Unfortunately, you don’t have the luxury of being able to contribute to an existing company 401k. You’ll need to be proactive to start your own retirement plan that you can begin contributing to each year. Small business retirement plans can also be a very attractive employee benefit.
Thankfully, there are lots of great small business retirement plans to choose from. In this guide, we’ll take a look in detail at the seven best small business retirement plans and discuss the pros and cons of each.
7 Best Small Business Retirement Plans
Whether you’re a solo entrepreneur or you have over 100 employees on your payroll, you can find a small business retirement plan that fits your situation. Here’s what you need to know about the 7 most popular small business retirement plans.
1. Individual IRA (Traditional or Roth)
Best for: Solopreneurs and independent contractors who don’t plan to contribute more than $6,000 a year.
Individual IRAs aren’t technically small business retirement plans at all. But if you’re just starting your business and don’t plan to make contributions exceeding $6,000 a year, a Traditional or Roth IRA may be all you need.
Convenience is the real advantage here. Individual IRAs are, by the far, the easiest to set up. You can open up an individual IRA in minutes with virtually any of the popular discount brokers or Robo-advisors.
With both Traditional and Roth IRAs, the annual contribution limit for 2019 is $6,000, or $7,000 if you’re age 50 or older.
Rules And Costs:
- Even if you later decide to open a SIMPLE IRA, SEP IRA, or 401k plan, you can continue to contribute up to the annual maximum to your Traditional or Roth IRA. So, yes, you can take advantage of tax-sheltered growth in both accounts.
- If you and your spouse file a joint return, you can each contribute to your own separate IRAs, even if your spouse does not have income.
- Since this is not an employer-sponsored plan, there is no individual IRA matching.
- IRAs are easy to move if you want to work with a different broker.
- You cannot borrow against a Traditional or Roth IRA.
If you don’t have any employees and don’t need high contribution limits, you may just want to stick with a basic individual IRA. They’re also great if you have income coming in from multiple businesses.
But as you begin to hire employees or your annual income grows, you’ll probably want to look into opening a full-fledged employer-sponsored retirement plan.
2. SEP IRA
Best for: Small business owners who want higher contribution limits and only have a few full-time employees
SEP (Simplified Employee Plan) IRAs are simple to set up and they come with high contribution limits. They also come with some great perks for your employees.
But that’s also one of the plan’s downsides. If you have several full-time employees, a SEP IRA plan could get very expensive.
The annual maximum contribution limit for a SEP IRA is $56,000, in 2019. That’s a hefty sum, but it’s important to note that most small business owners won’t be able to contribute that much. That’s because your annual contribution cannot exceed 25% of your annual income.
What makes SEP IRAs unique is that business owners are required to contribute the same percentage to their employees’ plans as they make to their own accounts.
So, on a SEP IRA plan, if you contribute 10% of your income to your plan, you’ll need to contribute 10% to all your full-time employees’ plans as well.
3. SIMPLE IRA
Best for: Small business owners who don’t plan to contribute more than $13,000 + 3% of salary a year for a maximum contribution of $26,000.
SIMPLE (Savings Incentive Match Plan for Employees) IRAs are aptly named because their best feature really is their simplicity.
Of all the small business retirement plans, SIMPLE IRAs are the only ones that don’t come with annual IRS filing requirements. And most SIMPLE IRA plans come with rock bottom administrative fees. They also come with flexible employer matching options.
But the annual contribution limit is much lower with SIMPLE IRAs than other small business retirement plans.
With a SIMPLE IRA, the maximum 2019 annual contribution is $13,000. You can also receive a matching contribution of up to 3% of your salary to the SIMPLE IRA. So for example, if your salary is $100,000, the company can match an additional $3,000 in contributions, bringing your total contributions to $16,000. Keep in mind, whatever you match for yourself, you will also have to match for your employees.
For those over age 50, you can contribute an additional $3,000 per year.
It’s important to note that there is no income “percentage” requirement on this contribution. So it’s possible you may be able to contribute more to a SIMPLE IRA than a SEP IRA.
Here are the matching options that come with SIMPLE IRA plans:
- Elective Contributions: Employers match employee contributions dollar-for-dollar for up to 3% of their annual pay. OR
Non-elective Contributions: Employers contribute 2% of every employee’s annual salary, whether they contribute or not.
