Over our nation’s 200+ year history, the promise of the American dream has motivated millions of individuals to start small businesses across the country. According to the US Chamber of Commerce, there are 33.2 million small businesses in America which account for 99.9% of all U.S. businesses.
One of the primary reasons small business owners venture out on their own is to create something that can benefit their own family and the employees they choose to hire. However, with the challenges that come from creating and running a small business, most small business owners spend a majority of their time dealing with the day-to-day tasks necessary to keep the business moving forward.
This often leaves little time to consider the various retirement plans that are available which can provide significant tax advantages to the small business owners and their employees.
Small business owners who want to maximize the tax breaks retirement plans can provide for their own family as well as their employees should consider available options and see whether establishing a retirement plan would help them reach their goals.
How Much Difference Can a Retirement Plan Make?
Before we begin discussing specific plans and their nuances, let’s start by considering the value a small business retirement plan can provide and why ensuring the right plan is in place is important.
To begin, let’s consider an example. The example will compare the long-term effect on wealth accumulation of annual contributions to a pre-tax small business retirement account versus making the same contribution to a regular taxable account. The example will compare the wealth accumulation impact on a tax adjusted basis to show the value after taxes have been paid to ensure an apples-to-apples comparison.
We will use $10,000 as the available income to contribute to the retirement plan annually. While each of the plans discussed throughout the article below have higher contributions limits, the limits vary based on the plan. Using $10,000 in the example will give us a number that demonstrates the tax advantages, and then we can multiply the value shown by the appropriate multiple to approximate the value of any plan above.
In other words, if we were comparing to the Solo 401(k) plan that allows an annual pre-tax contribution of up to $66,000, a small business owner who is able to max out the Solo 401(k) plan would see 6.6 times ($66,000 divided by $10,000 = 6.6) the benefit of our example.
The example will assume an annual pre-tax investment growth rate of 10% and a federal + state ordinary income tax rate of 40% and capital gains rate of 25%.
To appropriately account for taxes, we made the following adjustments:
- The pre-tax contributions to the retirement plan of $10,000 will be fully allowed since the contribution results in a corresponding tax deduction (i.e., no loss of the amount available to contribute since no upfront taxes are due).
- The comparable contributions to a non-retirement account will be reduced to $6,000 annually since 40% of the $10,000 earned is due in income taxes when earned.
- The ending balance of the pre-tax account for each year shown has been reduced by 40% to show the after-tax value of the account if distributed fully in that year.
- For the non-retirement account, the future value is not reduced for taxes since the annual $6,000 contribution is already “after-tax”; however each year, the account will only grow by 7.5% since 25% of the pre-tax return will be paid in tax (assuming all dividends are qualified and capital gains are realized).
Based on these assumptions, the value of investing $10,000 of income annually on a pre-tax basis in a retirement account versus simply investing the after-tax amount in a non-retirement account is the following.
As the graph above shows, the after-tax value of making the contributions to the retirement account significantly outpaces the value of simply investing in a taxable account. The reason is the value of deferring taxes. The longer the taxes are deferred, the more the taxpayer benefits from investing those tax deferred funds.
The following graph shows the difference between the after-tax value of the retirement account and the non-retirement account over time.
As demonstrated, the value of saving $10,000 per year in a retirement account versus saving the same amount in a taxable account can be significant. If we consider the potential benefit for a small business owner whose facts and circumstances allow them to contribute $66,000 annually (i.e. the maximum for a SEP IRA or a Solo 401(k) plan), the total benefit using the same assumptions would be the following:
The difference in the after-tax values of the retirement account value and the non-retirement account is the following:
As demonstrated, the value of taking advantage of retirement plans available to small business owners can result in hundreds of thousands to millions of dollars in value over time.
It is also important to keep in mind that the savings above haven’t considered any benefit from deferring taxes during high income years and withdrawing the money or converting them to Roth during retirement when the individual may be in lower tax brackets which could add additional benefits.
Because of the significant value that can be created by small business retirement plans, it is important for small business owners to make sure they are maximizing the tax advantages these plans provide.
Key Takeaway:
The tax benefits of retirement plans can result in hundreds of thousands to millions of dollars of additional wealth for small business owners who take the time to implement and maximize their benefits.
Types of Retirement Plans:
Small business owners have multiple retirement plans to choose from. Each plan has unique characteristics that allow it to fit specific situations better than others. Accordingly, there is no “one size fits all” approach. Some of the most common small business retirement plans are:
- SEP IRA Plan
- SIMPLE IRA Plan
- Solo 401(k) Plan
- Regular 401(k) Plan
- Defined Benefit Plan
Each plan provides a tax advantaged way to save for retirement which can result in significant tax savings and accelerated wealth accumulation for small business owners who take the time to identify and implement the plan that is the best fit for their small business. Before we review each plan in more detail, here is a summary of the main features of each plan.
