Retirement

Small Business Guide to Selecting a Retirement Plan

If you're self-employed or run a small company, it can be overwhelming to try and figure out what retirement plan would be best for you and your company. 

Use the graphic below to help you get an idea of which plan may be right for you.

Infographic based on the  American Funds  question guide

Infographic based on the American Funds question guide

Keep in mind that the graphic above does not include every single option available to employers, nor is it a definitive guide to selecting a retirement plan. The graphic above merely helps you to begin the conversation on choosing a retirement plan with the right questions.

Below is a brief overview of each of the different plans mentioned above. All of the following plans have the same tax status of contributions, meaning that your contributions are tax-deferred (up to certain limits).

SIMPLE IRA

Eligibility: Any employer with 100 or fewer employees that does not maintain another retirement plan.

Key Advantages: This plan allows for direct salary reductions with less administrative burden. It is also typically one of the least expensive plans to set up and maintain.

Who Contributes and What are the Limits?: Both the employer and the employee contribute to this plan. The employee funds the plan directly through a salary reduction. The employer is required to contribute either: 1) a 100% match of up to 3% of employee salary contributions (match can be reduced to 1% in 2 of 5 years), or 2) a 2% contribution for all eligible employees, whether they contribute to the plan or not.

The maximum contribution for this plan is $12,500 for 2017, plus a $3,000 additional for those that are age 50 and over (2017). 

Administration: By doing one of the two required options above, it removes all requirements for costly audits of the plan (top-heavy testing, highly compensated employee identification, etc.). There are also no annual filing requirements from the plan (form 5500) as with a 401(k), which brings down the plan cost and administrative burden of the plan. The employees are always 100% vested in both their contributions as well as the contributions of the employer.

Key Disadvantage(s): The SIMPLE IRA has lower contribution limits when compared to a 401(k) or a SEP IRA for employees of higher income levels ($60,000+).

SEP IRA

Eligibility: Any employer with one or more employees. 

Key Advantages: This plan is easy to set up and maintain. It is typically a more popular option with sole proprietors due to its higher contribution allowances for those with higher levels of income.

Who Contributes and What are the Limits?: The employer is the only one who can contribute to the plan.

The employer can contribute the lesser of 25% of employee compensation or $54,000 to the plan (2017). The employer must contribute the same percentage to employee accounts in each year that a contribution is made to their own account. 

Administration: There are no annual filing requirements (form 5500) on behalf of the plan. The employees are always 100% vested in both their contributions as well as the contributions of the employer. 

Key Disadvantage(s): A disadvantage of the SEP is that only the employer can only contribute to the plan, not the employees. The employer must also contribute the same percentage of contribution for their employees that they do in their own account (ie. if the employer contributes 15% of their own salary to the plan, they must also contribute 15% of each employee's salary to their plan as well).

Payroll Deduction IRA

Eligibility: Any employer with one or more employees.

Key Advantages: Easy to set up and maintain. No required employer contributions.

Who Contributes and What are the Limits?: The employees are the only ones who can contribute. They contribute via payroll reductions. 

Employees can contribute up to a maximum of $5,500 per year, plus an additional $1,000 if they are age 50 or older (2017).

Administration: There are no annual filing requirements for the plan. The only administration of the plan is the payroll deduction.

Key Disadvantage(s): This plan has the lowest contribution limits of all the plans. It also does not allow for employer matching.

401(k)

Eligibility: Any employer with one or more employees.

Key Advantages: This plan permits a high level of salary deferrals by employees. This plan also offers the most customization, with many different features (loans, vesting, matching, profit sharing, Roth capability, etc.). 

Who Contributes and What are the Limits?: Both the employer and employee can contribute to the plan. The employer is not required to contribute to the plan, but if no safe harbor contributions are made, the plan must undergo annual nondiscrimination testing.

Employees can contribute up to $18,000 via salary deferral, with an additional $6,000 if they are age 50 or older (2017). The employer can match up to 25% of employee compensation, but the combined employer and employee contribution cannot exceed $54,000 (excluding over age 50 catch-up contributions).

Administration: Annual nondiscrimination testing is required. For 5500 must be filed each year for the plan. A Third Party Administrator (TPA) is typically required for most 401(k) plans.

Key Disadvantage(s): 401(k) plans are typically the most expensive and complicated to administer. With greater customization comes greater cost and administration.

Solo 401(K)

Eligibility: Self-employed individuals or business owners with no other employees other than their spouse.

Key Advantages: This plan has all the advantages of a standard 401(k) plan. It has the added benefit of not having to conduct nondiscrimination testing for the plan as long as the business owner does not have any employees. 

Who Contributes and What are the Limits?: Both the employer and employee can contribute to the plan, assuming that the employee is the business owner or their spouse. 

The combined employer and employee contribution cannot exceed $54,000 just as in a standard 401(k) (excluding over age 50 catch-up contributions).

Administration: Form 5500 must be filed annually once the plan exceeds $250,000 in assets.

Key Disadvantage(s): Comparatively, these plans are typically more expensive for individuals looking to set up a retirement plan up for only themselves.

 

In short, there are many retirement options available to small businesses. It can be overwhelming trying to navigate the decision by yourself. It is worth taking the time and effort to evaluate your options and choosing a plan that fits your company like a glove. Doing so can save you a significant amount of money and headaches down the road.

