September 12, 2019 |
Once you begin hiring employees for your small business, you may want to set up a retirement plan. Unfortunately, navigating the world of retirement plans can be complicated. There are several different types of retirement plans to choose from, all of which have different advantages to consider based on what your company’s specific needs are. We’ve compiled a guide to help you maneuver through the details of the different retirement plans available to your small business in California.
Before discussing the retirement plans available in California, a good place to start is understanding why it’s a good idea to offer your employees a retirement plan in the first place. After all, retirement plans are not legal obligations and they are an additional cost to your business.
Most of your competitors are likely to have retirement plans for your employees, so if you don’t have one, it may be difficult to attract top talent to your company. Employees are much more likely to accept a position at a company that offers retirement benefits to help secure their futures.
Then, choosing a good retirement plan will show your employees that you care about their futures. You are rewarding them long-term for their work and for their loyalty to your company, which will help to motivate them. What’s more, a good retirement plan will help benefit your future as well as theirs.
Lastly, there are potential tax benefits to implementing a retirement plan. For example, you can deduct the contributions you make to your employees’ retirement plans as a business expense. Additionally, you may be able to qualify for a tax credit of up to $500 a year for certain expenses that you’re likely to incur while starting and maintaining your retirement plan for the first three years that you offer the plan.
Traditional 401(k) plans are arguably the most common type of retirement plan. Employers have the option to match contributions made by employees as well as participate in profit-sharing but are not required to go through the plan. These types of plans are typically best suited for companies with eight or more employees due to the higher administration fees that are involved.
Employers are given a ton of flexibility where contributions are concerned. You’ll be able to structure how you match employee deferrals if you decide to do so at all–and you can change or skip how much you match year by year based on how your business is doing. You can also establish your own eligibility requirements (such as requiring employees to work for you for at least a year before they qualify for the retirement plan).
You can also vest contributions over time, whether by matching or through profit-sharing, in case you’re worried about employees leaving early. Additionally, there are a lot of brokerage options that allow employees to trade in stocks and bonds.
A total of $56,000 can be contributed to a single traditional 401(k) plan (as of 2019). This amount consists of up to $19,000 in employee salary deferrals, $19,000 in employer matching, and $18,000 in profit-sharing contributions. Employees over the age of 50 can make an additional $6,000 in catch-up contributions. You can structure your matching formula however you want, including profit-sharing.
Administration fees are somewhat expensive, which is why traditional 401(k) plans are better suited for companies with at least eight employees. You will also have to pay for yearly compliance testing to ensure that you don’t discriminate in favor of employees with higher incomes.
Some of the setup and maintenance costs you may have to pay for a traditional 401(k) plan include a 0.25 to 2 percent annual plan administration fee, an 0.25 percent custodian fee, an 0.5 to 1.5 percent advisor fee, an 0.25 to 2 percent mutual expense ratio fee, an 0.15 to 1 percent recordkeeping fee, and trading commission fees.
Like most retirement plans, participants will have to pay a 10 percent early withdrawal penalty if they withdraw funds from their plan before the age of 59 ½. There are a few exceptions, such as if you are 55 and you’ve terminated employment, you become disabled, or you meet one of the other exceptions.
Self-employed business owners looking for other options should look into a self-employed 401(k) plan, also referred to as a Solo 401(k). Self-employed 401(k) plans are only for businesses with no full-time employees. This means that only you and your spouse can participate in the plan. In addition to being ideal for self-employed business owners, self-employed 401(k) plans also allow you to invest your savings in alternative assets.
First, a self-employed 401(k) plan allows you to invest in a variety of different assets, including not just stocks and bonds, but also alternative assets, like real estate. You can also borrow against the assets you have in your plan. Additionally, the administration costs are quite low compared to other plans. Lastly, if you think you might expand your business and hire full-time employees, you’ll be able to convert your self-employed 401(k) plan into a traditional 401(k) plan, thereby giving you a ton of flexibility.
Because you’re basically both the employer and the employee, there’s no contribution matching involved. Instead, all contributions are consolidated and considered profit-sharing, enabling you to contribute up to $56,000, or $62,000 with catch-up contributions, every year.
You can structure your self-employed 401(k) plan through an online brokerage firm or a mutual fund company with no administration costs. If you set up an account through an alternate provider (which provides more investment flexibility), expect to pay between $200 and $2,000 in administration costs.
If you invest in mutual funds, you’ll have to pay expense ratio fees of 0.03 to 1.5 percent that cover the costs of managing and trading those funds. If you set up your plan through an online brokerage, you’ll be charged fees for any trades made.
Withdrawing funds or selling assets to withdraw funds from your self-employed 401(k) plan will result in a 10 percent early withdrawal penalty if you do so before you reach 59 ½ years of age.
A defined benefit plan is one of the more old-fashioned retirement plans available. Essentially, it provides employees with a fixed benefit that’s usually based on their salary and their tenure. As the employer, you are responsible for managing the portfolio and for all of the investment risk. The big difference between a defined benefit plan and other retirement plans is that the retirement benefits are calculated ahead of time, while other pension funds depend on investment returns. You can design the plan as a cash balance plan or a traditional pension equity plan. Cash balance plans are particularly popular since they allow varying levels of contributions.