To better understand each plan and the circumstances that would lead a small business owner to consider one plan over another, we will walk through each of the plans in more detail.
Key Takeaway:
Small business owners have multiple retirement plans to choose from in order to maximize tax advantaged wealth accumulation.
SEP IRA Plan:
Overview: A Simplified Employee Pension plan otherwise known as a SEP IRA plan is a simple retirement plan for businesses to set up. SEP IRA plans have minimal start up or operating costs, and can be set up with any major custodian (Schwab, Fidelity, Vanguard, etc.).
With a SEP IRA, only the employer contributes to the accounts. In other words, employees cannot defer any portion of their salary into the SEP IRA. The employer can contribute up to 25% of each employee’s compensation to the employee’s SEP IRA. The employer can change the contribution percentage each year, but the amount contributed must be consistent for all employees.
In other words, the employer could contribute 25% to all employees in one year and nothing the next, but the employer can’t contribute different percentages to different employees in the same year).
Contribution Limits: Contributions to an employee’s SEP IRA are limited to the lesser of 25% of the employee’s compensation or $66,000 (2023). Contributions to a self-employed owner’s account are slightly more complicated, but the overall intention is the same. Contributions to SEP IRAs are always 100% vested which means the employee owns the full amount in the SEP IRA immediately.
Tax Advantages: SEP IRA contributions are tax deductible to the employer and are not taxable as income to the employee at the time of the contribution. The funds in the SEP IRA can be invested and will grow tax-deferred until the funds are ultimately withdrawn at which time the distributions are taxable as ordinary income. SEP IRA contributions are not subject to Social Security, Medicare, or federal unemployment taxes. Accordingly, a SEP IRA is a cost-effective way of compensating employees without the extra burden of payroll taxes.
Who Should Consider: SEP IRAs are a good option for small businesses who want a retirement plan that is simple to set up and administer. Given the employer is responsible for all the contributions, SEP IRA plans typically work best for small business owners who have very few or no employees other than themselves. SEP IRAs also work well for small businesses that want an option to share some of their profits during good years with no obligation to make similar contributions in future years.
Given the high contribution limits for SEP IRAs, small business owners with no employees often find SEP IRAs are an easy way to contribute heavily toward their own retirement on a pre-tax basis.
Key Takeaway:
SEP IRAs are a good option for business owners who want a simple solution and are comfortable contributing the same percentage of compensation to all employees’ SEP IRA accounts.
SIMPLE IRA Plan:
Overview: A SIMPLE IRA plan is also a straightforward retirement plan for businesses to establish with minimal start-up and operating costs. SIMPLE IRA plans are generally limited to small businesses with 100 employees or less; so they are not an option for large businesses. While SIMPLE IRA plans are similar to SEP IRA plans given the straight forward administration, they differ from SEP IRAs in how the accounts are funded.
With a SIMPLE IRA plan, employers and employees both have the ability to contribute.
Employers are required to choose one of two options for making employer contributions:
- Either the employer must match employee contributions up to 3% of compensation, or
- The employer must make a non-elective contribution of 2% to each eligible employee’s SIMPLE IRA account regardless of whether the employee contributes or not.
In addition to the employer contribution, employees can elect to defer a portion of their salary annually to their SIMPLE IRA accounts.
Contribution Limits: Employee salary deferral contributions to a SIMPLE IRA plan are limited each year. For 2023, employees can defer up to $15,500 to a SIMPLE IRA plan. Employees over age 50 are allowed to defer an additional $3,500 as a catch-up contribution. Similar to the SEP IRA, both employee and employer contributions to a SIMPLE IRA are always 100% vested for the employee.
Tax Advantages: SIMPLE IRA employer contributions are tax deductible to the employer. SIMPLE IRA employee contributions are not taxable to the employee when the salary deferral is made. The funds in the SIMPLE IRA can be invested and will grow tax-deferred until the funds are ultimately withdrawn. At that time the distributions are taxable as ordinary income to the employee. SIMPLE IRA employer contributions are not subject to Social Security, Medicare, or federal unemployment taxes while employee contributions are.
Who Should Consider: Often employers who want a plan that is simple to administer but have multiple employees may consider a SIMPLE IRA plan. Given multiple employees, a SEP IRA often becomes too costly given all the SEP IRA contributions must be employer funded. With a SIMPLE IRA, the employer can keep their contributions manageable while still providing each employee with the opportunity to make their own contributions.
The downside of a SIMPLE IRA plan is that the combination of the employee deferral limit and the limited employer match typically results in much more moderate annual funding. This is often acceptable for a business owner and employees who are young and have many years to make contributions, but business owners nearing retirement who want to make large contributions will typically find that a SIMPLE IRA will not allow for their desired level of funding.
