Financial advisors are continually recommending retirement plans to business owners. They often make that recommendation every tax year and wonder why the owners never do. When asked, about 40% of small business owners do not believe they have enough money to invest in a retirement plan for themselves or for their employees. Almost 75% believe that retirement plans are too expensive, and 61% lack the resources to administer a program.
Even though business owners may listen to the advice, they don’t have the time to research which retirement plan is the best for their company. With multiple options, they have much to consider, such as contribution levels, administration requirements, and plan rules. Without someone to guide them, they often give up.
What Retirement Plans are Available?
Qualified retirement plans fall into two groups:
- Individual Retirement Accounts (IRAs)
- Defined Contribution Plans (401k)
Under each category are individual plans that have different requirements. Understanding the differences among the programs makes it easier to focus on the best options for business owners and their businesses.
Individual Retirement Accounts (IRAs)
Most people are aware of traditional and Roth IRAs as personal savings instruments; however, employer-based IRA retirement plans also exist. With IRA plans, the maximum annual contributions are per person, meaning an individual with multiple IRAs cannot exceed the maximum across all IRA investments.
These IRAs lower taxable income because all contributions are made with pre-tax dollars. That means money placed in an IRA is taken out before taxes are calculated, decreasing taxable income. For 2022, the maximum contribution is $6,000.00 unless you are over the age of 50. Then the maximum is $7,000.00. Money in a traditional IRA is not taxed until it is withdrawn, but distributions must be taken at age 72.
Roth IRAs are the reverse of traditional IRAs. Contributions are taxed, but distributions are not. Roth IRAs provide more flexibility when it comes to managing retirement income. Because it has no mandatory distribution requirement, Roth withdrawals can be taken to minimize taxable income. The maximum retirement account contributions in 2022 are the same as for traditional IRAs.
Payroll Deduction IRAs
Employers agree to withhold employee-requested contributions as a payroll deduction. It is an employer-provided service with no requirement for a formal plan, participation, or contribution. The deductions are transmitted to an employee’s traditional or Roth IRA at an established financial institution. These IRAs follow the same regulations as any traditional or Roth IRA.
A SEP IRA or simplified employee pension IRA is designed for small businesses with few employees. A self-employed business owner with no employees may also contribute to a SEP IRA. For a sole proprietor, SEP IRAs allow contributions up to 25% of compensation to a maximum of $61,000 in 2022. However, only employers can contribute to a SEP IRA.
As an employer, you must contribute the same percentage to each employee’s account as you do to your own. If you contribute 15% of your compensation to an IRA, you must contribute 15% to each employee’s account. There is no employee contribution. All eligible employees must be included. An employee must be 21 years old, have worked for the company three of the last five years, and earned more than $600.00 in the prior year.
All employer contributions are tax-deductible, including those to employee accounts. Depending on the size of the contributions, a business can realize a lower tax liability. A SEP IRA does not require an annual contribution so that it can help organizations with cash flow challenges. SEP IRAs are traditional IRAs and must adhere to the same IRS regulations.
The primary difference between a SEP and a SIMPLE IRA is the employer contributions. SIMPLE IRAs require a mandatory annual contribution, but SEPs do not. They are available to sole proprietors and small businesses with less than 100 employees and operate in much the same way as a 401k plan. SIMPLE plans allow contributions to be invested in stocks, bonds, and mutual funds, depending on the IRA provider.
Employers either match employee contributions 100% up to 3% of an employee’s compensation or 2% of employee compensation regardless of contribution status. All contributions are made with pre-tax dollars, and employer contributions are tax-deductible. Maximum contributions change each year, with 2022’s contributions set at $14,000.00 unless the employee is age 50 or older. For those who are 50 plus, the contribution maximum jumps to $17,000.00 for 2022.
Defined Contribution Plans
Defined contributions plans are NOT defined benefit plans (often known as pension plans). Contribution plans are ways for employers and employees to save for retirement. These retirement instruments require a documented guide for how the plan operates and are more commonly known as 401k plans. In the past, only large corporations offered 401k plans, but changes in tax laws have created 401k options for small businesses and sole proprietors.
The solo 401k retirement plan is for business owners with no employees; however, a spouse may be included in a solo plan. Contributions are taken from pre-tax dollars, reducing taxable income. Given that the maximum contribution for 2022 is $61,000.00, a solo 401k has the potential to significantly reduce one’s tax liabilities.
A solo 401k may operate as a traditional or Roth 401k.To lower current taxable income, opt for a traditional IRA that will make contributions from pre-tax dollars. To lower taxable retirement income, choose a Roth IRA. Either option can result in lower taxable income.
Solo 401k plans allow a spouse to participate in the plan. As long as spouses earn an income from the business, they can contribute up to $20,500 in 2022. Profit-sharing is also an option under solo 401k plans that can increase annual retirement contributions. As solopreneurs, business owners can contribute part of their profits up to 25% of their spouses’ compensation to a 401k plan.
SIMPLE 401ks were designed for small businesses. They do not have restrictions regarding a company’s business structure, making it easier for employers with fewer than 100 employees to offer retirement plans. Employees must have completed one year of service, and be 21 years of age to participate in the plan. Each participating employee should have received a minimum compensation of $5,000 in the previous year. Unlike traditional 401ks, SIMPLE plans do not have to comply with IRS regulations regarding nondiscrimination and highly-compensated employees.
SIMPLE 401ks have a maximum contribution limit of $14,000 in 2022. An additional contribution of $3,000 can be made by employees over the age of 50. The $14,000 contribution is less than the $20,000 of a traditional 401k. Employees are fully vested after their first contribution.
Employers must contribute a matching contribution of up to 3% of an employee’s pay or a nonelective contribution of 2% of an employee’s pay. Employee contributions are pre-tax which can lower an individual’s tax liability. Employer contributions are tax-deductible.
Saving for Retirement
Sorting through the ins and outs of retirement plans can be overwhelming. Are the deductions being made correctly? Where should the employer contributions be held? These are the operational questions that give business owners pause. With the right accounting services partner, small business owners can take the worry out of retirement plans, save money, and lower their tax liability.
Disclaimer: We can help with all your accounting needs, however, if you need help setting up a plan for your business, please reach out for our recommendations.