Your guide to small business retirement plans
You’re a small business owner, looking to hire more help. But you wonder: Do you need to offer a retirement plan to your employees? Depending on the size of your business and your state’s requirements, you may not have to, but it could still be helpful to your success. Offering a retirement benefit can be one way to encourage people to work for you—and potentially stay longer. Plus, you probably need retirement savings for yourself so you can build your own nest egg.
There are a few different small business retirement plans to consider as you build your own future and show your employees that they’re valued. Here’s a look at different retirement plans for small businesses and what’s required.
- For a small business, it can make sense to use a SEP or SIMPLE IRA instead of offering a 401(k).
- SEP IRAs come with high contribution limits for business owners.
- SIMPLE IRAs allow business owners to either offer matching contributions or simply contribute to their employees’ plans.
SEP IRA
The Simplified Employee Pension (SEP) IRA lets business owners contribute as much as 25% of compensation or $66,000 (for 2023), whichever is less. This makes it one of the best ways to contribute higher amounts to grow your nest egg.
Setting up a SEP IRA is fairly straightforward:
- Create a formal agreement using IRS Form 5305-SEP or a document provided by a qualified financial institution. You can also create your own document, but that might be more of a challenge.
- Each eligible employee must receive information about the SEP IRA, including the agreement form you used to establish the plan.
- Create a SEP IRA account for each eligible employee. They will own and control their own accounts.
There are a few rules to keep in mind with the SEP IRA. You must contribute the same percentage to your employees’ plans that you’re contributing to your own (but note: Your percentage is based on your business’ modified net income, while your employees’ percentages are based on their salaries—see example below). And you must contribute to your employees’ accounts every year that you contribute to your own account. Annual contributions are required to be reported on IRS Form 5498.
For example: Suppose you decide to contribute 10% on behalf of your employees toward each of their SEP IRAs. Joe’s income is $80,000, so your employer contribution to his account is $8,000. Mary’s income is $85,000, so your contribution to her account is $8,500. Your contribution to your own SEP IRA, as owner, is 10% of the business’s net income (after deducting one-half of your self-employment tax and contributions to your own SEP),not your salary. Note that employees cannot make their own contributions to the SEP IRA you set up for them; the business owner is the only one who contributes.
The traditional SEP includes pre-tax contributions and required minimum distributions (RMDs) starting at age 73. There’s also a new Roth option that uses after-tax contributions, grows tax free, and can be withdrawn tax free after age 59 1/2.
SIMPLE IRA
Another choice for small businesses is the SIMPLE IRA. This plan is designed to be relatively easy to administer. It’s typically available only to businesses with 100 or fewer employees. Like the SEP IRA, there are just three steps to get started:
- Create a written agreement that indicates you’ll provide the benefit to eligible employees. The IRS offers the Form 5304-SIMPLE or Form 5305-SIMPLE to make the process easier.
- Provide employees with information about the plan, including whether you plan to make non-elective or matching contributions.
- Create an IRA account for each eligible employee.
Thanks to the SECURE ACT 2.0, there is a Roth version available for the SIMPLE IRA.
Roth vs. traditional: Which is right for me?
First, learn the differences. Get a side-by-side comparison.
You’ll have to decide each year how you’ll handle contributions. You can choose to match your employees’ contributions dollar-for-dollar on up to 3% of their compensation, or you can contribute up to 2% of your employees’ compensation outright—with no contribution requirement on their part.
Contribution limits for a SIMPLE IRA are lower than those for a SEP IRA at $15,500 per year (in 2023) with a $3,500 catch-up contribution for those over 50. There are rules about reducing the 3% matching contribution—it can’t drop below 1%. And you can’t reduce the matching contribution for more than two out of five calendar years.
401(k) plans
The 401(k) is one of the first accounts that comes to mind when many people think of employer-sponsored retirement plans. It, too, comes in traditional (i.e., tax deferred) and Roth varieties. However, it can be costly to establish a 401(k) plan as a small business owner, and some might find this retirement plan difficult to administer, as you’re required to:
- Find a custodian
- Establish a trust fund
- Create a record-keeping system
- File annual forms (something not required with SIMPLE IRA plans)
A traditional 401(k) requires annual testing to make sure the benefits to regular employees are proportional to those of the owners. If you as a business owner draw a salary much higher than your employees’ salaries, you might not be able to pass this non-discrimination testing.
A safe harbor 401(k) avoids the non-discrimination testing by requiring certain matching percentages that are immediately fully vested by employees.
In general, the 401(k) reporting and administration requirements can be onerous and/or costly. For those with small businesses, it might make more sense to stick with something else.
Solo 401(k)
If you don’t have any employees, you could consider opening a solo 401(k). Some brokers offer these accounts and can help you set up and administer one. You as the business owner act as both employer and employee in calculating your contributions. The total contributions can’t exceed $66,000 a year (in 2023), making this an account that provides for a high limit. But if you hire any employees who aren’t your spouse, you can no longer contribute.
Profit-sharing plan
It’s also possible to establish a profit-sharing plan. This allows you to contribute discretionary amounts to your employees’ retirement accounts based on how well your business does, up to $66,000 per employee per year (in 2023). Typically you put a pool of profits into an account and split the profits among the employees based on their salaries. There’s no limit on the size of businesses eligible to use a profit-sharing plan, and you can offer another type of retirement plan as well. However, you will need to file a Form 5500 each year. You’ll also need to perform benefits testing to ensure that highly compensated employees don’t get favorable treatment under the plan. The cost of administering a profit-sharing plan might be higher than using a SEP or SIMPLE IRA.
Comparison of small business retirement plans
| SEP IRA | SIMPLE IRA | 401(k) | Profit-sharing | |
|---|---|---|---|---|
| Who can open | Businesses owner with or without employees | Business owner with fewer than 100 employees | Business owner (of any size) with employees | Business (of any size) with or without employees |
| Annual contribution limits (2023) | 25% of compensation (or modified business net income for owners) up to $66,000 | $15,500 for employee portion with catch-up contributions of up to $3,500 over age 50 | $22,500 with catch-up contributions of up to $7,500 over age 50 | $66,000 or employees’ salary, whichever is lower |
| Roth option | Yes | Yes | Yes | No |
| Employee participation requirement | Age 21; worked for 3 out of the last 5 years; received at least $750 in compensation in 2022 | Earned at least $5,000 during any 2 years before the current year; expected to earn at least $5,000 in the current year | Must meet non-discrimination requirements, unless it’s a certain type of plan; set your own rules for employee eligibility | Must meet non-discrimination requirements, unless it’s a certain type of plan; set your own rules for employee eligibility |
| Annual reporting | Yes, simplified | No | Yes | Yes |
The bottom line
Small business retirement plans can provide a way to prepare for your own future as well as offer a valuable benefit for your workers. On top of that, there’s a tax credit that can help offset the cost of establishing a retirement plan for your small business. Additionally, contributions you make to your employees’ plans are tax deductible.
For a growing small business, your employees are typically your lifeblood. And often, they feel like an extension of your family. So it’s in your best interest to keep them incentivized and aligned with your business. But you don’t want the administrative requirements to be a full-time job, so weigh the pros and cons of each option before choosing which type(s) to offer.