Key Takeaway:
SIMPLE IRA plans are a good option for small business owners who want a simple solution and want employees to participate in contributing to their own retirement.
Solo 401(k) Plan:
Overview: A Solo 401(k) plan can only be established for a small business if the small business has no employees other than the owner and their spouse (subject to certain exceptions for part-time employees). However, for small businesses who qualify, a Solo 401(k) is an attractive small business plan.
A Solo 401(k) is much easier to administer than a typical 401k, but it does require more effort than a SEP IRA or SIMPLE IRA plan. Since a Solo 401(k) only exists in situations where there are no employees, many of the typical administrative requirements of a regular 401(k) plan are not necessary including annual non-discrimination testing.
While a Solo 401(k) is easier to administer than a typical 401(k), there are still administrative requirements such as the requirement to file an annual Form 5500-EZ if plan assets exceed $250,000 at the end of the year; so it is important that a small business owner understands these requirements before setting up a plan.
Contribution Limits: For qualifying employers, Solo 401(k) plans typically provide a better retirement option than either a SEP IRA or SIMPLE IRA due to higher contributions limits.
Solo 401(k)s allow for an employee elective deferral of up to $22,500 (2023) annually. Employees age 50 or older can defer an additional catch-up amount of $7,500 (2023) for a total of $30,000 in employee deferrals. In addition to employee deferrals, Solo 401(k)s allow employer contributions of up to 25% of compensation. Similar to the SEP IRA, the employer contribution limit is a little more involved for individuals who have net earnings from self-employment, however the end result is that a Solo 401(k) allows for significant employee deferrals and employer contributions. Total contributions (employer + employee) to an individual’s Solo 401(k) account are limited to $66,000 (2023) per year.
Given these contributions limits, Solo 401(k)s provide an option for business owners to make large employee deferrals (like a SIMPLE IRA yet bigger) and large employer contributions (like a SEP IRA) each year. These features often make a Solo 401(k) the best of both worlds and the plan of choice for business owners with no employees.
Tax Advantages: Solo 401(k) employer contributions are tax deductible to the employer. Solo 401(k) employee salary deferrals are not taxable to the employee when the deferral is made.
The funds in the Solo 401(k) can be invested and will grow tax-deferred until the funds are ultimately distributed to the individual at which time the distributions are taxable as ordinary income.
There are also options available where a small business can establish a Roth Solo 401(k) in cases where a small business owner would prefer to make their employee deferral contributions on an after-tax basis to a Roth account.
Who Should Consider: Small business owners who don’t have any employees and would like to maximize their tax advantaged savings will typically find that a Solo 401(k) plan will result in the largest allowable contribution compared to other defined contributions plans.
To maximize the benefit of a Solo 401(k), business owners should plan to contribute more than the employee deferral limit of $22,500 (2023) annually by including employer contributions.
An additional note to consider is that small business owners who are implementing a back-door Roth IRA strategy can benefit from a Solo 401(k) since assets in a Solo 401(k) are not counted toward the pro-rata rule for IRA to Roth conversions. As a result, a Solo 401(k) can be a useful tool for opening the pathway to back-door Roth contributions.
Key Takeaway:
Solo 401(k) plans are a good option for small business owners who do not have any full-time employees and want to maximize their retirement savings.
Regular 401(k) Plan:
Overview: For business owners who have employees, a regular 401(k) plan may be an option to consider. Similar to a Solo 401(k), a regular 401(k) plan allows employees to defer a portion of their salary to the plan each year and also allows for employer contributions.
However, since a regular 401(k) plan has multiple participants besides the owner, there is significant administrative work involved to ensure the plan remains compliant. Much of the administrative work is performed for a fee by a third-party administrator who specializes in administering 401(k) plans.
One of the benefits of a regular 401(k) plan is that there is significant flexibility in how the plan is structured; however, the plan will have to undergo non-discrimination testing annually to ensure the plan does not disproportionately benefit highly-compensated employees and owners.
For employers who would like to give up some flexibility in return for less administrative burdens, there are options to set up safe-harbor 401(k) plans with mandatory employer contributions that allow the plan to avoid certain annual testing requirements.
Contributions Limits: Regular 401(k)s, like Solo 401(k)s above, allow for both an employee elective deferral of up to $22,500 (2023) annually as well as employer contributions. Employees age 50 or older can also defer an additional catch-up amount of $7,500 (2023).
Employer contributions are defined in the 401(k) plan document and must be non-discriminatory. Often the contribution is based on a matching formula such as dollar for dollar on the first 3% of employee salary deferrals and 50% of the next 2% of employee salary deferrals.
Total contributions (employer + employee) to an individual’s 401(k) account are limited to $66,000 (2023) per year.
Tax Advantages: The tax advantages of a regular 401(k) account are consistent with the Solo 401(k) discussed above with the primary benefits being a significant salary deferral, employer contributions, and tax deferred growth within the account.
