Running a small business or being self-employed can offer flexibility, freedom and control over your earning potential. While the perks are plentiful, there’s one thing that is usually missing when you own a small business: an employer-sponsored pension plan. Creating pension plans for your small business might be a smart move as a small business owner. Pension plans are retirement plans in which an employer contributes to employees’ retirement funds. Usually, they promise a specific amount of benefits at retirement.
Unlike defined contribution plans such as 401(k)s, in which employees set aside a certain amount or percentage of their salary each month for retirement, defined benefit plans guarantee a certain amount for employees at retirement based on length of service and other factors. This creates more certainty for employees about their retirement funds. But according to statistics, the percentage of workers in the private sector with these pension plans has reduced drastically since the 1990s, propelled by employer attempts to reduce costs, regulatory changes and other reasons. These factors have obscured some of the benefits of pension plans, both for small-business owners and their employees.
Making a pension plan part of your small business benefit package is a strategy that can help you lure more talented employees, increase employee retention and set your business apart from the competition. As employers look for ways to differentiate themselves in the war for talent, a defined benefit plan can be a selling point. One advantage to pension plans is that they can be funded on a profit-sharing basis. If employees know their retirement is tied into results, it can motivate them to increase productivity. Pension plans enable owners to contribute much more to their own retirement funds than other plans.
The pension’s higher contribution limit is a wonderful way for small-business owners who have neglected to save for retirement to catch up and it is especially beneficial for small companies with a few younger, low-paid employees. Just like 401(k) plans and IRAs, self-funded pension plan contributions are tax-deferred for small-business owners, which allow them to pay taxes upon distribution, when their taxable income is likely lower. There are numerous benefits of setting up pension plans for your business, read on to understand the various options available and the best ways to set it up.
Available Pension Plan Options for Small Businesses
There are different types of small business pension plans to choose from when creating a pension plan, such as the “defined benefits plan” and “defined contribution plan.” But another distinction is whether the plan is qualified or unqualified. Qualified plans, like the 401k, let you take a tax deduction when you’re still contributing to the plan. So when employees retire and start using their pension plans, they will be taxed on the money that comes from it. Non-qualified plans are funds made up of after-tax money. A Certificate of Deposit (CD) is one example of a non-qualified plan. When the employee retires and withdraws the funds from the small business pension plan, it will not be taxed again. There are various ways to save for retirement for you and your employees as a small business owner. Below are three of the most popular options to compare:
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Simplified Employee Pension Plan (SEP IRA)
A SEP IRA can be formed by any sized business, including sole proprietorships, partnerships and corporations. You can set up one of these accounts for yourself and/or on behalf of your employees. Note that if you create a SEP IRA for your employees, only you as the employer can make contributions to it, on their behalf; they’re not allowed to put anything in directly.
According to reports, the annual contribution limit for a SEP IRA in 2019 is 25 percent of the employee’s annual compensation or $56,000, whichever is less. There is no catch-up contribution for SEP accounts. Have it in mind that IRS doesn’t allow loans from SEP IRAs, but employees and business owners can take in-service distributions. Contributions are always 100 percent vested. If distributions are non-qualified then income tax applies. The 10 percent early withdrawal penalty also kicks in if the person taking the distribution is under age 59 ½.
On the benefit side, a SEP IRA is comparatively easy and inexpensive for small business owners to set up. The annual contribution limits mirror the limits allowed by traditional 401(k) plans. Contributions can be deducted from income and qualified distributions are taxed according to traditional IRA rules. In this plan you’re not obligated to contribute to a SEP IRA for yourself or your employees each year. But if you do decide to contribute on behalf of your employees, you have to make a contribution for everyone who worked for you for the year.
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Savings Incentive Plan for Employees (SIMPLE IRA)
This option is also available to any small business but according to the IRS, it is generally best suited to those with 100 employees or less. With this plan, the employer is expected to contribute money each year for each employee by either matching up to 3 percent of compensation or making a 2 percent non-elective contribution. Employees can contribute but aren’t expected to and they’re always 100 percent vested in their SIMPLE IRA money. For 2019, the maximum employees can contribute is $13,000, or $16,000 if they’re aged 50 or older.
Just like SEP IRAs, SIMPLE IRAs have the same tax treatment as traditional IRA accounts. Early distributions are subject to the early withdrawal penalty and income tax; regular retirement distributions after age 59 ½ are taxed at ordinary income tax rates only. Both SEP IRAs and SIMPLE IRAs require the account owner to begin taking required minimum distributions at age 70 ½ to avoid a tax penalty. This pension plan option is also easy to set up and maintain. But they have lower annual contribution than SEP IRAs or solo 401(k)s (the next option on this list). You also don’t have the option to not make contributions for your employees with a SIMPLE IRA. This could be problematic if your cash flow is irregular from year to year.