 

Need help selecting a retirement plan for your small business, or evaluating an existing one? Let us know!

We can benchmark your plan with comparable ones on the market, as well as determine if your current plan is the right solution for you.

 

 

Resources:

 

IRS Small Business Retirement Plan Resources

DOL Guide to Choosing a Retirement Plan for Your Small Business

The Retirement Savings Order of Operations

There is no shortage of options for saving for retirement. Choices are great, but they can also make things difficult when you have so many of them. The sketch by Carl Richards below perfectly sums up the relationship between the amount of options a person has and the chances of actually getting anything done.

Image Source:  Carl Richards

Image Source: Carl Richards

So, between an employer retirement plan, IRAs, savings accounts, regular investment accounts, and a myriad of other options, where should your retirement dollars be going, and in what order?

Before I get into the specific order in which you should be funding your retirement, I have to mention one factor that trumps everything else: the amount you’re saving. If you are not setting enough money aside on a regular basis for retirement, none of this post matters. The biggest factor, by far, in setting yourself up for a successful retirement is increasing the amount you’re saving. Plain and simple.

Now, How About That Order?

1. Your Employer’s Retirement Plan

The first place you should look to save for retirement is in your employer’s retirement plan. How much? I always recommend that people invest AT LEAST up to the entire match that their employer provides. Why? I’ll give you several reasons:

  1. It is free money. No extra work required.
  2. Would you ever turn down a raise? Of course not. You are essentially turning down a raise if you’re not getting all of your employer’s matching contribution.
  3. 100% IMMEDIATE return on each dollar invested. I can’t think of anywhere else that guarantees an immediate doubling of your investment. Have an employer that does a partial match? I can’t think of anywhere else that guarantees an immediate 50% return either.
  4. It comes straight out of your paycheck. The reason that 401(k)s and plans like it have been such great tools for people over time is not because the investments have always been stellar, nor that the individuals investing in them have been investment gurus. Rather, it is because the 401(k) is a systematic way for people to contribute to retirement without the money ever touching their hands. It forces you to be disciplined in placing a set amount aside each month, regardless of what the market is doing.

Now, there are several factors that can complicate this decision. Your employer may have an extended vesting period that limits your ownership of your employer’s contributions until you have worked there for a certain period (anywhere from 1 to 6 years). However, if you plan on remaining at your job longer than a couple years, I would still contribute.

Another limiting factor could be that your employer doesn’t match at all, or maybe you can’t even contribute to your employer’s plan. You may have what is called a defined benefit plan, or some sort of pension or formulated retirement that is based on your salary and/or years of service. If these are the case, proceed to #2.

2.) High Interest Debt

Compound interest is a powerful thing. It can turn a molehill into a mountain given enough time.

There are two types of compounding returns: Ones that are working for you and ones that are working against you. Just as the compounding returns work for you in your investments, they work against you in your debts.

My rule of thumb is that if you have debt with an interest rate of 7-9% or higher, you are better off paying off your debts before focusing on investing.

Why?

Although the long-term average return of the market is around 10%, many experts feel that future growth will be lower and that 7% is a better forward-looking estimate (Investopedia). In reality, no one knows what the market will look like going forward. All we have is history and projections based off of that; nothing is guaranteed.

If you have a credit card debt at an interest rate of 19.89%, you have no business expecting your investments to outperform that debt. Likewise, if you have student loans at an interest rate of 9%, you can’t expect with reasonable certainty that your investments will outpace that debt.

3.) Roth IRA

The next step after you invest up to your employer’s match and have eliminated hight interest debt is working towards maxing out a Roth IRA if you are eligible. A Roth IRA is similar to a 401(k), but with some key differences. The main differences for the purposes of this article are:

  1. With a Roth IRA, you pay the taxes on your contributions now, as opposed to in retirement like in the 401(k).
  2. The IRS has an income phaseout on who is eligible to contribute to a Roth IRA. These limits are currently $117,000 to $132,000 single and $184,000 to $194,000 married filing jointly for 2016(IRS). There are no income limits in 2016 for 401(k)s.
  3. The IRS places a limit on how much someone can contribute to an IRA. For 2016, this limit is $5,500 per individual per year, $6,500 if you are above age 50 (IRS). This limit is $18,000 per year for 401(k)s.
  4. You have a wider range of investment options available in an IRA, as you are not limited to what is offered in your employer’s plan.

The difference in taxation may seem like a minor difference, but it can have a major impact on future net (after tax) retirement benefits. The question on whether or not your retirement dollars should be placed in a Roth or in your 401(k) or Traditional IRA is all based on one thing: taxes. If you expect your income to increase between now and the time you retire or if you are young, you are likely better off going with the Roth. If you believe that you are at the peak of your lifetime annual income, you may be better off deferring your taxes through contributing to your 401(k).

4.) Where Do Your Retirement Dollars Go From Here?

By now you will have invested up to the employer match at your work, eliminated your high-interest debt, and maxed out a Roth IRA (if you are eligible). From there, it makes sense for most people to focus on placing additional money in their employer retirement plan. After allocating a sufficient amount towards retirement, many with excess cash flow choose to open a regular investment account for intermediate and long-term goals.

There is no blanket answer for every person, but the above process is a prudent method for many to go about saving for retirement.