Small companies shouldn’t forgo retirement savings just because a 401(k) plan can be expensive to set up and maintain. There are options specifically for smaller businesses: a Savings Incentive Match Plan for Employees (SIMPLE) plan, a Simplified Employee Pension (SEP) plan, and a SOLO 401 (k).
If your company has more employees than just you and your spouse, you may want to consider either a SIMPLE IRA or a SEP-IRA. The plans have similarities and a few differences that must be considered when deciding between the two. Knowing the details of each type can help you decide which is the best choice for you, or which to offer your employees if you own a small business.
They’re Called SIMPLE Plans for a Reason
The SIMPLE IRA enables employees and employers to contribute to Traditional IRAs—they cannot be Roth IRAs—expressly set up for employees. The plan is more cost-effective for a small company (typically 100 or fewer employees) to set up than a 401(k), which requires both set-up and ongoing administrative costs.
Setting up a SIMPLE IRA comes down to completing a form, and there are no filing requirements. However, the company cannot have any other retirement plan. The plan must be set up by and for each eligible employee. To qualify, a worker must have earned at least $5,000 from the company in each of the past two years and plans to receive compensation of at least that much in the current year.
All contributions must be invested in the IRA account. Contributions are not subject to federal income tax withholding. SIMPLE IRAs can be set up at banks, savings and loan associations, insurance companies, regulated investment companies, federally insured credit unions, and brokerage firms. Contributions can be invested in stocks, mutual funds, and other similar types of investments. Investment options depend on the choices provided by the financial company maintaining the account.
The SIMPLE IRA Employer Contribution
The employer has a choice about contributing annual funds to the plan:
- Non-elective contributions: The employer contributes 2% of each employee’s salary into the plan each year, even if the employee does not contribute.
- Elective contributions: Dollar-for-dollar matching contribution, up to 3% of the employee’s salary.
The employee is always 100% vested in all the SIMPLE IRA funds.
The Simplicity Comes with A Cost Compared to Other Plans
This plan is easy and inexpensive to set up and maintain, and employees share responsibility for saving for retirement. However, the plan has inflexible contributions and lower contributions limits than other retirement plans. An employee can salt away more money each year in a 401(k) plan or SEP-IRA.
Participants cannot take out loans from these plans because the assets may not be used as collateral. An employee can withdraw funds, but the loan would be added to income and the IRA adds 10% to the tax bill for employees younger than 59 1/2.. If the employee withdraws funds within the first two years of participating in the SIMPLE plan, the IRS bumps up the 10% additional tax to 25%.
Choosing a SEP-IRA Plan
Simplified Employee Pension (SEP) plans can provide a significant source of retirement income by allowing employers to save money in retirement accounts for themselves and their employees. SEPs lack the start-up and operating costs of a conventional retirement plan and allow for a contribution of up to 25% of each employee’s pay.
Unlike other retirement plans, employees enrolled in a SEP-IRA do not deposit funds directly to their savings plan. Instead, the employer makes the contributions on their behalf. One key benefit: SEP-IRAs permit employers to omit contributions during years that the company is not generating a profit or is experiencing declining sales.
Most SEPs require that company owners make allocations proportional to employees’ salaries. As a result, all the contributions for the employees should be the same percentage of salary. Employees can start contributing after working three years at the company and must make at least $650 per year. Annual contribution limits are higher than standard IRAs, and those contributions are vested right away.
Establishing a SEP
Setting up a SEP is different than establishing a SIMPLE. The employer first has to choose a financial institution to serve as trustee of the SEP-IRAs that will hold each employee’s retirement plan assets. These accounts will receive the contributions made to the plan.
There are three steps to establish a SEP:
- Execute a written agreement to provide benefits to all eligible employees.
- Give employees specific information about the agreement.
- Set up an IRA account for each employee.
