So you are now ready to open a retirement plan for your business. Whether you are looking to minimize taxes or provide a valuable perk to your employees, there are many different choices available depending on what you are trying to accomplish. Which plan should you open? SEP IRA? SIMPLE IRA? Individual 401(k)? Safe Harbor 401(k) with profit sharing? Cash Balance or a Defined Benefit plan? This article provides general guidelines on how to select an appropriate plan for your business. Whether a particular plan is a good fit for your business should ultimately be determined by your CPA or your fee-only retirement plan adviser.
When selecting a plan for your business you need to consider both your personal financial situation and your current and future business needs. For a business with only a spouse employee, your personal financial situation will determine which plan will best address your needs. A mature business with many employees might need a plan that is customized to the needs of the business owners, especially when the owners want to maximize their own contributions. A plan opened for a solo proprietor is not going to be appropriate for a business with employees, so it is important to understand how to transition your retirement plan as your business needs change.
Owner with spouse employee
When your business is new, you might have just yourself and your spouse as employees. If your business does not have non-spouse employees (and you don’t plan to hire any in the near future), you might want to go directly to an Individual 401(k) (also called Solo 401(k) or Solo-k), bypassing both SEP IRA and SIMPLE IRA. An Individual 401(k) combines both salary deferral and profit sharing, which together allow you to contribute as much as $54,000 ($60,000 if you are over 50). An Individual 401(k) can also be opened for a partnership with no common-law (or non-spouse) employees. If you are looking to contribute $100k or more, a Defined Benefit (DB) or a Cash Balance plan might be more appropriate. An Individual 401(k) can be opened at a discount brokerage such as Vanguard (although in some cases it makes sense to set up a separate brokerage account and to use a Third Party Administrator), while a DB Plan requires the services of a Third Party Administrator (TPA) that provides administration and compliance services. An open architecture record-keeper is also necessary to get access to low cost investment options. A DB plan usually makes sense for those who are 45 or older as your available contribution will be much lower if you are younger than 45, but there are cases when younger owners can benefit from adding a DB plan to the existing 401(k) plan. DB plans are rather complex, so qualified help in setting and managing a plan is required, however it is more than worth it as you can put away as much as $250,000 a year pretax.
As with all retirement plans, once you start contributing sizable amounts, you need to make sure that your portfolio is managed conservatively without taking too much risk. You are already receiving a large tax deduction on your contributions, so taking excessive risk can easily result in big losses that will negate any benefit obtained from lowering your tax liability.
Small businesses with non-spouse employees
As an owner of a small business with employees, you want to save money for retirement without having to spend too much on plan cost and employee contributions. A SEP IRA will not work in the long term because you have to contribute the same percentage to all of your employees. An Individual 401k you’ve had from before cannot be used once you hire a single employee and he or she becomes eligible to participate in a retirement plan. The most cost-effective choice is SIMPLE IRA. While the SIMPLE IRA contribution limits are low ($12,500 or $15,500 for those over 50), and you are required to contribute to your employee accounts (match up to 3% or contribute 2% to all eligible employees), SIMPLE IRA does not cost anything to open and operate.
If your business has grown and you also want to increase your contribution as well as to provide a plan that is considered to be the industry standard, you can transition to a 401(k) plan. There are three components to a 401k plan contribution. As in Individual 401k, there is the salary deferral and profit sharing, though in corporate 401k plans profit sharing is often discretionary. The third component is the employer match, as with SIMPLE IRA. Individual contribution to a 401k plan is $18,000 ($24,000 with the catch-up contribution for those over 50). Some 401(k) plans are Safe Harbor, meaning that they offer to match up to 4% of participating employee’s contribution (alternatively, a 3% non-elective contribution to all eligible employees can be made instead), while other plans have no employer match (and still others match more or less than 4%). Whether your company offers a match or not depends on the type of design that would work best for your particular practice demographics. Corporate 401(k) plans require the services of a Third Party Administrator (administration, testing and compliance) and a record-keeper (online portal, access to low cost index funds), so there are extra costs associated with running these plans as opposed to Individual 401(k) and SIMPLE IRAs.
Midsize company, companies with high earning owners/key employees
If your company already has a 401(k) plan, you and your key employees may be interested in contributing much more than what is allowed by a standard 401(k) plan. A 401(k) plan can be designed to allow higher contributions for a certain class of higher earning owners and/or employees, who may contribute significantly more than the maximum of $18,000. The price for the higher contribution for key employees is a relatively modest contribution made on behalf of other employees in addition to any existing employer match and/or profit sharing. This is called a cross-tested plan, and it is commonly used when the owners would like to contribute more than a traditional 401(k) plan allows. The maximum contribution for cross-tested plans is still limited to $54,000 ($60,000 for those over 50).
