Some financial planners are hesitant to advise business owners about which retirement plan to sponsor for their business because this decision requires specialized knowledge. However, the practice of suggesting the ideal plan choice is an essential financial planning skill and most business owners rely on their advisor’s advice. In an effort to help business owners choose the best retirement plan for their employees and themselves, we are highlighting some important information to consider.
Business owners may want to think of retirement plan options in terms of their main attributes. A couple of material options that we will highlight here are: defined benefit plans vs. defined contribution plans and pretax vs. after-tax and/or Roth contributions. Defined benefit plans are generally funded by employers and guarantee benefits for employees at retirement based on certain factors. Defined contribution plans are generally funded by employees (with the potential for employer matching) and the benefit available at retirement depends on the salary deferrals the employee chose to make to the plan and the investment growth of the contributions. Which plan is right for a business will depend upon factors such as cash flow, the ownership structure, and the number and types of employees, among other things. We are going to focus here on two common examples of these plans—401(k)s and Simplified Employee Pension (SEP)plans—and highlight the tax treatment of contributions to the plans.
The most popular type of employer-sponsored retirement plan is undeniably the 401(k), a defined contribution plan. A 401(k) must include elective deferrals, otherwise known as employee-salary deferrals, where a plan participant (employee) can choose to take their full salary in cash or save some of it for retirement by investing in the plan. In addition, the plan can include either matching contributions from the employer and/or non elective contributions (employer contributions to the plan not contingent on an action by the employee). Not only is a matching contribution an incentive to entice employee plan participation (and fulfill certain IRS plan requirements) but it is also an attractive benefit that many job seekers are looking for when evaluating potential employers. Employee contributions to the 401(k) plan as well as matching and non elective contributions (when applicable) are put into a plan participant’s individual account and the participant typically selects from a menu of investment options offered by the plan and allocates monies to available investments as they see fit (called self-directed investing).
As mentioned above, the tax treatment of contributions to qualified plans is also important. Many 401(k)s offer options for both pretax and after-tax and/or Roth contributions. Pretax contributions provide upfront tax advantages, as these contributions reduce a plan participant’s taxable income in the year of contribution. By making pretax contributions to a qualified plan, employees will enjoy tax-deferred growth on plan assets, and perhaps most importantly, they will get to invest money for retirement that otherwise would have gone to pay current taxes. However, business owners should also be aware of the value of after-tax and/or Roth contributions when considering what retirement plan options to provide to their employees. Although the initial tax savings are sacrificed, the employee will not have to pay any taxes on growth of the contributed funds. Generally, it may make sense to choose a Roth option if their tax rates are expected to be higher in retirement and to use a pretax contribution [traditional 401(k)] if their tax rate is expected to be lower in retirement. However, be aware that Roth contributions are accessible without tax consequences or penalty, will not trigger extra taxes on Social Security benefits, and provide for tax diversification of retirement withdrawals.
For small employers and salaried employees who also have Schedule C earnings, SEPs, commonly in the form of SEP-IRAs, may be an appropriate option. Only employers can contribute to SEPs on behalf of owners and their employees, using pretax dollars. Employers can contribute up to 25% of each employee’s compensation, though the limit for the self-employed is 20% of their net self-employment earnings. A SEP has the advantage of being easier and less costly to establish and administer than most other alternatives. It also has other advantages:
For a small business or a person who seeks substantial savings from their Schedule C income, a solo 401(k), or solo-k plan, might make sense because, unlike other plans, it allows employees to put in the maximum elective salary deferral in addition to regular plan contributions. Here’s an example: Sarah E. is a 35-year-old professional who has $20,000 in Schedule C consulting income in addition to her salary at MWC Company. She can contribute the entire amount of her consulting income ($20,000) to her solo-k ($4,000 under the 20 percent Keogh limit, plus $16,000 in elective salary deferrals).
Some other factors favor choosing a solo-k too, like the solo-k can apply a Roth feature. When this is the case, there are no immediate tax savings, but qualifying distributions may be received tax-free just like a Roth 401(k)/IRA. The solo-k can also have a loan feature, which is offered on a 401(k) but not on a SEP.
In addition to delivering tax advantages for the business owner and employees of the business, it is important to point out several other benefits of a retirement plan for employers. For one, a retirement plan will help to attract and retain employees. The plan will also allow for a graceful transition in the workforce. In other words, senior employees will have the wherewithal and ability to retire and can be replaced by younger employees at lower salaries. And ultimately, a retirement plan is part of effective compensation planning that can save the employer money.
If you would like to learn more about choosing a retirement plan for your business, please don’t hesitate to reach out to us. We are here to help.
Scarinci, C. (2005). IRAs and 401(k)s: how to pick the best plan: providing employee retirement accounts is a challenging task for the small business owner. Journal of Accountancy -New York, 199(3), 37–44.
This information is presented for educational purposes only and is not intended to constitute financial, tax, or legal advice. Morton Capital Management dba Morton Wealth(“Morton”) makes no representation that the strategies described are suitable or appropriate for any person. You should consult with your financial, tax and legal advisors to thoroughly review all information and consider all ramifications before implementing any transactions and/or strategies concerning your finances.
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