Small business owners are often too busy making sales, servicing clients, or otherwise running their operation on a day-to-day basis to spend a lot of time thinking about the future. But the smart ones will plan for their future retirement. Owners can both address future concerns and help themselves immediately since retirement savings offer tax reduction advantages. There are a broad away of retirement plan options. Which is best for what types of businesses?
From the point of view of the business owner, “easy-to-use” is often the most attractive option. Lisa Chu, owner of Black n Bianco Kids Wear in Los Angeles, California, says, “As a small business owner the retirement plan I am using is SEP IRA. It’s a very simple and solid retirement plan and one of the most popular among small business owners. It’s not as intricate as a 401k but still offers a tax-deducible contribution and is a low cost saving retirement plan.”
Another important factor is how owners view the business itself as an asset within their retirement portfolio. “Every business, no matter how big or small, will go through at least 3 of the 4 stages: 1) Protecting its value, 2) Growing its value, 3) Unlock its value (taking money out of the business), and 4) Preserving its value,” says Tam Pham of New York Life Insurance Company in Pittsburgh, Pennsylvania. “A retirement plans depends significantly on how business owners see their business playing a role in their retirement. For example, if the business owners plan on selling the business and/or passing it along to their heirs, owners may want to consider setting up a retirement benefit plans that includes their employees (or at least the key employees).”
When looking at the types of plans recommended by professionals and used by many small business owners, the choices themselves can be reduced to less than a handful. Levar Haffoney, Wealth Manager at Fayohne Advisors in New York City, says, “The 3 most popular retirement plans for small businesses are 401k plans, SEP IRAs, and SIMPLE IRAs.”
Within these options, however, exist several variations, giving business owners and excellent range of options that can be customized for their specific needs. “My three ‘most popular plans’ would come from the SIMPLE family (IRA, 401k), SEPs and some form of 401k,” says Charles J. Stevens, Jr., Principal at Evergreen Financial, LLC in Plymouth, Massachusetts. “All have an application and need to be tailored to the business in question.”
Of the three choices, two are very easy to set-up and maintain. They tend to be seen most often in small businesses. “SEP IRAs and Simple IRAs lead the pack when it comes to retirement plans for small businesses due to their simplicity with solo 401k plans gaining some ground,” says Edwin E. Draughan, Wealth Strategist at Strong Wealth Management, LLC in Manhattan Beach, California. “The simplicity and flexibility of SEPs and Simple IRAs make it a popular choice for small business owners. SEPs require the owners to make the contributions to employees’ accounts (25% of salary up to $53,000 total), whereas SIMPLEs are a combination of employer and employee (either a 3% match of contributions by employer or 2% non-elective contribution by employer for each eligible employee). It all depends on the preference of the owner because both keep difficulties at a minimum which is perfect for small business owners.”
It is therefore critical that business owners understand (or at least find someone they trust to explain) the implications of each type of plan. “It’s all about understanding which plan is most appropriate for the specific organization, and even most advisors don’t have a clear understanding of the considerations,” says Bruce Gendein, President of The Senex Group in Woodland Hills, California.
What Makes These Plans So Popular?
The first step to understanding which plan is best for any particular business owner is to understand what attracts different owners to each of the different plans. “Saving for retirement is rarely an easy task, but for small business owners, it’s even more of a challenge,” says Gendein. “Not only are Social Security benefits alone highly inadequate (not to mention uncertain), but saving for retirement out of ‘take home pay’ is often a pipe dream for business owners. Each of these plans helps business owners save on a pre-tax basis.”
When done correctly, the business impact of tax savings actually magnifies if employees are involved. In additions, the benefits accruing to the employees make the business a more attractive employer. Eric C. Droblyen, President of Employee Fiduciary, LLC, located in Saint Petersburg, Florida, says, “Business benefits include: 1) Employer contributions are tax-deductible; 2) Tax credits and other incentives for starting a plan may reduce costs; and, 3) A retirement plan can attract and retain better employees. Employee benefits include: 1) Employee contributions can reduce current taxable income; 2) Contributions and investment gains are not taxed until distributed; 3) Contributions are easy to make through payroll deductions; and 4) Compounding interest over time allows small regular contributions to grow to significant retirement savings.”
In addition, the employee isn’t bogged down by vesting rules and the employer isn’t constrained by complicated compliance rules. For example, Pham says a SIMPLE IRA “is easier to set up and administer than a qualified retirement plan. The contributions from employee and employer are excludable from the employee’s gross income. The employees are fully vested in all contributions (theirs and the employer). And finally, a SIMPLE IRA isn’t subject to the general nondiscrimination rules for other qualified plans or to the rules for top-heavy plans.
Still, the bottom-line is the simplicity offered by these plans. This is especially critical for small business owners, who must prioritize their time and focus on profit-oriented matters, not employee benefits. “These plans are so popular because they are relatively easy to establish, the administrative costs are reasonable, and there are tax benefits associated with offering a plan,” says Haffoney.
Chu likes here SEP IRA precisely for these reasons. She says “it’s one of the most popular retirement plans because it’s easy to setup and you do not need to file any documents with the government. Plus the administrative costs are very affordable and easy to maintain. Safe, reliable and easy to manage makes it one of the most attractive retirement plans for small business owners.”