Rules and Costs:
- While it can take 3-5 years for employees to become “vested” on some 401k plans, all contributions to SIMPLE IRAs are 100% vested right from the start.
- SIMPLE IRAs are typically better than 401k plans if you or your employees want more freedom to choose the funds that you’re invested in. It’s usually easier to invest in stocks, bonds, CDs, and other investments with SIMPLE IRAs as well. So if self-directed investing is your thing, you may want to consider a SIMPLE IRA (or a SEP IRA).
- SIMPLE IRAs do not allow loans.
- You should have no administrative fees, although your brokerage may want to charge a small annual custodian fee.
- With a SIMPLE IRA, if you cash out or move your assets into a rollover IRA within two years of opening your account, you will be subject to a 25% penalty in addition to ordinary income tax. The normal penalty is 10% so this is a significant increase.
If you only have a few employees and you don’t plan to contribute more than $13,000 annually to your retirement plan, it’s hard to go wrong with a SIMPLE IRA.
4. Solo 401k
Best for: Solopreneurs and independent contractors who want higher contribution limits.
Solo 401k plans are nearly identical to Traditional 401ks, with the exception being that only the business owner and their spouse are allowed to contribute. But Solo 401ks come with much less paperwork and overall administrative cost than Traditional 401ks.
Also, most people will be able to contribute more to a Solo 401k than a SEP IRA…even while earning less.
One of the cool things about a Solo 401k is that a business owner can contribute as both an employer and employee. As of 2019, business owners can contribute up to $56,000 a year, to a Solo 401k ($62,000 for those age 50 or older).
Here’s how that breaks down.
- Employee elective deferral: You can contribute up to 100% of “earned income” up to the annual contribution limit, which is $19,000 in 2019, or for those age 50 or older, $25,000. These contributions can be made pre-tax or on after tax-basis if your plan has a Roth option.
- Employer non-elective contribution: 25% of compensation, which the IRS defines as net earnings from self-employment minus one-half of your self-employment tax and minus the contributions you make to your retirement plan. This is made in addition to your personal $19,000 contribution for a maximum contribution of $56,000.
Rules and Costs:
- Once your plan exceeds $250,000, you’ll need to file Form 5500 with the IRS every year.
- If you decide to hire employees later, you can convert your Solo 401k to a Traditional 401k. You won’t be required to match employee contributions. This is a benefit over the SEP IRA.
- Like with a Traditional 401k, you are allowed to borrow against your Solo 401k assets.
- While Solo 401k plans may require a little more paperwork to set up than a SEP IRA or SIMPLE IRA, the administrative costs should be similar.
For most sole proprietors and independent contractors, a Solo 401k offers one of the best blends of simplicity and flexibility. But if you’re looking for a retirement plan that can cover your employees, you’ll want to look elsewhere.
5. Traditional 401k
Best for: Small business owners who have 10+ employees
Until now, we’ve only looked at retirement plans that are low cost. When you’re just starting out as a small business, that will probably be one of your main priorities.
But once your business has grown to the point that you have at least double-digit full-time employees, a Traditional 401k may be worth it despite the fact that they’re more expensive.
Why? Once you have 10, 20, or 5o employees that need to be included in a small business retirement plan, managing it yourself would be time-consuming and labor-intensive. Plus, 401ks give small business owners more freedom when it comes to contribution matching than you get with SEP IRA or SIMPLE IRA plans.
The maximum annual contribution to Traditional 401k plans is $56,000. Here’s how that total number is broken down:
- Employee salary deferrals: $19,000 max
- Employer match: $19,000 max
- Employer profit-sharing contribution: $18,000 max
Traditional 401ks do allow catch-up contributions of up to $6,000 for those who are age 50 or older.
Rules and Costs:
- Traditional 401ks are one of the expensive forms of retirement plans. Expect to pay around $2,000 a year for administration. However, the cost of the plan will be shared by all of your employees.
- You have ultimate control over matching contributions. You can choose whatever percentage you want or choose to not match at all. And if you want to change your matching percentage down the road, you can do that too.
- Each year your 401k plan will have to go through compliance testing to make sure that every employee is receiving a fair benefit from the plan–not just your highest-earners. You’ll also need to submit a File 5500 for your 401k plan each year. Here is more info on compliance testing.
- Just like with Solo 401ks, you can borrow against assets inside a Traditional 401k.