The main benefits for an employee is that they don’t have to defer any of their own money into their account to receive contributions. This means that employees simply do not have to worry about their retirement funds. For the employer, it can be beneficial due to the fact that they allow varying levels of contributions. You can contribute money into your own retirement fund but don’t have to match that number or percentage for your other employees. Essentially, this allows you to take a lot of money out of your business and shelter it from taxes. You could end up saving as much as 40 percent in taxes doing this.
The contributions that you must make to a defined benefit plan will be based on the pre-calculated amount that your employees will be entitled to when they retire. However, the yearly contribution to an employee’s defined benefit account can’t exceed the lesser of 100 percent of their average compensation for their highest three consecutive calendar years or $225,000 (as of 2019). Note that this number is adjusted regularly to stay in line with cost-of-living changes.
Expect to pay a hefty sum of money in administration fees as a result of having to use an enrolled actuary to determine the funding levels that you will need to create the defined benefit.
While defined benefit plans are great for high earning employees, the maintenance costs can be quite high for the employer. It’s not uncommon to pay a couple thousand dollars in management fees every year.
The only way for an employee to tap into their plan’s funds early is to take out a loan against it; however, they will have to follow IRS guidelines very carefully. The loan is also limited to either the highest of $10,000 or 50 percent of the employee’s vested account balance, or $50,000–whichever is the lesser of the two. If you don’t pay back the loan on time, you’ll have to pay income taxes on what you borrowed. Additionally, if you withdraw money before you’re 59 ½, you’ll have to pay a 10 percent early withdrawal penalty.
Safe Harbor 401(k) plans are a great alternative to traditional 401(k) plans because they have the same contribution limits but make it easier to maximize contributions since annual compliance testing is not required. However, to qualify, you will have to match at least 4 percent of your employees’ contributions to their plans. Safe Harbor 401(k) plans are best suited for companies with a high employee turnover rate or a company that runs the risk of violating the annual compliance testing required by traditional 401(k) plans.
The biggest advantage is the ability for highly paid employees to maximize their contributions without being limited by annual nondiscrimination testing. This lack of compliance testing also means that employees will save money on the administration of their plan.
Safe Harbor 401(k) plans have the same contribution structure as traditional 401(k) plans. As of 2019, a maximum of $56,000 can be contributed to a Safe Harbor 401(k) plan a year. This includes $19,000 in employee salary deferrals, $19,000 in employer matching, and $18,000 in profit-sharing contributions. Employees who are 50 or over can contribute an additional $6,000.
As the employer, you have two matching options. You can match employee deferrals up to 4 percent. You can do this dollar-for-dollar or you can match dollar-for-dollar up to 3 percent and then match 50 percent up to 5 percent. The other option is to contribute 3 percent of your employee’s annual salary to their Safe Harbor 401(k) whether the employee decides to defer any of their salary to their account or not.
There are a few administration fees that you will have to pay when implementing a Safe Harbor 401(k) plan.
You will need to pay a number of setup and maintenance costs. These may include a 0.25 to 2 percent annual administration fee, a 0.25 percent custodian fee, a 1 percent financial advisor fee (if you use a financial advisor), a 0.25 to 2 percent investment fee, and a 0.15 to 1 percent recordkeeping fee.
Access to the plan’s assets is only provided upon the triggering of certain events, such as these:
If a withdrawal is made before the age of 59 ½ and an exception did not apply, then the distribution will be counted as ordinary income and there will be a 10 percent early distribution penalty.
A SIMPLE IRA lets you make pre-tax or tax deductible contributions to your employees’ retirement accounts. They’re better suited for small businesses with less than 100 employees. Generally speaking, they are a fantastic option if you have between 5 and 15 employees and they want to contribute between $7,000 and $26,000 a year.
Not only is a SIMPLE IRA easy to set up, but it’s so simple that it can be self-administered. Additionally, no annual plan filings or compliance testing is required. It’s a particularly good alternative if your business is operating on a budget since a SIMPLE IRA does not have any administrative costs despite the fact that it has many of the same benefits as a 401(k) retirement plan.
Contributions are made through employee salary deferrals and employer contributions. The limit on total contributions you can make to a plan in one year is $26,000 (as of 2019). This means that employees can only defer up to $13,000 of their salary and employers can only match up to $13,000. However, employees who are aged 50 or over can contribute an additional $3,000 (meaning their total limit is $29,000). Employers cannot match this additional amount.
As far as employer contributions go, you have two options. You can match employee contributions dollar for dollar for up to 3 percent of their annual pay or you can contribute 2 percent of every employee’s annual pay to their account no matter what they contribute.
There are no administration costs for a SIMPLE IRA. However, there are some set up and maintenance costs to be aware of.
Setting up a SIMPLE IRA will either cost around $350 for the entire plan or $25 per participating employee.