Stevens has experienced similar reasoning with his clients, but offers a very significant additional benefit. He says, “I would assign their popularity to low cost, minimal paperwork, relief of the fiduciary responsibility if employee directed, ease of installation and low on-going maintenance.” The reduction or even elimination of fiduciary liability represents a major advantage for an owner too busy running the business to pay attention to the latest machinations at the DOL.
We cannot understate the very low cost of these options. “The SIMPLE (‘Savings Incentive Match Plan for Employees’) and the SEP (‘Simplified Employee Pension’) are most popular because they’re easy to set-up and inexpensive to maintain,” says David Chwalek, Financial Advisor at Senes & Chwalek Financial Advisors, Concord, Massachusetts. “Plan costs are typically $10 or $15 a year per employee and the initial paperwork is about the same as opening your own IRA account.”
Do Either Corporate Structure or Size Matter?
Surprisingly, these popular plans are very flexible when it comes to structure. “In my experience, corporate structure does not matter,” says Droblyen. “However, contributions cannot be made to any of these plans from S-Corp distributions.”
Indeed, the structures are only relevant to the extent they can influence how business earnings flow to the owner. Bruce Graev, Wealth Advisor at Bruce Graev Financial Associates in Marco Island, Florida, says, “More important than the organizational structure is how the owner gets paid. Contributions to these plans usually depend on the W-2 income, and not K-1 or 1099 income.”
There remains a common belief that corporate structure still matters because it once had a greater influence on retirement plan options. “Not long ago, you had to be a corporation to enjoy the maximum benefits of a Qualified Retirement Plan,” says Gendein. The good news: regulatory changes over the past decade have made these benefits available to businesses of all sizes, regardless of structure, as long as the employer receives compensation subject to payroll taxes.”
Size, and the nature of the employee relationship, though, has a tremendous impact in determining which retirement plan vehicle presents the optimal choice. Haffoney says, “The number of employees can impact the plan that you choose. For sole proprietorships, single member S-Corps, and single member LLCs, a SEP IRA or a SOLO 401k work best. For businesses with several employees, SEP IRAs work best. For larger firms (50+ employees), 401k plans work best.”
It’s not just the number of employees, it’s also the difference in age between the owner and the employees. “More important than the number of employees is the age and income of the employees,” says Graev. “The older the owners, and the younger the employees, the more the owners can put away for themselves.”
Chu, whose actually gone through this analysis in selecting the best retirement plan for her own firm, says, “If you have 50 or less employees, a SIMPLE IRA would probably be the best option for your retirement plan as it is funded by employee deferrals and employer contributions. Employees can decide how much they want to contribute and the employer must also make that contribution. For a sole proprietor who wants to make the greatest contribution available solo 401k would probably be the best choice. Especially with a working spouse as it’s the most cost effective option.”
Some feel other issues are more important than the number of employees. “I wouldn’t say employee number is a factor,” says Droblyen. “What’s more important when choosing between a 401k or an IRA-based alternative are answers to the following three questions: 1) Do my employees need the higher contribution limits offered by a 401k plan? 2) Does my business need the design flexibility of a 401k plan? and 3) Do my employees need access to their account prior to retirement for emergencies?”
Still others suggest the potential for compliance complexity is most critical. Stevens says the “number of employees to be covered has a major impact on plan design/selection as does age and payroll. For example, 401k administration costs are dependent to a degree on the number of employees and the number of participants and the payroll spread. If the salaries are lumped at low end and high end, the discrimination testing necessary to administer the plan increases. Vesting schedules in 401k plans can also impact costs due to the administration work necessary for proper allocations. Loan features can drive up costs in addition and the more employees raises the number of loans possible if the plan allows borrowing.”
Then there’s an entire different point of view. “While 401k plans are often most appropriate for larger organizations, Defined Benefit (DB) plans are often more appropriate for revenue-rich businesses with only a handful of employees,” says Gendein. “In most cases, SEP or 401k plans are designed to maximize benefits for a large number of employees, while DB plans are designed to maximize benefits for the business owner and certain key people. Because of this structure, funding costs of DB plans inevitably rise with the number of employees, leaving a smaller share of assets to the owner and key people.”
Retirement plans can play an integral part in many aspects of a small business, stretching well beyond the single dimension of retirement. Take it from a small business owner. Chu says, “Small business owners really need to have a clear understanding of all the retirement plans to implement cost saving measures for their business. Not only will help deduct taxes, but it will help them plan for their retirement. Many small business owners don’t understand how to attract talented and high quality employee’s with a retirement plan. If you want your small business to grow you must offer a generous retirement plan to your employees. As it will be the most cost effective measures to expand your business. Finding the right strategy will help you grow your business and save for your retirement.”
But the strongest selling point of retirement plans to small business owners continues to be the tax savings. “It’s important to realize that if your business is providing you with enough money to meet your current lifestyle needs, you are paying an extremely high tax rate on the excess,” says Gendein. “By using an appropriate retirement plan to place some of this money into an asset-protected trust on a deductible basis, you can significantly reduce the taxes you pay today while quickly increasing your retirement income in the future. But not all plans are right for all businesses—or all business owners. Talk to a specialist in plan design (or ask your advisor to do the research) and be sure you select the plan that will deliver the greatest benefits to help ensure a great retirement.”
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