Retirement Plans for Small Businesses

Do you work for a small business that offers no retirement plan? Are you self-employed and so busy that you're (regretfully) putting your retirement plans on the back burner? Do you own a small business and want to provide a retirement plan for your employees? You've come to the right place.

Retirement plans provide a tax-advantaged way to grow wealth for retirement. A well-designed retirement plan can help attract and retain talented employees and give the employer the satisfaction of knowing they've helped their employees -- as well as themselves -- toward a financially sound retirement.

There's a host of different plans available for businesses, and each comes with its own set of rules. Some are dead easy to implement; others are more complicated. Some are qualified plans and others are nonqualified plans. Qualified plans meet certain government requirements and offer tax benefits to both the employer and employee. Conversely, nonqualified plans are not eligible for tax-deferral benefits, and they're generally geared to the top brass.

We focus on qualified plans, of which there are two basic kinds -- defined benefit plans and defined contribution plans. Read on to learn about 10 types of retirement plans for small businesses.

Pension Plans Just the Ticket for Small Biz

Defined benefit (pension) plans

Somewhat of a dying breed in plans for large firms, a defined benefit plan could be just the ticket for a small shop. Corporate America has largely moved away from pension plans and toward the defined contribution plans, such as 401(k)s, because employers make no guarantees about benefits available to 401(k) plan participants at retirement. Investment risk for 401(k) plans falls on plan participants rather than the employer.

With a defined benefit plan, however, the plan participant's annual retirement benefit is determined by the plan's benefit formula, generally based on tenure and pay. The maximum annual benefit allowed at retirement is the lesser of $200,000 (in 2012) or 100% of final average pay.

Of the different types of retirement plans, defined benefit plans are the most complex to set up and operate. These plans can delay vesting of benefits, meaning employees must work for a minimum time period before they're entitled to benefits. These plans can also exclude some employees from plan participation. An actuary has to certify annually the amount the employer must contribute to the plan. The plan has to file an annual return and meet annual nondiscrimination testing standards among eligible plan participants. These plans can be designed to allow plan loans to employees.

The Skinny on Defined Contribution Plans

Considerations for defined contribution plans

As already noted, much more common these days are defined contribution plans such as 401(k) plans that don't promise a specific pension-type benefit. They have become more popular options for small businesses and their employees.

Some defined contribution plans are subject to annual testing to ensure the amount of contributions made on behalf of the rank-and-file employees is proportional to contributions made on behalf of owners and managers or highly compensated employees. These plans are also required to file an annual report with the federal government showing details about the plan and its operation. But other qualified plans don't require annual testing.

Below are some variables to consider when deciding among various plans.

  • Are employer contributions optional or required?
  • Are employee contributions allowed?
  • Are plan documents required?
  • Are annual returns required?
  • Is annual nondiscrimination testing required?
  • Are catch-up contributions available to age 50-plus participants?
  • Are plan loans allowed?
  • Does the plan sponsor, or employer, have fiduciary responsibility to put the employees' interests above its own?
  • Does the plan require a third-party administrator because of its complexity

Solo 401(k) Plans for Mom and Pop Shops

Solo 401(k): Only for the self-employed

Officially called "one-participant 401(k) plans" the solo 401(k) is a traditional 401(k) plan covering a business owner who has no employees, or the business owner and his or her spouse. In general, these plans have the same rules and requirements as any other 401(k) plan.

The business owner wears two hats in a solo 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can contribute elective deferrals of up to 100% of compensation up to the annual contribution limit of $17,000 in 2012. And the owner must make employer nonelective contributions of up to 25% of compensation (as defined by the plan) or up to the contribution limit for self-employed individuals.

Use the rate table or work sheets in Chapter 5 of Internal Revenue Service Publication 560, "Retirement Plans for Small Business," for figuring your allowable contribution rate and tax deduction for your 401(k) plan contributions. Overall contributions to a participant's account, not including any age-based catch-up contributions, cannot exceed $50,000 for 2012.

Payroll Deduction IRA a Hands-Off Plan

Payroll deduction IRA

With a payroll deduction individual retirement account, the employees establish a traditional IRA or Roth IRA at a financial institution and subsequently authorize a payroll deduction amount for the account. Businesses of any size, including self-employed business owners, can establish a payroll deduction IRA program.

From the business's perspective, this is the easiest plan to implement. No plan documents are required. Only the employees make contributions to their accounts. Employees choose where to hold the account and how the account is invested. Employee contributions are limited to their traditional IRA or Roth IRA contribution limits, which in 2012 is $5,000 plus another $1,000 for workers age 50 or older. The employer isn't offering much more than an automatic savings plan vehicle for the employee, but it's better than nothing.

SEP IRAs a Step Up From Some Other Plans

Simplified employee pension plan, or SEP

From the employee's perspective, a SEP plan is an improvement over the payroll deduction individual retirement account plan because only the employer contributes to the traditional IRAs, called SEP IRAs, that are set up for the workers. The employee doesn't contribute any money to the SEP. All businesses as well as the self-employed can establish a SEP. There is no annual return for the employer to file, no nondiscrimination testing standards to meet, and the contributions are invested in IRAs.

The company can also use the Internal Revenue Service model form as its plan document.

The employer can decide each year whether and how much to contribute to the SEP. For 2012, contributions to an employee's SEP cannot exceed the lesser of 25% of the employee's compensation or $50,000. Elective deferrals and catch-up contributions are not allowed in SEP plans.

