Small business retirement plans can be broken down into two main groups when evaluating the various small business retirement plan options.
1) Small business retirement plans for businesses with W-2 employees.
2) Small business retirement plans for a one person business, an owner and spouse business, or a partnership with no W-2 employees.
Retirement plans for business owners with full time W-2 employees
When a small business owner has W-2 employees (other than themselves or a spouse) who work more than 1,000 hours they are not eligible for an Individual 401k. Small business owners who have W-2 employees may be required to make contributions on behalf of their employees. Small business owners who have full time W-2 employees typically select a corporate 401k, Simple IRA, SEP IRA or Defined Benefit Plan.
Small business owners with full time employees generally select from retirement plans that fall into 3 categories.
1) Retirement plans that are exclusively funded by the employer.
SEP IRA - The employer makes a contribution for any eligible employees according to a percentage between 0 to 25% of compensation. The percentage is the same for employer and eligible employees.
Defined Benefit Plan - The employer makes the contributions according to a specific formula based on actuarial calculations. The maximum retirement income benefit is $210,000 in 2015.
2) Retirement plans that are employer and employee funded.
SIMPLE IRA - Employees can make a voluntary contribution in 2015 up to $12,500 or $15,500 if age 50+ and the employer makes a mandatory match according to 2 options.
401k - Employees can make voluntary contributions in 2015 of up to $18,000 or $24,000 if age 50+. The employer has the option of making a company match or a profit sharing contribution. An employer match and/or profit sharing contribution is not required.
3) Retirement plans that are exclusively employee funded.
401k - Employees can make voluntary contributions in 2015 of up to $18,000 or $24,000 if age 50+. An employer match is not required.
Small business retirement plan options (no W-2 employees)
Many independent contractors, entrepreneurs, self employed individuals and small business owners are in business for themselves and have no W-2 employees or have a spouse as their only W-2 employee. Self employed business owners who fit this profile typically select the Individual 401k, SEP IRA, Defined Benefit Plan or Simple IRA.
Selecting the right small business retirement plan for your needs is primarily dependent on your income and on the amount of your desired annual retirement contribution. Each retirement plan benefits a business owner differently based on their income and depending on how much they would like to contribute each year.
For many successful business owners the decision usually comes down to either a SEP IRA or Individual 401k due to the high contribution limits and flexible annual contributions. Individual 401k plans have greater administrative responsibilities than a SEP IRA, but may allow a larger annual contribution at identical income levels due to the way the annual contributions are calculated.
A Defined Benefit Plan may be a good choice for business owners age 45 or older who would like to make retirement contributions in excess of the limits of an Individual 401k or SEP IRA. Depending on the age and income of the business owner annual contributions to a Defined Benefit Plan can exceed $100,000. Defined benefit plans are complicated and they require the services of an actuary to calculate the annual contributions and as a result they are the most expensive administratively. For business owners in a financial position to take advantage of the high contribution levels in a Defined Benefit Plan, the administrative expense may seem minimal relative to the tax savings.
A Simple IRA is easy to setup and low administrative responsibilities, but has lower annual contribution limits so they may be a good choice for business owners with relatively lower incomes.
Another issue to consider is would you like to have the option of borrowing against your retirement plan by taking a loan. Of these self employed retirement plans only Individual 401k plans and Defined Benefit Plans are permitted by IRS rules to have a loan provision.
- 2015 SEP IRA contribution limit maximum is $53,000.
- Easy to set up and minimal administrative responsibilities.
- An Individual 401k may provide a larger contribution compared to a SEP IRA at the same income level.
- For those age 50+ there isn't an additional catch-up provision like there is with the Individual 401k.
- Loans are not permitted.
What are the advantages of a SEP IRA?
The SEP IRA has broad appeal due to its high maximum contribution limits and its ease to set up and maintain. The 2015 SEP IRA contribution limit maximum is $53,000. The annual contribution into a SEP IRA is based on a percentage of W-2 wages if you are incorporated or net income if you are a sole proprietorship. The SEP IRA is a great choice for self employed business owners who would like to contribute up to 25% of their W-2 wages or 20% of net self employment income.
S or C corporation or a LLC taxed as a corporation.
- For incorporated businesses up to 25% of W-2 wages can be contributed into a SEP IRA.
Sole proprietorship, partnership or a LLC taxed as a sole proprietorship.
- Annual contributions up to 20% of your net adjusted self employment income (or net adjusted business profits) can be contributed into a SEP IRA.
Learn more about a SEP IRA.
- 2015 Individual 401k contribution limit is $53,000 ($59,000 if age 50+ due to a "catch-up" provision).
- Tax free loans are permitted with an Individual 401k plan. Loans are permitted up to 50% of the total value of the Individual 401k up to a maximum of $50,000.
- Roth 401k - There is an option to make Roth 401k contributions with the salary deferral portion of the Individual 401k. Contributions into a Roth 401k are not tax deductible, but withdrawals are tax free after age 59 ½.
- Potentially greater administrative responsibilities and administrative fees compared to a SEP IRA.
What are the advantages of the Individual 401k?
The Individual 401k and SEP IRA are popular because both plans have high contribution limits and have completely discretionary annual funding requirements. In 2015 a SEP IRA has a maximum contribution limit of $53,000 and an Individual 401k has a contribution limit of $53,000 ($59,000 if age 50+).
A SEP IRA is easier to setup and has less administrative costs than an Individual 401k, however an Individual 401k may allow a greater contribution at the same income level due to the way the contribution is calculated.
After tax Roth contributions can be made into an Individual 401k. Roth 401k contributions are not tax deductible, but are received tax free when withdrawn after age 59 ½. SEP IRA contributions can only be made pre-tax and does not have a Roth option.
Another important distinction between these retirement plans is an Individual 401k has a loan provision. IRS rules do not allow loans with a SEP IRA. Individual 401k loans are permitted up to 50% of the total 401k value with a $50,000 maximum.
Learn more about the Individual 401k.
Defined Benefit Plans
- Depending on the age and income of the business owner, annual contributions can exceed $100,000 or more.
- Loans may be permitted, however this may increase annual funding requirements.
- More expensive to set up and to maintain.
- Rigid annual funding requirements.
What are the advantages of a Defined Benefit Plan?
The Defined Benefit Plan is appropriate for those age 45 or older who wish to make tax deductible contributions in excess of the maximum limits of the Individual 401k or SEP IRA. Defined Benefit Plans offer substantial tax deductible retirement contributions and significant future retirement income. Depending on your age and income the annual contribution to a Defined Benefit Plan can exceed $100,000.
Defined Benefit Plans have greater administrative fees and more rigid annual funding requirements, but may be ideal for business owners who wish to shelter the largest percentage of their income and/or who want to make the largest retirement plan contribution permitted by IRS rules.
Learn more about the Defined Benefit Plan.
- A Simple IRA is easy to set up and has low administrative responsibilities.
- 2015 Simple IRA contribution limit is $12,500 or $15,500 if age 50+. In addition there is a maximum 3% employer contribution.
- Relatively low maximum annual contribution limits.
- Loans are not permitted.
What are the advantages of a Simple IRA?
Self employed business owners that have a Simple IRA are able to contribute up to 100% of their income up to the maximum contribution limits of $12,500 or $15,500 if age 50+. As a result, significant contributions can be made into a Simple IRA even at lower income levels. A good candidate for this plan doesn't mind the relatively low maximum contribution limits. Self employed individuals who would like to contribute in excess of the limits of a Simple IRA should consider an Individual 401k since it has higher contribution limits.
Learn more about the Simple IRA.