If the owners would like to contribute significantly more than $50,000, a Cash Balance plan should be considered. The best results can be obtained when a cross-tested 401(k) plan is coupled with a Cash Balance plan, in which case as much as $250,000 can be contributed pretax. A Cash Balance plan is a type of Defined Benefit, thus the amount contributed to Cash Balance plan increases with age. Whether this plan is appropriate depends on many factors, and because of its complexity, professional help is required in setting up and managing the Cash Balance plans. While a typical 401(k) plus Cash Balance plan may cost roughly double what it would cost to run just the 401(k) alone for administration and record-keeping (for a business with 20 employees or fewer), this could be a great option for businesses with high earning owners and key employees.
Planning tips for small business owners
If you are planning to hire employees in the future and currently do not have a plan, the following approach might work for you. If you are not going to hire for at least a year or two, you can start with an Individual 401k. Once an employee is hired, an Individual 401(k) cannot be used, but instead you can open a SEP IRA where you can contribute up to 25% of your W2 income or $54,000, whichever is less. If an employee works for you for 3 out of 5 past years, they are eligible to receive the employer contribution (this rule can be made less restrictive by allowing employees to participate with either one or a two years of service). From the date of hire, you can have a SEP IRA for up to 2 years until you need to make employer contributions on behalf of your employees. After that, if you still want to offer a retirement plan, you can transition to a SIMPLE IRA, eventually followed by a cross-tested Safe Harbor 401(k).
Partners with spouse employees can start with an Individual 401(k), which would be a great way to put away significant money towards retirement. However, care must be taken when structuring compensation in the case of S-Corporation as only the W2 income (not the distribution) counts towards your retirement plan contribution. Once employees are hired, it may make sense to transition to a 401k with profit sharing to allow owners to contribute as much as $54,000 ($60,000 if over 50).
How to go about opening a plan
Plans for business owners or partners with spouse employees do not require a Third Party Administrator, and are therefore easy to open and maintain. While many brokerages such as Fidelity and Schwab offer a good selection of plans, Vanguard offers the largest number of high quality and low cost index funds including multiple global asset classes as well as numerous index and passively managed fixed income funds. The lower mutual fund management cost should be enough to justify opening a retirement plan at Vanguard.
When setting up a 401k and a Defined Benefit plan for a solo owner it is often a good idea to use your own Third Party Administrator who can provide a custom plan document for both 401(k) and Defined Benefit plans, as well as to open your accounts at an open architecture record-keeper rather than at a discount brokerage. While the cost of using a record-keeper is higher, the benefits often justify the cost especially for a combo 401(k)/DB plan.
To open a plan you need to find a good adviser specializing in retirement plans who can provide a number of important services to the plan. The adviser needs to be a fiduciary and their compensation has to be fee-only (ideally, fixed fee vs. an asset-based fee) to avoid any conflicts of interest. Your adviser should provide access to low cost index funds, develop risk-managed model portfolios, run enrollment and education seminars and offer individualized advice to plan participants. An adviser acting as a fiduciary for the plan can also select the best Third Party Administrator for your plan and have an ERISA attorney available to make sure that your plan complies with numerous laws and regulations. If your adviser is doing their job, you will not have much work to do as a plan sponsor.
How to run a successful plan
Here are some guidelines on how you can have a successful plan, especially if your business has employees:
- Minimize administrative and mutual fund fees. Lower cost funds beat higher cost ones, and higher cost funds take away your return without any added benefit.
- Use low cost index funds and risk-managed model portfolios. Studies have shown that a small number of high quality investments work best, and model portfolios that manage risk can help investors stay the course during market crashes.
- Provide individualized investor education. Make sure that your employees have access to the best advice available to help them with their investment management. One-on-one advice can also protect you as a plan sponsor from fiduciary liability as general advice is not sufficient when it comes to helping employees make the best investment decisions.
- Make sure that your plan advisers don’t get paid to sell products, and that all of their recommendations are made with your best interest in mind. As a plan fiduciary, you are responsible to make sure that your plan is run in accordance with existing laws and regulations. While you can outsource much of your fiduciary liability by selecting an appropriate adviser, you are still liable for making sure that the adviser you select is doing their job.
- To select the right plan for your business, you need to be clear about what personal financial and business objectives you are trying to accomplish by opening a retirement plan.
- Your retirement plan needs will change as your personal and business situation changes, thus you need to be aware of your options and take action when change is necessary.
- Entrust plan design and management to fiduciaries who will act in your best interest to make sure that:
- The right plan is selected for your business.
- The plan is managed prudently in accordance with your individual and business objective.
- The plan services help protect you from fiduciary liability and enable your employees to get the best results with their individual accounts.