be maximized (based on the law) for a SEP. The company can contribute up to 25% of employee salary each year, up to a maximum of $73,500 (2023)
SIMPLE (Savings Incentive Match Plan for Employees)
SIMPLE plans, like SEP, use an IRA as the funding vehicle. Any business with 100 employees or fewer can sponsor a SIMPLE by filing form 5305-SIMPLE. Your financial advisor will assist. Employers are required to either match employee’s contribution up to 3% or a employer-only contribution of 2% of salary.
These are very popular because they’re just so dang easy to initiate. The one significant downside is that contribution limits are much lower than the other two small business choices: SEP IRA or 401K. In 2023, the contribution limit for SIMPLE is only $15,500. 401K and SEP limits are $73,500 (2023, over 50 y.o.)
These plans are started by:
- Adopting a plan document. These can be based on templates—such as a Safe Harbor plan which drastically reduces compliance risk. Custom plans can be written and adopted by engaging an attorney.
- Officially notifying all eligible employees
- Creating a trust or brokerage account to hold plan assets.
Not widely known, but a typical 401(k) plan consists of two parts:
- Cash or Deferred Arrangement (CODA): the part where employees contribute, and employers often match up to a certain percentage. This is the “401K” part. The limit for this contribution is $30,000 per year (2023, over 50 y.o.)
- Profit Sharing plan: discretionary contribution made by the company only. Big businesses don’t use this part very much, but small businesses really should. The limit for this contribution is 25% of employees’ pay.
The total contribution for both parts is $73,500 (2023, over 50 y.o).
Contribution limits are the legal maximum and employees and employers both contribute. The 401(k) differs from SEP and SIMPLE in an important way. It is a truly “qualified” plan, which means it must satisfy a bunch of nondiscrimination rules that IRA-based plans don’t. This reality has allowed financial advisors and third-party administrators (3PA) to charge excess fees to maintain compliance. It’s true, this can be a difficult and time-consuming task. Which is why we recommend “Safe Harbor” 401K plans for small businesses that want to choose a 401K. Adopting a safe harbor plan allows business owners to rest easy. The plan will never fall out of compliance. In the majority of cases, this is the way to go!
The Profit Sharing portion of the plan can be tuned to (legally) benefit owners and senior management more than rank and file. The allocation of contributions is laid out in the plan document. The allocation must be a consistent mathematical formula, but the formula can be tweaked to favor older workers (Age-weighted plan), or those who are classified as owners or managers (New Comparability plan). A third way is to do Social Security integration with the profit-sharing plan. It’s a bit involved, but basically those who make more than the Social Security wage base (currently $160,200) will be able to save a much higher percentage than those who are below that income.
Allocation in a 401K is an involved topic that requires its own article. The bottom line for owners of small businesses is that you can probably save a lot more than you think if you choose a safe harbor 401k with a profit-sharing plan tuned to benefit company ownersthip.
The Takeaways: What to Remember
Owners Benefit Most Personally
- There are ways for the owner to receive lion’s share of profit allocations
Not as difficult to start as you think
- Few forms to manage
- Professional advisor help
- Payroll tax savings every period
- Above the line income tax deduction for the business
Do right by your employees!
- Your best employees need a retirement savings plan to stay long-term
Access to expertly managed investment portfolios for all risk profiles from ultraconservative to very aggressive.
- It’s not about having a tax-advantaged savings account. It’s about using it well for more retirement savings and a better retirement