Retirement plans offer significant tax advantages to small business owners and give them and their employees incentive to save for the future. Several types of retirement plans are available to small businesses, each with its own requirements and restrictions. The same plan is not necessarily ideal for companies of all sizes and ownership structures, so small business owners need to do their homework before making a decision.
As a CPA, you can help business owners select and implement the plan that is most appropriate for them. You can base your recommendations on the unique characteristics of your client's business, such as the owner's retirement goals, how the business is set up (as a sole proprietorship, a limited liability company, a C corporation, or an S corporation), the number of employees, and so on. You can also help them understand the legal and compliance issues related to each type of plan, as well as any tax advantages it might bring.
What follows is an overview of the types of plans, as well as a discussion of issues to consider as you assist small business-owner clients throughout the often-confusing process of choosing a retirement plan.
MAJOR TYPES OF RETIREMENT PLANS
Various types of retirement plans are available to small business owners. The major ones include the following (see the chart, "Comparison of Retirement Plans for Small Businesses," for more details on the four most common types of plans):
Simplified employee pension (SEP) plans
SEPs can be used by businesses with any number of employees. Contributions are made by the employer only (up to the lesser of 25% of each qualified employee's compensation or $55,000 for 2018) and are tax-deductible as a business expense. The primary advantage of SEP plans is how simple they are to administer. After adoption, no annual IRS forms generally need to be filed for a SEP, and administrative costs are minimal.
There are three steps to establishing a SEP. The employer must (1) execute a written agreement to provide benefits to all eligible employees; (2) give employees certain information about the agreement; and (3) set up an IRA account for each employee. The IRS has a model SEP plan document, Form 5305-SEP, Simplified Employee Pension — Individual Retirement Accounts Contribution Agreement. However, not all employers can use Form 5305-SEP, and instead some must use a prototype document.
However, SEPs do not allow employees to defer income, and employees are always 100% vested in employer contributions to their SEPs. Therefore, they may not be the best choice for companies in industries with high employee turnover or that want to use a retirement plan to help retain employees. Another potential drawback to these plans is that they require the employer to make contributions at the same percentage to all eligible employees. Because of this requirement, a smaller company with a self-employed owner may lack sufficient cash flow to support such a plan if the owner wants to make a large contribution to his or her SEP.
Savings incentive match plan for employees (SIMPLE) IRA plans
SIMPLE IRAs are generally available to businesses with 100 or fewer employees who received $5,000 or more in compensation in the preceding year. These plans are funded by tax-deductible employer contributions and pretax employee contributions.
As the name implies, SIMPLE IRAs are simple to implement and administer. To implement this plan the employer can use Form 5304-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) — Not for Use With a Designated Financial Institution, or Form 5305-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) — for Use With a Designated Financial Institution. As with Form 5305-SEP, the employer is required to keep the form in its records but does not file it with the IRS.
A small employer may wish to implement a SIMPLE IRA plan because it allows employees to defer income by making salary reduction contributions (subject to annual limitations) to their SIMPLE IRAs. Another potential advantage to an employer of a SIMPLE IRA plan over a SEP is that it generally requires a smaller contribution on the employer's part. An employer must match each employee's salary reduction contribution dollar-for-dollar up to 3% of the employee' compensation or make a nonelective contribution of 2% of an eligible employee's compensation (up to $275,000 for 2018), regardless of whether the employee makes a salary reduction contribution.
As with SEPs, though, employees are always 100% vested in employer contributions to SIMPLE IRAs, so they may not be the best choice for companies in industries with high turnover.
Qualified plans are more complex than SEPs or SIMPLE IRAs and, therefore, have more stringent reporting requirements. But they can be more appropriate for larger or growing businesses. Larger businesses generally have the staff and infrastructure to accommodate the required reporting of a qualified plan and, typically, desire features such as loan provisions and in-service withdrawals allowed in qualified plans that are not allowed in a SEP or SIMPLE IRA. There are several types of qualified plans, which can be broken down into two broad categories: defined benefit and defined contribution plans.
