Retirement plans can be a great benefit for small business owners looking to attract and retain employees. But between IRAs and 401(k)s, it can be challenging to decide which is the best plan suited for your organizational needs. For greater ease, some employers might prefer the SIMPLE IRA. For flexibility, though, the variety of choices available in a 401(k) can make this retirement plan a more attractive option.
Choosing a retirement plan is often one of the most important financial decisions a business owner can make. To help with your decision, we explained the differences between a SIMPLE IRA and a 401(k) as well as the pros and cons of each retirement savings plan.
What is a SIMPLE IRA?
A Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) IRA is a tax-deferred retirement savings account that can be established by employers, as well as self-employed individuals. As the name implies, many employers prefer this plan for its simplicity in that it’s quick to set up and ongoing maintenance is straightforward and inexpensive from an administrative standpoint.
The Difference between a SIMPLE IRA and a Traditional IRA
While SIMPLE IRAs and Traditional IRAs are similar, SIMPLE IRAs are aimed more toward small business owners and self-employed individuals. With a SIMPLE IRA, employers must match part of their employees’ contribution. Employers have two options for matching according to Motley Fool: They can either match contributions up to 3% of their employees' compensation, or contribute a fixed rate of 2% of compensation regardless of employee participation in the plan. The contribution limits are also different. The amount an employee contributes from their salary to a SIMPLE IRA cannot exceed $13,500 in 2020 and 2021. Conversely, for a Traditional IRA, the total contribution limit can’t be more than $6,000 in 2020 and 2021 ($7,000 if you’re age 50 or older).
The Difference between a SIMPLE IRA and a SIMPLE 401(k)
A SIMPLE 401(k) plan is a cross between a SIMPLE IRA and a traditional 401(k) plan. The same eligibility rules that apply to a SIMPLE IRA apply to a SIMPLE 401(k). One key difference is the employer contribution limits. All employer contributions to a SIMPLE 401(k) are subject to a compensation cap ($290,000 for 2021); with a SIMPLE IRA, only non-elective employer contributions are subject to a compensation cap.
To qualify for a SIMPLE IRA, employers can have no more than 100 employees who have received at least $5,000 in compensation from the employer for the previous year. There is also no age limit with a SIMPLE IRA, making it available to all employees within the company. By choosing a SIMPLE IRA, employers are not allowed to maintain any other plan.
Employer contributions are mandatory with a SIMPLE IRA and are deductible on your business tax return. Regardless of whether an employee contributes, employers must either match up to 3 percent of an employee’s pay or match a contribution equal to 2 percent of an employee’s compensation. For two out of every five years, an employer who elects to make matching contributions has the option to reduce their contribution amount to one that is between 1 and 2.99 percent. With a SIMPLE IRA, all contributions vest immediately.
As with any retirement savings plan, there are some limits to how much can be contributed to a SIMPLE IRA. For 2020, the annual contribution limit is set at $13,500 (up $500 from 2019) for employees. Workers that are 50 years in age or older can contribute $3,000 more, for an annual total of $16,500. Meanwhile, there is no limit on employer matching contributions, with one exception. Employers using the 2 percent contribution based compensation model can only match their contribution on up to $280,000 salary.
Administrative responsibilities and fees
As previously alluded to, there are minimal administrative requirements associated with SIMPLE IRAs. There are no annual tax filing requirements, either – business owners just need to be sure to send annual plan details to employees. Another advantage of SIMPLE IRAs is the low cost of setup and maintenance.
What is a 401(k)?
A 401(k) is a defined contribution retirement plan that comes with a lot of flexibility for employers who would like to offer it as a benefit to employees. While this type of retirement savings plan can be more complex to establish and maintain, being able to choose how you want to contribute to employee accounts as well as having the option of a Roth 401(k) can sway employers to select this plan.
Any company with one or more employees is eligible to offer a 401(k). However, 401(k)s are limited to employees at least 21 years old who worked at least 1,000 hours in the previous year.
