There are several different types of retirement plans small business owners can choose from. Each have their pros and cons, including costs, contribution limits and unique tax advantages.
In this guide we’ll cover the five top options:
Before we dive into the details on this topic, we also suggest you check out Gusto, our recommended payroll provider. Gusto will manage all payroll taxes on your behalf, issue payments via direct deposit, generate year-end W-2s and 1099s, help you find workers comp insurance and more. Visit Gusto to learn more.
What Do We Recommend?
SIMPLE IRAs are the easiest way to set up a retirement plan where both employees and employers can contribute pre-tax dollars to the plan. It’s a great option for small businesses who want to avoid the overhead and administrative hassle of a 401(k).
Also, should you later decide to start a 401(k) for extra flexibility, your employees can easily “rollover” IRA funds into a 401(k) account (after a 2 year waiting period).
SIMPLE IRA vs. SEP IRA vs. 401(k)
Traditional or Roth IRA
Administrative Costs per Employee (Per Year)
Employee & employer funded
Employer funded only
Employee & employer funded
Employee funded only
Contribution Limits (2016)
3% of salary (employer)
25% of salary (up to $53,000)
$53,000 (employee + employer)
Annual testing with IRS
In addition to employer retirement plans, there’s individual plans like SEP IRAs, Traditional IRAs and individual 401(k)s. These are good options for self employed who just need a retirement account for themselves (and/or spouse). Traditional IRAs are also a good option for employees who are not currently offered a retirement plan at their business.
Below, we’ll describe each of these retirement plan options in detail, starting with the one we think is best for small businesses:
1. SIMPLE IRA – Best General Small Business Retirement Plan
Summary: A SIMPLE IRA is a great option for small businesses (under 100 employees) that are just starting out. It allows both employees and employers to make pre-tax (or tax deductible) contributions. It’s also one of the easiest retirement plans to set up, as it has no IRS filing requirements and minimal service fees.
The main downsides to a SIMPLE IRA is that employers can’t contribute all that much (up to 3% of an employee’s salary – so $1,500 for an employee that earns $50,000 a year). Also, you have to offer the plan to all employees who earn over $5,000/year, regardless of their length of time at your business or their part-time vs. full-time status.
Who contributes: Both the employer and employee. Contributions are mandatory for employer, but elective for employee.
Contribution Limits: Employees can contribute up to $12,500 in 2016. All employees aged 50 or over are allowed to contribute an additional $3,000, bringing their total to $15,500. Employers can contribute up to 3% of an employee’s salary (including bonuses, commission and all other compensation.)
Matching Requirements: Employers are given two contribution options:
- Match employee contributions on a dollar-for-dollar basis up to 3% of their annual pay. If an employee does not contribute, there is no matching requirement.
- Contribute to all employee accounts (whether or not they choose to contribute) an amount of 2% of their annual pay
Filing Requirements: No annual filing requirement with IRS
Advantages: SIMPLE IRAs are the easiest way to offer your employees a “real” retirement plan – one where employees contribute money and you match their contributions. Unlike 401(k)s, there’s no filing or testing requirements by the IRS, which makes SIMPLE IRAs a lot easier to setup and manage.
Disadvantages: SIMPLE IRAs do not allow much flexibility. Employers have only two options for how they contribute. You also have to offer it to ALL eligible employees – even your summer interns (if they earn over $5,000.) 401(k)s, by contrast, give you a lot more discretion.
Cost: Through Vanguard, there’s a cost of $25/year per account. So if you have 10 employees, the cost would be $250 per year. Additionally, you may need to purchase software to manage withholdings and deposits. Payroll software like Gusto, however, comes with this functionality built-in.
The other cost to consider is the fund expense ratio. This is a small fee the mutual fund takes from your employee’s investments. Expect this to be anywhere from 0.15 to 1% of the investment, and be wary of anybody who charges over 1%.
2. SEP IRA – For Self-Employed
Summary: If you’re self employed and want to start a retirement account for yourself (and a spouse), SEP IRAs are one of the easiest and most flexible options.
SEP IRAs let you contribute up to 25% of your annual compensation (or $53,000, whichever is lower) to your retirement fund. Unlike a SIMPLE IRA, there’s no minimum contribution requirement. You can change it from year to year, and even take a year off.
Although SEP IRAs can technically be used at a small business with employees, they’re not a particularly strong option. This is because SEP IRAs are employer-funded ONLY: There’s no way for employees to contribute to their own retirement funds. On the other hand, this is what makes SEP IRAs a good option for self employed.