Defined benefit plans. Commonly referred to as pension plans, defined benefit plans promise to pay employees a steady income stream at some point in the future. The amount each employee receives is most commonly based on earnings history and length of service. Employers must contribute enough to the defined benefit plan each year to satisfy what's known as a minimum funding requirement. Due to the complexity of the minimum funding calculation and other requirements, administration of a defined benefit plan usually requires professional assistance from an actuary. For that reason, very few small businesses use them.
Defined contribution plans. With defined contribution plans, employers contribute into individual accounts for each employee. Employees generally have the authority to invest the money as they see fit among the investment options provided by the plan. Defined contribution plans do not require immediate vesting of amounts contributed to the plan by employers and may allow employee loans.
Types of defined contribution plans include profit sharing plans and money purchase plans. Under a profit sharing plan, an employer's contributions are discretionary, so the employer is not required to make contributions to the plan each year. Under a money purchase plan, contributions are mandatory, so the employer must make a contribution to the plan each year, and the contribution percentage used to determine the contribution amount for each year cannot vary.
Profit sharing plans can include a 401(k) feature (also known as a cash or deferred arrangement, or CODA) under which the employees participating in the plan can choose to have a portion of their pretax compensation contributed to an individual account rather than receive the compensation in cash. These contributions are called "elective deferrals" because the employee elects to defer the receipt of the amount contributed to the account. A profit sharing plan with a 401(k) feature is popularly referred to as a "401(k) plan." A "solo 401(k) plan" is a 401(k) plan that covers only a business owner and his or her spouse.
For 2018, participants in a 401(k) plan can make elective deferrals of up to $18,500 ($24,500 for participants who are age 50 or over at the end of the calendar year). If the plan permits, employers can contribute a percentage of each employee's compensation to the employee's account (a nonelective contribution) or can, within certain limits, match the amount of employees' elective deferrals or do both. Total employer and employee contributions to a 401(k) plan are limited to the lesser of:
- 100% of the employee's compensation, or
- $55,000 (for 2018).
A 401(k) plan can be designed so that employees' ownership in employer matching or nonelective contributions becomes vested over time, subject to a vesting schedule. After the vesting period for a contribution is completed, the employee is 100% vested in the employer contributions and has a nonforfeitable right to the full amount of the contributions in his or her account. Providing for vesting of employer contributions to a retirement plan may help an employer retain valued employees.
Under a graded vesting schedule, an employee vests in employer contributions incrementally over a period of years. Many plans use a five-year vesting schedule, with the employee vesting in 20% of employer contributions per year of service, with the employee being 100% vested in the contributions at the beginning of year 6. For example, an employer's plan document includes a five-year vesting schedule for employer matching and nonelective contributions to employees' accounts as a plan provision. The employer makes matching employer contributions to an employee's retirement account in the amount of $10,000 in year 1. Should the employee decide to leave the company during his second year of service, he or she would be entitled to retain $2,000, or 20%, of the employer contributions.
Alternatively, some plans provide for "cliff vesting." With cliff vesting, the employee vests in all employer contributions subject to vesting after the employee meets a specific minimum number of years of service. This vesting method reduces the amount of employer contributions retained by employees in higher-turnover industries.
A 401(k) plan is more complicated for businesses to implement and administer than a SEP or SIMPLE IRA. Though, in recent years, they have become less complex and less expensive for smaller businesses, they will generally require the expertise of a third-party administrator (TPA) to maintain compliance with all funding requirements and testing of the plan. This type of plan requires an annual return to be filed with the IRS (Form 5500, Annual Return/Report of Employee Benefit Plan) and strict compliance with regulations. Excise taxes and penalties could become substantial if the plan is not administered correctly.
Solo 401(k) or solo Roth 401(k) plans
If an owner and his or her spouse are the business's only employees, they may qualify for a solo 401(k) plan. These plans are typically offered and administered by mutual fund and insurance companies. They allow the same benefits as the plans offered by much larger companies but usually have low administrative costs.