After deciding on the financial institution that will serve as the trustee for the employees' SEP IRAs, there are three steps to establishing a SEP: execute a written agreement to provide benefits to all eligible employees, give employees the required information about the agreement, and set up an IRA for each employee.

SIMPLE IRAs Easier Than Other Plan Types

SIMPLE IRA

A "savings incentive match plan for employees," or SIMPLE, individual retirement account is for businesses that have 100 or fewer employees and no other company retirement plan in place. The employer has a required contribution that is either a matching contribution equal to a certain portion or percentage of the employee's contribution, or a minimum nonelective contribution that is made to all plan participants.

A matching contribution encourages plan participation, whereas a nonelective contribution is made whether or not an employee participant contributes to the plan. In 2012, the employee can contribute up to $11,500 annually to this plan. Plan participants ages 50 and older can also make catch-up contributions of up to $2,500 more per year.

The company doesn't have to file an annual return for the plan. Annual nondiscrimination testing is not required, and the company can use the Internal Revenue Service model form as its plan document. The contributions are invested in IRAs.

SIMPLE 401(k) Plans a Cousin of SIMPLE IRAs

SIMPLE 401(k)

A "savings incentive match plan for employees," or SIMPLE, 401(k) plan limits employer contributions to either a dollar-for-dollar matching contribution, up to 3% of pay; or a nonelective contribution of 2% of pay for each eligible employee. No other employer contributions can be made to a SIMPLE 401(k) plan. These plans are not subject to annual nondiscrimination testing. In SIMPLE 401(k) plans, all required employer contributions are always 100% vested. Employees also cannot participate in any other retirement plan of the employer.

The maximum amount that employees can contribute to their SIMPLE 401(k) accounts is $11,500 in 2012. An additional catch-up contribution of $2,500 is allowed for employees aged 50 and over.

Safe-Harbor 401(k) Plans Escape Annual Tests

Safe harbor 401(k)

The employer, by meeting the contribution standards of a safe-harbor 401(k) plan, doesn't have to worry about annual nondiscrimination testing for employer contributions. That's largely because employer contributions are mandatory in a safe-harbor 401(k) plan. The employer can make either matching or nonelective contributions under a safe-harbor plan.

In the former scenario, the employer can match each eligible employee's contribution, dollar for dollar, up to 3% of the employee's compensation, and 50 cents on the dollar for the employee's contribution that exceeds 3% (up to 5% maximum) of the employee's compensation. The alternative is for the employer to make a nonelective contribution equal to 3% of compensation to each eligible employee's account.

The employer has to make either the matching contributions or the nonelective contributions every year. The safe-harbor 401(k) plan document will specify which type of contribution will be made, and the employee has to receive this information before the beginning of each year. This plan can allow additional catch-up contributions in the amount of $5,500 (in 2012) for employees ages 50 and over. The plan can also be designed to allow plan loans, which allow employees to borrow against their plan balances.

Automatic Enrollment 401(k) Plans Popular

Automatic enrollment 401(k)

What's different about this plan is that it automatically enrolls eligible employees in the plan. The employee is permitted to change the amount of his or her contribution or can opt out of contributing to the plan altogether. But unless the employee elects to opt out, he or she will be automatically enrolled.

Like the safe-harbor 401(k) plan, this plan is exempt from the annual nondiscrimination test. The initial automatic employee contribution must be at least 3% of compensation. Contributions may have to be automatically increased so that, by the fifth year, the automatic employee contribution is at least 6% of compensation. The automatic employee contributions cannot exceed 10% of compensation in any year.

The employer can choose to make one of two types of contributions to all participants: either a nonelective contribution of 3% of compensation, or a matching contribution of 100% for salary deferrals up to 1% of compensation and a 50% match for all salary deferrals above 1% but no more than 6% of compensation.

Traditional 401(k) Plans More Complicated

Traditional 401(k) plans

A traditional 401(k) plan doesn't fall under the safe-harbor provisions for annual nondiscriminatory testing. That means this plan is subject to annual testing that ensures the contributions made on behalf of rank-and-file workers is proportional to those made on behalf of owners, managers or highly compensated employees. These plans also must file an annual report showing details about the plan and its operation to the Internal Revenue Service, the U.S. Department of Labor, plan participants and the public using Form 5500. Most one-participant plans (sole proprietor and partnership plans) with total assets of $100,000 or less are exempt from this annual filing requirement.

The plan can be written to allow plan loans so employees can borrow against their plan balances.

Profit-Sharing Plans Offer Flexibility

Profit-sharing plans

A profit-sharing plan allows the employer to decide, within limits, from year to year whether to contribute on behalf of participants. Employers of any size can implement a profit-sharing plan.

In a year when the employer does make a contribution, there needs to be a set formula for determining how the contributions are divided. This money is accounted for separately for each employee. Employer contributions to the plan can be subject to a vesting schedule that requires a set time period to elapse before employees can own them. Once vested, the employer contributions can't be forfeited.

There's an annual testing requirement to ensure benefits for rank-and-file employees are proportional to benefits for the owners and managers of the firm.

In establishing a profit-sharing plan for the company, the employer has some flexibility in choosing some of the plan's features -- such as when and which employees can participate in the plan. Other plan features are required by law, such as how contributions are deposited in the plan.

Unless it includes a 401(k) cash or deferred feature, a profit-sharing plan usually does not allow employees to contribute.