Who contributes: Employer only
Limits: Employers can contribute up to 25% of their total annual compensation (or $53,000, whichever is lower).
For a self-employed person, the contribution limit is actually lower – around 18% of your net profits. This is because you need to factor in the contribution itself as an expense. To view the full formula, check out this explanation on The Motely Fool here.
Matching Requirements: SEP IRAs are one of the more flexible plans in terms of employer contributions. You can choose to contribute whatever percentage of salary/profits you like (below 25%). This percentage can change from year to year, depending on your profitability. If you do have other employees at your business, however, bear in mind that all eligible employees must receive the same percentage.
Reporting Requirements: No annual filing requirements with the IRS.
Advantages: The key advantage to a SEP IRA is that you can contribute whatever amount you feel comfortable with from year to year. Unlike a SIMPLE IRA, you’re not locked into a given percentage. Likewise, the higher limits of a SEP IRA makes it an attractive choice for higher-paid self-employed.
Disadvantages: SEP IRAs don’t work well for small businesses with employees. The reason is that employees cannot contribute to their own account. Employees can typically open a separate Traditional or Roth IRA account if they wish to save more, but this will incur an extra cost to them.
Cost: Through Vanguard, the cost is $20/year for each account with less than $10,000. So if you’re just starting out and have 10 employees to cover (including yourself), the cost would be $200 per year.
The expense ratio (percentage mutual fund takes from your employee’s investments) can be anywhere from 0.15% to 1%.
3. Traditional 401(k) – A More Flexible Option
Summary: Say you find yourself frustrated by the limitations of a SIMPLE IRA: Perhaps you want to contribute more than 3% to employees with seniority? Or, perhaps you want employees to work for a year before they’re offered an account. In either case, a 401(k) is the way to go.
401(k)s are similar to a SIMPLE IRA in that both employees and employers can contribute pre-tax dollars. The main difference is that the employee contribution limit is much higher ($18,000 vs. $12,500 for 2016) and employers have a lot more freedom as to how they contribute funds.
Whereas a SIMPLE IRA gives employers only 2 options (flat 2% of pay, or dollar-to-dollar match up to 3% of pay), 401(k)s can basically be setup however you like. With this freedom comes more administrative hassle, however. The IRS requires annual testing to ensure your plan is fair to employees. Likewise, 401(k)s have considerably higher start-up and administration fees.
Who contributes: Employer and employees.
Limits: Employees contribute up to $18,000 per year into a 401(k) (for 2016.) An additional $6,000 if allowed for employees aged 50 or over. Employers can contribute an additional amount depending on how much the employee puts in: Combined, employees and employers cannot exceed $53,000 (in 2016.) So if an employee contributes all $18,000, their employer can add up to $35,000.
Filing Requirements: Form 5500 must be filed annually with the IRS
Advantages: Traditional 401(k) plans give employers the most flexibility: You can choose to make a fixed contribution for all employees, to make a dollar-for-dollar match for employees who contribute or to match a percentage of employee contributions. Likewise, you can set conditions for who gets employer-matching. For example, you might require employees to be at your business for at least a year before they qualify.
Disadvantages: The downside to traditional 401(k) plans is that they have to be examined every year by the IRS. The ADP and ACP nondiscrimination tests are administered to ensure that your policy doesn’t disproportionately benefit higher-earning employees. This means a few extra hours of clerical work to put together the data needed for testing. Also, if your plan fails the test, it could mean costly mandatory contributions to your rank and file employees to “even” things out.
Cost: The cost of a Traditional 401(k) plan tends to be much higher for small businesses than larger businesses (relatively-speaking). A company with 10 employees should expect to pay around $1,000 a year to their provider, according to ShareBuilder401k. Additionally, employees will pay an expense ratio (a small fee that goes to the mutual fund) that’s anywhere from 0.15% to 1% of their funds.
4. Safe Harbor, SIMPLE or Individual 401(k)
Summary: While traditional 401(k)s are typically seen at larger businesses, there are some off-shoots that are far more suitable for small businesses. Consider one of these plans if you want the flexibility and higher contribution limit of a 401(k) without the high administrative cost and hassle:
Who contributes: Employer and employees.
Limits: Same as Traditional 401(k), except for SIMPLE 401(k). (explained below)
Filing Requirements: Form 5500 must be filed annually with the IRS
Safe Harbor – A safe harbor plan is similar to a traditional 401(k), but with the benefit of not having to undergo nondiscrimination testing. Safe harbor plans are less flexible: Employers are required to contribute to all eligible employees, either a fixed percentage of payroll, or matched deferrals up to a certain amount. This helps ensure that contributions are spread more evenly.
