Choosing a retirement plan for your business
Hiring and keeping good employees is important to your business’s success. One way to entice talented people is to offer a retirement plan as a benefit. As an added bonus, having a retirement plan can reduce your business’s taxable income. But there are a lot of different plans available. Here’s what you need to know about choosing a retirement plan for your business.
What kinds of business retirement plans are available?
Retirement plans help workers save money for their retirement. Since social security only replaces about 40% of your working income, most people need to rely on savings to maintain their lifestyle after they stop working. The IRS allows workers to save pre-tax money in certain accounts for this purpose. The money grows tax deferred until you take it out, at which time it is taxed like regular income.
Three basic types of retirement plans
1. IRA plans. These are individual retirement accounts (IRAs) that are set up for employees by the company. They are easy and inexpensive to set up and administer, so they are popular for small businesses. There are three kinds:
- Payroll Deduction IRA An account is set up for each employee who wants one, and the employer deducts the requested amount from the employee’s pay and deposits it into their account. With this type of plan, only the employee makes contributions. The maximum amount an employee can contribute in 2020 is $6,000, with an additional $1,000 ‘catch-up’ contribution allowed for employees age 50 and over.
- Simplified Employee Pension (SEP) IRA With this type of plan, the employer contributes a percentage of each person’s salary into their plan account. The percentage must be the same for each employee in a given year, but can vary from year to year. So, if your company has a really good year and wants to reward its employees, it can contribute a larger percentage to their SEP IRAs. If business is slow in a certain year, the company can contribute less. The employer can contribute up to 25% of each employee’s compensation but no more than $57,000 per employee in 2020. Employees do not make contributions to SEP IRAs.
- Savings Incentive Match Plan (SIMPLE) IRA Both employer and employee can contribute to this type of plan. Employees can make contributions through salary deduction of up to $13,500 in 2020, plus a $3,000 ‘catch-up’ contribution if you’re 50 or over. The employer must contribute to each employees’ account, whether the employee contributes or not. If the employee contributes, the company must match up to the first 3% of their salary, dollar for dollar. If the employee does not contribute, the company must contribute 2% of their salary.
2. Defined contribution plans are designed to deposit a certain amount of money into the employee’s account. These plans tend to be used more often by bigger companies since they can be more complicated and costly to set up than IRA plans. You should seek the advice from a financial institution or employee benefit advisor to set up one of these plans. There are two basic types.
- Profit sharing plan This is an employer-funded plan that allows employers to contribute up to $57,000 to each employee’s account in 2020. These plans can have a vesting schedule, so that employer contributions become available over a period of years (usually five). Employees do not contribute.
- 401(k) plan This type of plan accepts contributions from both employers and employees. Typically, the employee will contribute a percentage of their salary and the employer will match up to a certain percentage, so the more the employee contributes, the more the employer contributes. The combined contribution in 2020 is limited to $19,500, plus a $6,500 ‘catch-up’ contribution for those aged 50+.
3. Defined benefit plans, commonly known as pensions. These are employer-funded plans that promise a certain amount of income to be paid out in retirement. They are rare and becoming rarer, as they represent an open-ended commitment on the part of the employer.
Which retirement plan is right for my business?
Every business is different, so you should consult your tax or employee benefits advisor before making a decision. But there are a couple of questions you can ask yourself to help guide you toward the right plan.
Whom do you want to contribute to the plan – you, your employees, or both?
If the answer is just you, consider a SEP IRA or profit sharing plan. In either case, you can determine the amount you will contribute on a year-to-year basis. If you want to make sure your employees stay with you for a few years after you make the contributions, try the profit sharing plan with a five-year vesting schedule.
If the answer is just your employees (which includes you for your own account), consider a payroll deduction IRA or SEP IRA. A SEP IRA has higher contribution limits, so if you or your employees want to put away a significant amount, the SEP IRA is a better option.
If the answer is both, a SIMPLE IRA or a 401(k) plan is a good choice. The 401(k) lets people save more, but the SIMPLE is easier and less expensive to administer.
How much will people want to contribute?
If you have employees who make a lot of money and you think they will want to make large contributions, a 401(k) or SEP IRA is a good choice. Note that some 401(k) plans limit the amount that high earners can save if you don’t have participation from a majority of your lower-wage employees, so watch for so-called discrimination testing, which makes sure you’re treating all your employees fairly.
Does your business’s profitability vary significantly from year to year?
If you think you may be hard-pressed to make contributions some years, but able to contribute significantly in other years, a SEP IRA or a profit sharing plan is a good option. These plans let you decide whether or not you want to contribute to your employees’ accounts in any given year.
A retirement plan is an important employee benefit and may help you hire and retain talent. Another plus is that the contributions you make to your employees’ accounts are usually deductible, so they will reduce your company’s taxable income. Consult with your tax professional or an employee benefits specialist to determine the best plan for your company.