One advantage of a solo 401(k) is that it allows self-employed individuals to obtain tremendous benefits through income deferral. Additional tax savings can be achieved if the company matches 25% of the employee's compensation. For example, an owner/employee, age 51, operates an S corporation and received a Form W-2, Wage and Tax Statement, with $50,000 of wages. The employee deferred the maximum allowed employee contribution of $24,500 in 2018. His business contributes 25% of his gross wages, or $12,500, on his behalf. The total amount of contributions would be $37,000, which is the maximum amount allowed.
Comparison of retirement plans for small businesses
PROMPT CLIENTS TO THINK ABOUT THEIR REASONS FOR CHOOSING A RETIREMENT PLAN
To choose the right retirement plan, business owners need to weigh a variety of factors, one of the most crucial being their goals for the plan. Therefore, the first step in helping clients choose a plan is often to determine the "why" behind it: Do they desire to provide incentives to their employees? Are they seeking superstar employees and wish to compete with other companies that offer a variety of benefits? Or do business owners desire greater tax incentives and an opportunity to grow their wealth?
Your clients' answers to the "why" question can help guide their choice of plan. For example, if they want to create a sense of ownership among employees, they might consider a plan that allows profit sharing. This type of plan fosters a proprietary approach by the employees to the overall success of the company and can motivate employees to participate in the company's production and profitability.
Business owners who are interested in promoting employee retention, on the other hand, may want to select a plan that allows for the segregation of employees for funding purposes — for instance, a plan that provides greater corporate contributions for more senior employees who serve in leadership roles.
CPAs should also encourage clients to think about what their employees want and need. Too often business owners simply adopt a plan and offer it to the workforce without a true understanding as to the needs and desires of their employees. By performing a simple survey of the employees they wish to retain and/or reward, business owners may find commonalities that can help them narrow down the attributes to look for in a plan.
FACTORS TO CONSIDER WHEN SELECTING A PLAN
It is also vital for the CPA to evaluate all known factors that would impact the operation, funding, and reporting requirements of a retirement plan. Some of the most important factors include:
- Affordability. The plan must be affordable for the company to administer and fund.
- Who can contribute. The employee, employer, or both.
- The number of employees and their eligibility to participate.
- Employee turnover and vesting period. An important criterion for choosing a retirement plan is employee turnover in the business. Should the business experience a good deal of employee turnover, the company should give special consideration to the plan's vesting period.
- Contribution limits. The minimum and maximum contribution limits for employers and employees need to be considered.
- Administrative requirements. Another factor to discuss is how difficult the plan will be to administer. As they often have limited administrative personnel, small business owners usually seek plans and benefits that place less of a compliance burden on their human resources or payroll specialists. Many companies may select a SIMPLE IRA rather than a 401(k) because it takes less time to administer.
- Need for a TPA. An important aspect to consider when selecting a plan is whether it will require a third-party administrator — which means that the business owner will incur an additional cost. A 401(k) plan or defined benefit plan requires TPAs that provide valuable compliance services. These more sophisticated plans must meet certain IRS regulations to maintain their favored tax status. Should a plan fail to meet the required regulations, the plan may be subject to excise taxes and penalties.
- Operational aspects. How can contributions be made, assets managed, and information be provided to participating employees?
- Withdrawal limits and timing. How and when can assets be accessed? What are the penalties for early withdrawal? Are there exceptions to these rules?
Equipped with knowledge on myriad personal financial and tax topics, CPAs can be valuable advisers to small business owners in setting their retirement goals. They can play a vital role in assisting these clients in choosing a retirement plan that fits their personal goals as well as their business requirements.
About the author
Jimmy J. Williams (firstname.lastname@example.org) is CEO, president, and wealth manager at Compass Capital Management in Tulsa, Okla.
To comment on this article or to suggest an idea for another article, contact Courtney Vien, senior editor, at Courtney.Vien@aicpa-cima.com or 919-402-4125.
- "Case Study: Advantages of a One-Person 401(k) Plan," The Tax Adviser, Nov. 2017
- Governmental and Employer Retirement Plans (#166420, online access)
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