For more on Safe Harbor 401(k) plans, check out this guide from TriStar Pension Consulting.
Automatic Enrollment – An automatic enrollment 401(k) is a type of safe harbor plan. The employer contributes a fixed percentage or amount to all employees enrolled unless they opt out. Again, this type of plan helps to pass or avoid non-discrimination testing. Also, since all employees are automatically enrolled, this often increases amount of participants in the plan.
Individual 401(k) – This type of plan is available to sole proprietors or partners who have no employees. It enables business owners to save for retirement with the flexibility, perks, and higher contribution limits of a 401(k) (up to $53,000 per year). It’s very similar to a SEP IRA, but with a few key distinctions: Individual 401(k)s allow business owners to take out loans against their savings. Also, individual 401(k)s require more setup time and annual reporting than SEP IRAs.
SIMPLE 401(k) plan – Similar to a SIMPLE IRA, this plan is available to small businesses with 100 or fewer employees. Contribution limits are actually the same as SIMPLE IRAs ($12,500), and employers have the same matching requirements. There’s only a few key differences between SIMPLE 401(k)s and SIMPLE IRAs:
- SIMPLE 401(k)s allow employees to take out loans against their savings. IRAs do not.
- Employees must be 21+ to participate in a SIMPLE 401(k) plan. IRAs have no age requirement.
- SIMPLE 401(k)s require a Form 5500 be filed annually with the IRS. IRA plans do not.
5. Individual Retirement Plans (Traditional IRA and Roth IRA)
Summary: These are not group retirement plans, but rather an option for employees and self employed who want to set up a retirement account on their own. One key advantage to an IRA is that it’s portable – if you leave your job, you can continue contributing to the same retirement account. Likewise, if you’re self employed and have multiple ventures, you can contribute pay from all of them.
There’s two different types of IRAs: Traditional and Roth. The key difference is how they manage taxes. You can contribute to a Traditional IRA tax-free, whereas a Roth IRA is taxed. When you withdraw funds in retirement, however, a Roth IRA, it is tax-free, whereas a Traditional IRA is subject to income tax.
Who contributes: Employees only.
Limits: The maximum amount for Traditional IRA is $5,500 for 2016. Employees who are 50+ can contribute an additional $1,000, for an overall limit of $6,500. Roth IRA limits are typically the same, but with potential limitations depending on your income level. (See here)
Traditional vs. Roth – Which is Better? Both also have unique savings advantages: A Traditional IRA helps you save more now by making pre-tax contributions. A Roth IRA helps you save more later, by allowing tax-free withdrawals.
Most individuals prefer the former choice, as one’s tax bracket is typically lower during retirement. Therefore you can save money by paying taxes later, when your tax rate is lower. If you anticipate your tax bracket may be higher during retirement, however, a Roth IRA would be a wiser choice.
Matching Requirements: N/A. IRAs are funded exclusively by employees, so there’s no matching from employers.
Reporting Requirements: No filing requirements with the IRS.
Advantages: Easiest of all retirement programs to set up – there’s essentially no administrative cost. Portability can also be a major advantage.
Disadvantages: Contribution limits are very low compared to other plans. Employers cannot make contributions at all. Also, if you’re a business owner, remember that this is not an employer benefit plan. IRAs have to be setup by employees. You may still be expected to assist them, however, by withholding pre-tax payments and sending them to the mutual fund.
Cost: Traditional/Roth IRAs are the least expensive retirement funds to setup and manage. Vanguard charges employees just $20/year until they have over $10,000 in their account. There’s also an expense ratio (percentage mutual fund takes from your investment) that can be anywhere from 0.15% to 1%, depending on the funds you select.
Employers pay nothing for individual IRAs, unless you want to use software to manage withholdings. Payroll software like Gusto comes with this functionality built-in.
The Bottom Line
If you want to set up a retirement plan that allows you and your employees to contribute pre-tax dollars, a SIMPLE IRA is the best way to go. It’s easy and inexpensive to set up, and gives you the flexibility to match employees, or pay them a fixed percentage.
At some point, you may want to switch to a 401(k) so you can contribute a higher percentage (above 3%), or so you can set more rules on contribution matching. The good news is that SIMPLE IRA funds can be moved to a 401(k) with no fees or tax penalties, as long as it passes a 2-year waiting period.
Thanks to Mark Zoril of PlanVision for providing valuable information to this article.