You’re going to pay more in administrative fees with a Traditional 401k than with other retirement plans. In essence, you’re paying someone else to take the headache of small business retirement plan management off your hands. That could be a trade-off worth making if you have a lot of employees.
But, remember, your employees will share in the cost of the plan. For this reason, it’s important to shop around so that you and your employees aren’t paying more fees than you should.
6. Safe Harbor 401k
Best for: High-earning small business owners with 10+ employees
Safe Harbor 401k plans are identical to Traditional 401k plans in most regards. But, if you are a high-income earner, a Safe Harbor 401k could help you steer clear of compliance issues and keep more of your money sheltered from income tax.
The contribution limits for Safe Harbor 401k plans are exactly the same as Traditional 401ks. The 2019 maximum annual contribution is $56,00, with an extra $6,000 per year allowed for those who are age 50 or older.
Where Safe Harbor 401k plans differ from Traditional 401k is in the employer match department. With Safe Harbor 401ks, employer contributions must meet one of two minimums:
- Elective contributions: Employers must match employee deferrals up to 4% of the employee’s salary. They can do this by matching 100% deferrals up to 4% of salary or matching 100% up to 3%, then 50% up to 5%. OR
- Non-elective contributions: Employers must contribute 3% of every employee’s annual salary, regardless of whether employees participate themselves.
Why would small business owners submit themselves to these requirements? Because, in return, their plans will be exempt from annual nondiscrimination testing.
Remember, Traditional 401k plans must submit to compliance testing on an annual basis. Sometimes, for high-income earners, these compliance tests will result in part of their contributions being returned and taxed as regular income. To avoid these issues, some high-earning small business owners find it worth it to apply for Safe Harbor 401k plans.
Rules and Costs:
- Safe Harbor 401k plans have high administrative costs, just like their Traditional 401k counterparts. They may be a bit cheaper though since there is no annual compliance testing.
- Like all other 401k plans, you can borrow against your assets.
- Although there is no annual compliance testing, you’ll still need to file Form 5500 each year.
Safe Harbor 401k’s avoid the compliance testing of traditional 401k’s, so if your plan is top-heavy this could be the answer you’ve been looking for. However, they do require a higher contribution from the company to employee’s accounts.
7. Defined Benefits Plan
Best for: High-income earners who want to contribute the highest possible annual amount.
Never heard of a defined benefits plan before? How about it’s more common name–the employee pension?
Yes, that’s right, a pension plan could still be a relevant option for certain small business owners. But in order for a defined benefit plan to be worth its high cost, you’ll need to be putting truckloads of money into your account each year.
What makes defined benefits plans so unique is found in its name. Unlike all of the other plans that we’ve looked at so far, pensions have defined annual benefits limits, not defined annual contribution limits.
With defined benefits plans, the plan needs to grow large enough to provide the required annual payment before the employee retires. If you didn’t start contributing to a defined benefits plan until your mid-forties, for example, that number could easily be over $100k.
And while there are limits to the annual benefits that someone can receive from these plans, they are incredibly high. The defined benefit plan cannot exceed the lesser of:
- 100% of the participant’s average compensation for his or her highest three consecutive calendar years
- $225,000, for 2019
And, yes, all contributions to a defined benefits plan are tax-sheltered.
Rules and Costs:
- Setting up a defined benefits plan is often even more expensive than a traditional 401k. You’ll need to hire an enrolled actuary to decide the level of funding you’ll need in order to create the defined benefit in retirement.
- You will be required to make a minimum contribution each year, regardless of how well your business does.
- Employees do not contribute to a defined benefits plan. The employer takes full responsibility for the plan and takes on all of the investment risks.
- You can borrow against a defined benefits plan.
Because employers take on all the responsibility and risks associated with defined benefits plans, they aren’t typically a good option for business owners who have a lot of employees.
However, there are situations where it could be a good fit. Doctors, lawyers, consultants, and owners of small family businesses are the typical ideal candidates for defined benefits plans.
But you shouldn’t consider a defined benefits plan unless you think you think you’ll need to contribute more than the $56,000 annual max that you’re already allowed to make under SEP IRA or 401k plans.
Deciding which small business retirement plan is right for you really comes down to two keys: your number of employees and how much you plan to contribute on an annual basis.
Once you’ve answered those two questions, it shouldn’t be too hard to choose a small business retirement plan that fits your unique situation.