Given the flexibility allowed in setting up a 401(k) plan, there are opportunities for additional tax planning through adding various provisions to the plan, but the availability of useful tax options for the business owners themselves depends on the facts and circumstances of each situation since non-discrimination testing may nullify certain benefits.
Who Should Consider: A regular 401(k) plan is a good option for business owners who have more than 100 employees and want to maximize their ability to save for retirement as well as for those who simply want more flexibility in the retirement options they provide to their employees.
Key Takeaway:
Regular 401(k) plans are a good option for business owners who either have more than 100 employees or who want more flexibility in designing their plan features.
Defined Benefit Plan:
Overview: Each of the previous plans discussed so far fall into the category of “Defined Contributions Plans” where the contribution amount is set, and the amount ultimately received is determined based on future returns.
The next category to consider is called a “Defined Benefit Plan.” With a defined benefit plan, the benefit is a pre-determined amount based on factors such as years of service and compensation. Contributions to a defined benefit plan are actuarially calculated based on the amount needed to fully fund the future benefit.
Typically, defined benefit plan contributions can be significant, especially for older participants who are nearing retirement. This is because the contributions have to provide a set benefit but there are fewer years for those contributions to grow as the individual nears retirement.
In certain cases, defined benefit plans may allow a small business owner to contribute $200,000 or more into a defined benefit plan annually. As a result, a defined benefit plan can be a great tool for making very large retirement contributions near the end of an individual’s career.
Contributions to a defined benefit plan are typically made solely by the employer and are tax deductible as a business expense.
Defined benefit plans must follow various rules for ensuring minimum participation and non-discrimination. Accordingly, a small business owner who implements a defined benefit plan must contribute for employees as well. However, since the contribution is based on the future benefit, young employees who have lower salaries often require a more modest contribution. This makes defined benefit plans attractive for business owners nearing retirement with minimal or young employees.
Given the complexity of the benefit and contribution calculations, defined benefit plans are more costly to administer. Defined benefit plans also have minimum funding requirements which require small businesses to make ongoing contributions. Accordingly, it is important to have consistent income to fund future contributions before considering a defined benefit plan.
Contributions Limits: Defined benefit plan limits are based on the future benefit rather than the current contributions. The IRS limits the maximum benefit from a defined benefit plan to annual payments equal to the lesser of 100% of the participant’s average compensation over their highest three calendar years or $265,000 (2023).
Given the significant allowable benefits, the required contributions often allow a business owner to accelerate their retirement savings. These annual contributions are calculated by an actuary and in certain cases can allow a small business owner to save over $200,000 pre-tax each year for retirement.
Upon retirement or separation from service, a participant typically has multiple options for receiving their benefit which includes annual payments or a lump sum that can be rolled over to another retirement account such as a traditional IRA.
Tax Advantages: The primary tax advantage of a defined benefit plan compared to other small business plans is the opportunity to make extremely large retirement contributions and receive a corresponding tax deduction. Amounts contributed result in a tax deduction to the employer and can grow tax deferred until they are withdrawn by the participant.
Who Should Consider: The best candidates for a defined benefit plan would be small business owners who are nearing retirement and want to make substantial pre-tax retirement contributions beyond what is allowed by the defined contributions plans discuss previously.
The most effective scenarios typically occur when the small business has few employees and the ones they have are significantly younger than the business owner. It is also important that the small business is consistently profitable which ensures that it will be able to fund the ongoing required contributions without difficulty.
Key Takeaway:
Defined benefit plans can allow very large retirement contributions. Many factors such as number of employees, age, business profitability, etc. can influence whether the plan is a cost-effective option for the business owner.
Retirement Plans Startup Costs – Tax Credit:
Small businesses that start a retirement plan may be eligible for the retirement plans startup costs tax credit. This credit is available for employers who:
- Have 100 or fewer employees who received $5,000 in compensation during the prior year.
- Have at least one participant who is a non-highly compensated employee.
- Didn’t have a plan in the prior three years that benefited the same employees.
The amount of the available credit is 50% of the eligible startup costs, up to the greater of:
- $500; or
- The lesser of:
o $250 multiplied by the number of non-highly compensated employees eligible to participate in the plan, or
o $5,000.
For employees who qualify, the tax credit can help offset some of the costs of setting up and administering a retirement plan.
Conclusion:
For small business owners who have realized the American Dream of a successful and highly profitable small business, considering small business retirement plans is an important part of minimizing taxes and growing wealth.
While the challenges and day-to-day tasks of running a small business often command the owner’s primary attention, it is important to take a step back and ensure they have the right retirement plan in place for their future.
If you have a small business and are interested in working with a Family CFO to see whether there are options available to accelerate your wealth accumulation, maximize your retirement savings, and minimize your tax burden, we would love to connect to see if what we do is right for you.