Employees will be able to withdraw from their account at any time. However, if they are under the age of 59 ½, then they may have to pay a penalty. If the withdrawal occurs within the first two years of participation, that penalty can be up to 25 percent. If it occurs after that two year period, it can be up to 10 percent.
If you’re currently running a business without employees, then you’re essentially self-employed. If you are self-employed and you want to set up a retirement plan for yourself, look into a SEP IRA plan. Keep in mind that it’s not the best option if you have full-time employees. SEP IRAs, require you to fund contributions for all of your employees directly proportional to the amount you contribute to your own account based on annual pay.
The SEP IRA is one of the more flexible plans available. You can choose how much you contribute to the plan and change that amount from year to year. You can even choose not to make any contributions one year if business is down. It’s also much easier to set up to trade individual stocks and bonds online than other retirement plans. Finally, contribution limits are quite high, making it an excellent option if you’re both highly paid and self-employed.
SEP IRAs differ significantly from other types of retirement plans. This is because there are no employee contributions. The employer is responsible for the entirety of all contributions made to the plan for both themselves and their employees. They must also be in direct portion, based on their annual compensation. For example, if you contribute 20 percent of your income to your SEP IRA account, then you are required to contribute 20 percent of each employee’s income to their SEP IRA account. The reason behind this requirement is that all contributions are classified as profit-sharing. It’s why SEP IRAs are more suitable for business owners with no full time employees.
The most that you can contribute to an SEP IRA plan (as of 2019) is the lower of either $56,000 or 25 percent of the annual income. However, it’s quite flexible in that you can contribute anywhere from 0 to 25 percent, or from $0 to $56,000. You can also change how much you contribute from year to year.
If you choose to implement an SEP IRA plan, you will be required to pay for regular maintenance fees as well as regular trading and investment costs. This is typical for most retirement plans.
One of the perks of setting up a SEP IRA plan is that there is no initial setup fee. However, there are trading commission fees if your SEP IRA was established through a brokerage firm to trade individual securities whenever there are trades in the account. You may also be charged mutual fund fees to cover trading and management costs. Additionally, most financial institutions will charge between $10 and $20 a year for the SEP IRA assets they hold for each employee.
Withdrawals can be made from a SEP IRA at any time; however, they will be subject to current federal income taxes. Additionally, if whoever makes the withdrawal is under the age of 59 ½, then they may have to pay a 10 percent penalty.
Be sure to consider how many employees you have and what their needs are. Certain plans are great for smaller companies who only have a handful of full-time employees, such as a Simple IRA. However, a traditional 401(k) is much better suited for larger companies. If you have high earning employees who want to make larger contributions, then Safe Harbor 401(k) plans and traditional 401(k) plans may be your best bet. A lot will depend on what your employees want. For example, some may not want to contribute their own money to a savings plan. In this case, you might want to consider a defined benefit plan, which can still help attract high quality employees who want retirement benefits but doesn’t require them to defer any of their salary.
Of course, if you’re a self-employed business owner, you should go with the SEP IRA or the self-employed 401(k) plan. If you think that you’ll eventually hire full-time employees, a self-employed 401(k) plan is an excellent option since you can convert it into a traditional 401(k) plan without much hassle.
As much as you want to meet the needs and wants of your employees, you’ll be limited by what you can afford. In this case, a SIMPLE IRA might be a better solution than a 401(k) plan since the contribution limits are lower. If this is the case, avoid Safe Harbor 401(k) plans since they require large contributions. If you can afford to match larger contributions but are still working within a strict budget and want some flexibility in case of a down year, look into how flexible the plan is. The ability to suspend matching or change what you match year by year can be helpful (which a traditional 401(k) plan allows you to do).
Additionally, while a defined benefit plan is very beneficial to employees, it requires that you take on a lot of risk since you’ll be responsible for all investments. However, if you only have a few employees, it might be a good option since you can vary how much you contribute from one employee to another (meaning you can contribute more to your plan than you do to one of your employees).
Besides the size of the contributions, consider the administration costs of a plan and the amount of time that you need to put into maintaining it. You’ll likely want a financial advisor or firm running the plan for you, but administration costs vary greatly from one plan to another. The traditional 401(k) plan will cost the most in terms of administration costs, while a SIMPLE IRA won’t cost nearly as much since it can be self-administered–but would require your time to do so.
Every retirement plan has its own set of advantages and disadvantages. Begin by determining exactly what you want out of a retirement plan for your employees and what your company’s goals are. Do you want to reward employee loyalty? Or is it more important that you attract high quality employees by offering attractive benefits packages? Or do you want to make sure you have the flexibility to remain within your budget in the event that your business experiences a down year? These are important questions to consider before you look at retirement plan options and make a final decision.
Implementing a retirement plan is beneficial to you, your employees, and your business. As you can see, there are many retirement plan options to consider, from SEP IRAs and SIMPLE IRAs to Safe Harbor 401(k), self-employed 401(k), and traditional 401(k) plans. Although it might seem a little overwhelming at first, do your due diligence. Compare the pros and cons of each type of retirement plan and make your choice based on the current and future needs of your business.