I recently worked with a client who owns a small business and who was researching setting up a company retirement plan. He found there was an abundance of information about defined benefit and defined contribution plans.
He read about a pension plan, a Simplified Employee Pension (SEP) IRA, a Savings Incentive Match Plan for Employees (SIMPLE) IRA, a 401(k), a Roth 401(k) and profit-sharing plans. While he was able to evaluate different features of each plan option, he struggled to determine what the right plan was for his business.
We discussed the outlook for the business, plans to attract and retain talent, and the benefits of establishing a company retirement plan for his employees. In addition, we reviewed the tax incentives and tax credits for the company, as well as the benefits of being able to save a large amount in a tax-advantaged manner as the business owner.
He owns 100 percent of an early-stage startup with four employees, the business is growing rapidly and he intends to scale to 10-15 employees over the course of the next year. My client was interested in providing some form of a match as a benefit to his employees, but he also wants them to be able to contribute towards their own retirement. Because he has younger employees, he is particularly interested in a Roth option, where after-tax contributions can grow 100 percent tax-free for retirement. At the end of our discussion, we had a clear vision of what he was looking for and we reviewed each plan option in the context of his needs and wishes to determine the rights plan for his wishes and his company.
SEP IRA. We began our discussion with the SEP IRA. This is a low-cost option for a small business owner to make substantial pre-tax contributions to a retirement plan that grows tax deferred. It is typically a good fit when the owner and possibly their spouse are the only employees of the business. The SEP IRA is easy to set up, with minimal paperwork and administrative requirements when compared to other employer-sponsored plans.
While the SEP IRA checks off many of our client's boxes, it doesn't meet all his needs. Because of the eligibility and contribution guidelines of a SEP IRA, with a growing employee base and the desire for the owner to maximize his contribution, this business would have to make substantial contributions to all the employees -- that may cause cash flow problems for the startup. Consequently, we determined the SEP IRA was not a good fit and moved on to our next option.
SIMPLE IRA. The SIMPLE IRA is another tax-deferred retirement plan, also designed for small businesses. It is easy to establish, does not require the filing of annual financial reports with the government and has minimal administrative costs. Technically, the SIMPLE IRA is for businesses with less than 100 employees, though, in practice, it is common to see small businesses with less than 10 employees select a SIMPLE IRA plan option. Each employee is able to contribute pre-tax dollars to their SIMPLE IRA via payroll deductions. The business will then either provide a company match of up to 3 percent for those employees who participate or elect to make a fixed 2 percent contribution across the board for each eligible employee's pay.
While my client liked the ease of the SIMPLE IRA, the low cost and the idea that he would easily be able to determine the maximum employer liability for the company match (based on total payroll), he did not feel that the plan was as recognizable a company benefit as a 401(k). In addition, the SIMPLE IRA also does not allow for tax-free growth with a Roth feature, so we moved on to our next option.
401(k)/Roth 401(k) and profit sharing. We wrapped up our conversation discussing a 401(k) plan that would include a Roth 401(k) option and discretionary profit-sharing component. My client understood that 401(k) plans are more involved than a SIMPLE IRA or SEP IRA due to increased administrative and recordkeeping costs, disclosures to plan participants, filing and reporting requirements as well as fiduciary responsibilities. Still, offering the 401(k) plan would allow his fast-growing business to offer benefits that mattered most to my client, as well as to remain competitive in the marketplace for attracting and retaining talent.
The company employees would be able to make their own contributions via salary deductions. They may select the traditional pre-tax contribution option, where the balance grows tax deferred, or the after-tax Roth 401(k) option for contributions that would grow 100 percent tax free for retirement. To avoid annual contribution testing, the plan design included a safe harbor feature, where the company would make a contribution of 3 percent of compensation for each eligible employee (known as a non-elective contribution). My client liked that the employer contribution for each employee is easy to determine based on total payroll, tax-deductible to the business and would be an easy benefit to explain to prospective hires. Lastly, we included the discretionary profit-sharing plan feature so that as the company continues to grow, the employer could make additional proportionate contributions to the owner and employees.
Ultimately, this company retirement plan most appropriately met the needs, wants and wishes of our business owner and his startup.
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