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We work with small business owners all the time. The entrepreneurial spirit runs through them all, and their passion for their businesses is evident each time we meet. Most spend the waking hours of their day working on their business and trying to improve their craft in order to help their customers, their employees, and their business succeed. Because of this laser focus, many small business owners don’t think about themselves when it comes to retirement. Too often, we find small business owners are over-reliant on the value of their business as their main source to fund retirement.
In fact, a Small Business Administration work paper showed the magnitude of the problem. The SBA noted that only about 18 percent of all business owners participated in a 401(k)/Thrift plan. Micro-businesses with fewer than 10 employees had 401(k)/Thrift plan participation of 10%. The good news is that as 401(k) plans have become easier and cheaper to manage, those numbers are increasing. However, in order for many to have a comfortable retirement, it’s important that these numbers keep improving.
So what can be done? While it’s not feasible for every small business to have a 401(k), they should at least examine their retirement plan options. For this reason, we produced five different strategies small business owners could employ depending on their business's lifecycle stage.
If you are self-employed or employed in a business with just your spouse, you have the ability to set up your own 401(k) plan. The advantage of this is the ability to do employee contributions each year as well as a tax-deductible profit-sharing contribution from the company.
The solo 401(k) is a great option for self-employed individuals. This lets the owner/employee contribute up to $19,000 for 2019 ($25,000 if you are 50 and older) of their compensation indexed to inflation. In addition, the employer has the ability to contribute a tax-deductible profit-sharing contribution of up to 25% of compensation or of net self-employment income (net profit less half your self-employment tax and the plan contribution you made for yourself as an employee). The combined limit for those contributions in 2019 is $56,000 or $62,000 if you are 50 and older.
The employee contributions can also be post-tax and placed into a Roth 401(k), which will never be taxed again in the future. This is a good way to add tax-free distributions in retirement to your balance sheet. Another benefit is that these 401(k) assets are protected by ERISA, which means they are shielded against creditors of the company should something go wrong and the business fails.
In lieu of a 401(k) plan, you could do a SEP IRA designed for sole proprietorships and small business owners. You can be a sole proprietorship, partnership, S or C Corporation, or an LLC. This is only funded with employer contributions. Vesting is immediate, and you must contribute for all eligible employees. Contributions can be made up to 25% of compensation or $56,000 for 2019, whichever is less. Because of this higher contribution level and the fact it’s all employer-based is the reason it’s most often used for sole proprietorships that want to get the tax deduction for the contribution for the owner. A Roth option is not available in the SEP because it’s an employer contribution.
In the instance where a company is growing fast and needs to attract workers, retirement plans are often used as a benefit to attract employees. For those looking to add a quick plan for themselves and their employees with minimal administration, a SIMPLE IRA can be used (for businesses with fewer than 100 employees).
This provides employees the ability to contribute up to $13,000 for 2019 ($16,000 for those 50 and older). It also provides a required employer match in one of two ways:
Note: You must establish a SIMPLE plan between January 1st and October 1st of the plan year, and you may not maintain any other retirement plans in addition to the SIMPLE. You can set up the SIMPLE using Form 5304-SIMPLE or Form 5305-SIMPLE with the IRS and notify your employees of its opening.
In this case, an employer may have been using a SIMPLE IRA or other plan and wishes to increase the amount that employees and owners can save for their retirement.
A 401(k) plan is probably the best choice in this situation. With a 401(k), you can customize (within regulatory requirements) vesting schedules, employer match, and profit sharing. For this article, we are going to talk about the Safe Harbor 401(k) plan, which does not subject itself to discrimination testing because of its stated employer match characteristics.
Employees can contribute up to $19,000 for 2019 ($25,000 if you are 50 and older) of their compensation indexed to inflation to the 401(k) plan. These contributions can be pre-tax into a traditional 401(k) or after-tax into a Roth 401(k) (Roth distributions are tax-free in retirement).
For the employer match in a Safe-Harbor plan, an owner has two options. The first is matching 3% of employee deferrals plus 50% on the next 2% of employee deferrals. You would not need to match if there were no employee contributions. Another option is to match a flat 3% of employee compensation regardless if they have contributions to the plan or not.
Obviously, this strategy provides good benefits for employees and owners. The safe harbor plan eliminates the need for discrimination testing and ensures the maximization of deferrals for all employees regardless of compensation.
Additionally, if employers wanted to, a profit-sharing component could be added to the plan. There are a few ways to calculate the profit-sharing piece that you should examine during plan design. Ultimately it could give owners the discretionary ability to make a contribution of up to 25% of eligible payroll to an overall maximum contribution per eligible employee of up to 100% of compensation not to exceed $56,000 or $62,000 for those over age 50.
Reporting requirements to the IRS would include an IRS Form 5500 and potentially an audit for those with more than 100 participants done by an outside CPA firm. The Department of Labor will also monitor fiduciaries to the plan.
Something to consider in companies trying to maximize retirement contributions and pre-tax dollars is a Cash Balance Plan. Essentially, this is a defined benefit plan on top of their current 401(k). With the most anyone can save in a 401(k) plan being $56,000 or $62,000 annually, the addition of a cash balance plan could allow somebody older than 60 to save more than $200,000 annually in pretax contributions.
Funding these types of plans requires contributions made directly from the business (no employee deferral) into a pooled account. The plan document and actuarial specifics determine how much each employee/owner would have allocated to each plan. The plan is then invested as a group, and an actuary must certify every year that the plan is properly funded. If it’s not, additional contributions from the firm may be needed to “catch the plan up” to funded status.
Those leaving the plan may be able to roll their “asset value” out of the plan into IRAs of their own or keep assets in the plan, ultimately allowing for distribution later.
Obviously, these plans require additional filings to the IRS and actuarial expenses. These are optimal for smaller, closely held businesses that are highly profitable. Many medical and legal practices offer these plans to their groups in order to provide for retirement and pre-tax savings.
This is your choice as a business owner and is certainly an option. However, you should still try to diversify some funds outside your business.
If you or your spouse lacks access to a retirement plan at work, you have the ability to make a deductible contribution into an IRA of up to $6,000 or $7,000 as of 2019. This contribution can be made annually regardless of income if no plan is offered to you. Depending on your income, you may also be allowed to contribute to an after-tax Roth IRA to provide for tax-free distributions at a later date.
It’s a good idea to take funds out of the business if they aren’t needed for two reasons: liability and diversification. Funds removed from the business would be less subject to any frivolous lawsuit filed against the company. Funds can be moved to a regular investment account to diversify into other assets outside your area, sector of the economy, and safer assets you may need for a rainy day. Qualified dividends and capital gains taxes are often lower than income tax rates that may be generated by leaving assets in the business for growth.
Providing outside assets for your retirement lessens the stress that the value of the business has to provide. It allows for liquidity and diversified revenue streams that could lower your personal risk profile and financial reliance on the business.
Whatever the case, there are multiple retirement plan options for small business owners to examine. While many focus on the need to reduce taxes, there are additional reasons, such as diversification, employee recruitment, liability, and creditor protection. Be sure to consult with a qualified CPA and Investment Advisor who has expertise in retirement plans to find the option that is most appropriate for yourself, your employees, and your business.