Under a 401(k), employees have the option to set aside a portion of their income and invest it in a qualifying retirement account. This money is tax-deferred, meaning that the employee doesn’t pay federal income taxes on their contributions.
Perhaps one of the biggest advantages of offering a 401(k) is that employer contributions aren’t mandatory. Rather, employers have the option to match none, some, or all of their employees’ 401(k) contributions. Usually, business owners will set limits on how much they’ll match. For example, you might match employee contributions up to 6 percent of an employee’s salary, and only have your contributions fully vest after two years.
Employer contributions are deductible up to IRS limits. As of 2020, combined contributions of employee and employer are limited to less than 100 percent of compensation, or $56,000. For workers aged 50 and older, that limit is raised to $62,000. Should an employer chose not to contribute, employee contributions are limited to $19,000, or $25,000 for those aged 50 and older.
In addition to the traditional 401(k) as mentioned above, there are additional provisions that can be made, such as a Roth option or profit-sharing.
The option of a Roth 401(k) can be a major deciding factor in selecting this retirement plan. A Roth option for your 401(k) plan allows you and your employees to contribute post-tax earnings toward retirement and face no additional taxes on those savings or investment earnings when the money is withdrawn at retirement.
Having the Roth option can be a cost-effective way to make your retirement savings plan more attractive because you and other highly-compensated employees won’t be subject to an income cap. Furthermore, contributions to the account are taxed up-front, rather than at the time of withdrawal. While certainly a plus, the additional tasks associated with the administration and taxation of a Roth 401(k) can be burdensome on a small business.
Profit-sharing is another option that can be added to a 401(k) plan with a simple amendment. Profit-sharing allows business owners to contribute pre-tax dollars to employee retirement accounts based on how well their business did in the year. For profit-sharing 401(k) plans, the annual contribution limit is $56,000 per employee (or 100 percent of their salary, if it’s lower).
Profit-sharing plans can serve as a great motivation tactic for employees to work hard toward meeting your goals. As with all other types of 401(k)s, implementing a profit-sharing 401(k) plan can also allow small business owners to benefit from lower tax liability, controlled contributions, and improved talent acquisition and retention.
Administrative responsibilities and fees
With more flexibility comes greater administrative duties and plan fees associated with 401(k)s. For one, employers that offer 401(k)s are subject to a compliance audit every year to ensure that plans don’t favor highly-compensated employees over those who are paid less. In addition, employers are subject to higher setup and maintenance costs. Generally, plan fees tend to expensive, even more so for small businesses.
SIMPLE IRA vs 401(k): How to Decide
As described above, there are many pros and cons to each retirement plan. To help decide which plan is best for your company, ask yourself the following questions:
Why are you setting up a retirement plan?
There are many benefits to setting up a retirement plan, which you’re likely considering. For instance, retirement benefits are listed among the most important employee benefits, according to Monster’s 2019 State of the Candidate survey. Beyond employee acquisition and retention, you may be trying to save for your own retirement as a small business owner. Contribution limits may be a factor here, especially for profitable owners who may prefer the 401(k) for the higher contribution limit.
Will you need to adjust employer contributions?
In an uncertain economy, mandatory employer contributions can be both a detriment and a benefit to small business owners. While mandatory contributions can certainly help attract employees, maintaining contributions could present some challenges, should your business fall on hard times. That’s where 401(k)s provide an advantage to employers who may need to make adjustments to their contributions in the future. With a 401(k), you would also have the option to set vesting terms, which allows you to require employees to remain employed by you for a set time before taking ownership of your contributions to their accounts.
Retirement Planning for Small Business Owners
Offering retirement plans is important to attracting and retaining quality employees, but is a benefit that can come with a lot of complexity and risk. That’s where a professional employer organization (PEO) like Group Management Services (GMS) can help. From cutting costs to reducing stress to saving valuable time, GMS can take on the administrative burdens associated with retirement plans, in addition to other employee benefits and HR responsibilities like payroll, human resources, and risk management, to allow you to focus on growing your business.
Contact GMS today to see how we can help make retirement plans simpler for your small business.