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Understanding the benefits of IRAs, 401(k)s and defined benefit plans for you and your employees
As a business owner, you naturally focus your energy, time and resources on growing and sustaining your business, while fostering an environment where your employees can thrive and support your vision. As you set your priorities, planning for retirement may fall to the bottom of your list. In fact, according to a 2016 BMO Wealth Management survey of more than 400 business owners, 75% had saved less than $100,000 for their retirement. This illustrates that most business owners prioritize their business over retirement planning.
Whether you don’t see the benefit of planning now or simply have not had the time for it, failing to plan for retirement can come at a high cost. You may forego the tax and wealth planning opportunities that a well-structured retirement savings strategy can provide, while your employees may miss an important benefit that can help them prepare for their futures.
Below, we review three categories of retirement savings plans available to business owners – Individual Retirement Accounts (“IRAs”), 401(k)s and defined benefit/pension plans. We identify the pros and cons of each and provide specific ideas to help you put a plan in place. We’ve also included a detailed comparison chart to help you decide which may be right for you.
Do you really need a retirement plan?
If your business is thriving and generating a steady income, you may not see the benefit of putting retirement money aside today. Perhaps you are overwhelmed by the options available or are hesitant to add another responsibility to your already lengthy list. If the value of your business has been growing, you may plan to sell it and monetize the value later in life, essentially considering the business to be your retirement plan. However, unforeseen factors may impact the value of your business and your ability to continue running it, such as health, family or economic changes. In such cases, a separate retirement plan can help provide an important safety net.
With a retirement plan, you can:
IRAs: The easiest way to start saving
Both you and your employees can take advantage of the benefits of an Individual Retirement Account, at little to no cost to your business.
Traditional or Roth IRA. Anyone with earned income can open an IRA (though there are income limits for Roth IRAs). Although these types of IRAs have the lowest contribution limits, you can set one up in conjunction with another retirement plan to increase savings.
SIMPLE IRA. Designed for small businesses with fewer than 100 employees, a SIMPLE IRA allows employees and employers to make contributions. Employees can choose whether or not to contribute, but as the employer, you must make matching contributions up to 3% of compensation or 2% nonelective contributions, so you will need to be committed to the plan year after year. In addition, the business (generally) cannot maintain another retirement plan in conjunction with a SIMPLE plan.
SEP IRA. With this plan, the contribution limits are higher than with any other type of IRA; you can potentially put away up to $55,000 per year for yourself, depending on your income. In addition, you have the flexibility to contribute or not each year, depending on the cash flow needs of your business. The percentage of salary contributed to all plans must be equal, so if you have employees, you’re required to invest the same percentage of their salary in their accounts as your own salary.
Employer-sponsored IRA. Designed to help your employees save faster, this plan allows them to contribute to an IRA through payroll deductions.
Self-directed IRA. These plans allow you to direct your retirement savings to an area of investing in which you’re particularly savvy, such as real estate, private equity or hard money lending. Traditional and Roth tax benefits and contribution limits apply.
Pros and Cons of IRAs
Low cost and very easy to start
No plan administrator required
No annual compliance testing
Flexible contributions (except SIMPLE IRAs)
May have lower contribution limits than defined benefit or 401(k) plans
No loan options
401(k)s: Greater savings ability with greater flexibility
In general, 401(k) plans may be a bit more complex and costly to set up than IRAs. However, most plans will allow both you and your employees to set aside more money for retirement.
Solo 401(k). This solution allows a sole proprietor with no employees (except a spouse) to make contributions as both the employer and employee, potentially up to $55,000 (plus $6,000 catch-up if you’re over age 50), depending on your income. Contributions as employee and employer may be fully tax-deductible, further reducing your income taxes. You can also establish the plan as a traditional 401(k) or Roth 401(k), depending on your goals.
Traditional 401(k). Employees can contribute up to $18,500 pretax per year, commonly through payroll deductions. Business owners can make matching contributions to encourage employee participation, or profit sharing contributions based on cash flow each year, all of which are tax deductible for the business.
Roth 401(k). Like a Roth IRA, there is no up-front tax savings, but any growth and subsequent withdrawals are tax-free in retirement. Contributions to a Roth 401(k) are not subject to the income limits that apply to Roth IRAs. Employer matching contributions are pretax and may not be directed to the Roth portion.
Pros and Cons of 401(k)s
Higher tax-deferred contribution limits
Employer matching of employee contributions allowed
End-of-year profit sharing to incentivize employees allowed
Tax-free loans up to IRS limits
More costly than IRAs
Additional forms for bigger plans
Defined benefit/pension plans: Maximum Retirement Savings
These plans allow you to sock away more than any other type of retirement plan. An actuary uses statistics, such as the age of the participants (you and your employees), salary levels and years until retirement to calculate the contribution limits. Older business owners with younger employees can potentially maximize benefits to their own accounts based on these calculations, in some cases resulting in allowable contributions of $100,000 or more. Contributions are fully tax deductible. If you’re looking to put away as much as possible, and have the cash flow to do so, a defined benefit plan may be right for you.
Pros and Cons of Defined Benefit/Pension Plans
Save more than any other type of plan
Can be paired with a 401(k) or profit sharing plan to maximize contributions
Most expensive option to maintain
Requires annual reporting and actuary calculations
Must have consistent income available to cover IRS minimum funding requirements
Establishing a retirement plan does not need to be complicated or time-consuming. Your financial professional can help by handling the setup, directing you to investment options that are appropriate for your situation, and sending you annual reports to share with your accountant. Start by engaging your financial and tax professionals to help you:
Project your retirement needs and define how much you can safely put away to meet those needs.
Project the annual tax savings possible given your personal and business situations.
You may find it makes sense to fully fund a tax-deferred plan up to IRS limits, split savings between pretax and after-tax vehicles, or save a portion to a tax-deferred account and put the rest back into the business. Working with your advisors will enable you to make the best decision for you and your business.
Just as a business plan sets your company up for success, a retirement plan can help both you and your employees prepare for a better future. Ask your financial professional for help understanding and choosing the right business retirement plan for you.
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