There’s a Plan for One-Man Shops Too: The Solo 401(k)
Self-employment has many advantages and perks, but one benefit that is not available to most small business owners or entrepreneurs is an employer-sponsored retirement plan like a 401(k). To provide retirement options for solo business owners, the IRS allows the solo 401(k), or a one-participant 401(k), which has many aspects of an employer-sponsored plan.
To describe these plans, the IRS states that the business owner wears two hats in a Solo 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can contribute both:
- Elective deferralsup to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit:
- $20,500 in 2022 or $27,000 in 2022 for those age 50 and older.
- Employer nonelective contributionsup to:
- As the employer, you can contribute additional profit-sharing funds of up to 25% of your compensation or net self-employment income—i.e., your net profit less half your self-employment tax and the plan contributions you made for yourself.
- The limit on compensation used to factor in your contribution is $305,000 this year.
Total contributions to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed $61,000 this year. The one exemption to a solo 401(k) is your spouse – they can contribute too, if they work in the business.
The Bottom Line
Small business owners may not have the budget to set up a 401(k) plan for themselves and their workers. However, if you want a way to save for retirement, there are a few options. Owners can choose between a SIMPLE IRA or SEP-IRA. Both plans provide an alternative and more affordable method to encourage retirement savings.
If you are looking for some great examples of how these plans work you may want to look at Hack Your Wealth Blog which has a great article on the Solo 401k and how it compares to the SIMPLE IRA and SEP IRA. https://hackyourwealth.com/
This work is powered by Seven Group under the Terms of Service and may be a derivative of the original. More information can be found here.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content not reviewed by FINRA
SECURE 2.0 Act Enhancements Across the Retirement Continuum
SECURE 2.0 Act Enhancements Across the Retirement Continuum
Whether you have student loans, need to catch up in the final years before retirement, are facing taking required minimum distributions in retirement, or want to enact a charitable giving strategy, new rules create a smoother path.
5 Steps to Budgeting
Making a budget might seem overwhelming at first, but hear this: You can do it. How? By breaking down the process a bit.
What Is a Budget?
Real quick though, let’s define the word budget. A budget is just a plan. It’s not a restriction on spending—it’s a plan for what you’ll do with your money. It’s a plan for what’s coming in and what’s going out.
When you learn how to make a budget—and do it every month—you’re giving your money purpose. You’re taking control. Goodbye, money anxiety. Hello, money goals.
How Do You Create a Retirement “Paycheck?”
“How do I get my money out of my retirement plan and into my checking account?”
The question is not as simple as it appears – that’s why people ask it. They’re not asking about the mechanics of a 401(k) withdrawal. They want to understand the switch from saving to spending, and it’s an entire cascade of questions covering how to decumulate assets in retirement. These include:
• When should I take social security?
• How can I ensure I’ll have enough income for my needs?
• How can I invest for growth without taking too much risk?
• What about taxes?
At University Financial Strategies our mission is to help families think beyond just saving for college, but helping leverage strategies that leverage your unique situation to help you save on college costs. We take into consideration topics like specialized college-planning strategies for business owners, planning for financial aid, school-specific scholarships, coordinating college planning with grandparents, cash-flow strategies and options for covering shortfalls, to name just a few.
4801 Glenwood Avenue
Raleigh NC 27612
The information on this site is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, University Financial Strategies, LLC.(referred to as "University Financial Strategies") disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement and suitability for a particular purpose. University Financial Strategies, LLC.does not warrant that the information will be free from error. None of the information provided on this website is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments.
Your use of the information is at your sole risk. Under no circumstances shall University Financial Strategies, LLC.be liable for any direct, indirect, special or consequential damages that result from the use of, or the inability to use, the materials in this site, even if University Financial Strategies, LLC.or a University Financial Strategies, LLC.authorized representative has been advised of the possibility of such damages. In no event shall University Financial Strategies, LLC.have any liability to you for damages, losses and causes of action for accessing this site. Information on this website should not be considered a solicitation to buy, an offer to sell, or a recommendation of any security in any jurisdiction where such offer, solicitation, or recommendation would be unlawful or unauthorized.