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Solo or Individual 401(k)
A solo 401(k) is a 401(k) that is designed just for sole proprietors. (The only exception is if you own a business and your only employee is your spouse.) Note that with this type of small business retirement plan, you are expected to make contributions as the employer and the employee. As the employee, you can contribute up to $19,000 for 2023 or up to $25,000 if you’re 50 or older. As the employer, you can contribute up to 25 percent of compensation, unless you’re self-employed.
Howbeit, you have to use a special formula to calculate your employer contribution for the year. The formula is based on your net earnings after you’ve deducted one-half of your self-employment tax and your employee contributions. Meanwhile, of all three small business retirement plans discussed so far, a solo 401(k) is the most difficult to set up and the most expensive to maintain. But you get the benefit of a tax deduction for your contributions, as well as generous annual contribution limits. You could also supplement your 401(k) with contributions to an IRA.
Step By Step Guide on How to Set Up a Pension Plan for Your Small Business
To avoid some of the most common mistakes new business owners make when setting up their first pension plan, consider the following steps:
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Contact a financial advisor
A financial advisor can be a great partner in retirement planning, helping you nail down your retirement timeline and building an investing plan to get you there. Finding the right financial advisor that fits your needs doesn’t have to be hard. There only platforms and experts everywhere in the United States. Take time to consider how much money you’ll need to retire comfortably. A retirement calculator can help you pin down how much you need to retire and how much you need to save to get you there.
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Review the options available to you with the financial advisor
Experienced business owners can often get away with building their own pensions, but as a new business owner, don’t try it. Get the help you need from an experienced pension expert to ensure you’re getting the best deal and choosing the best option for your company. The most common small business pension plans just like we stated above are SEP Individual Retirement Accounts, SIMPLE IRAs and 401k plans. The one best-suited to your situation depends in large part on what your company can afford. Some are funded entirely by employer contributions, some entirely by employee contributions, and some by a combination of both. Be sure to review the costs associated with each plan and the tax savings that could benefit your business bottom line. Though it is important to understand the startup costs associated with each plan, it is more important to understand the fees you’ll be subjected to throughout the life of your plan.
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Contact a plan administrator
Contact a pension plan administrator, even with the help of your financial adviser, to open your small business retirement plan. Ask your bank, accountant or business attorney if they have firms they can recommend that function as plan administrators. If you have no recommendations, contact a brokerage firm with whom you may already be doing personal investing, and ask for the small business planning department. File IRS Form 5300, Application for Determination for Employee Benefit Plan. You can find this form along with instructions on how to fill it out the IRS website at IRS.gov.
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Get a tax credit for setting up a plan
If you don’t yet have a plan but set one up to cover at least one employee who is not an owner or spouse (“a non-highly compensated employee”) and you don’t have more than 100 employees, then you may be eligible for a tax credit for small employer pension plan startup costs. While the name of the credit implies it is for a pension plan, it can be used for a 401(k) or any other qualified retirement plan. The credit is 50 percent of startup costs up to a top credit of $500. The credit can be claimed for the first three years of the plan. And you can even start to claim the credit in the year prior to the start of the plan.
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Give notice of plan participation to employees
Notably, you must give notice to employees of their eligibility to participate in a plan. The time frame for the notice and the required content depends on the type of plan offered. For instance, in the case of a SIMPLE IRA, you must give each employee the following information before start of the election period (generally from November 2 through December 31 for a plan starting on the following January 1):
- The employee’s opportunity to make or change a salary reduction choice.
- The employer’s type of contribution (matching contribution, which is keyed to the employee contribution, or non-elective contribution, which is independent of any employee contribution).
- A description of the plan from the financial institution hosting it.
- A written notice that the employee’s balance can be transferred without cost or penalty if the employee uses a designated financial institution.
Conclusion
Before you get started, know that there are costs involved. Pension plans have long-term benefits, but won’t be cheap to set up. Annual administration fees are often higher than those of other retirement plans. You’ll need to pay an actuary to calculate employee funding levels annually. And if your business needs a lot of liquid capital, pension plans may not be the right fit. But for many small-business owners, the retirement-savings benefit of a pension plan make it a good option.
Creating a pension plan for your employees is up to you. You might find that there are plenty of benefits to offset the cost to your business, including motivation and loyalty of your employees. Whatever you decide, remember that there’s no better time to start saving for retirement than now. The longer you wait to choose a retirement plan for your small business, the less time your money has to grow.