Small Business Retirement Plan Options: 401(k)s vs. SIMPLE and SEP IRAs
Defined contribution (DC) plans, such as 401(k) plans, are the most popular type of workplace retirement plan in the United States today. According to Department of Labor statistics, there are 633,021 DC plans in the U.S. (516,293 of which are 401(k) plans), covering more than 90 million total participants.
These figures are impressive, but nearly half of U.S. private sector employees—roughly 55 million—work for a business that does not offer a retirement plan at all. That’s a problem. Why? Workers generally save less when they can’t make contributions to a workplace retirement plan automatically by payroll deduction.
401ks are not the only retirement plan option for small businesses - IRA-based alternatives exist. These alternatives should be considered when a business does not need the key virtues of a 401k plan – high contribution limits and design flexibility – but wants to help employees save for retirement. Like a 401k plan, these alternatives offer automatic payroll deduction, making retirement savings easy.
Small businesses should consider all of their options when deciding to offer a retirement plan to its employees. When they don’t, they can be more inclined to offer no plan at all, making it more difficult for employees to save sufficiently for retirement.
Retirement plan options
Small businesses have 3 basic retirement plan options today – 401k, SIMPLE IRAs, and SEP IRAs. To help choose the right plan for your business, you need to understand their features and match them to your priorities (e.g., higher contributions or simpler administration).
1. 401k plans
- Highest employee contribution limits - $19,500 + $6,500 catch-up for 2021
- Highest total contribution limits - $58,000 ($64,500 including catch-up contributions) for 2021
- Employees can make pre-tax or after-tax (Roth) contributions
- Most flexible eligibility, contribution, vesting and distribution options
- Employee loans and hardship withdrawals available
- Administrative costs generally higher than IRA alternatives
- More complex ERISA compliance requirements, including annual discrimination testing (non-safe harbor plans only) and Form 5500
- Easy and inexpensive to set up and operate
- Employees share responsibility for their retirement
- No discrimination testing or Form 5500 required
- Lower employee contribution limits – $13,500 + $3,000 catch-up for 2021
- Inflexible employer contributions – employer must make either a 3% matching contribution or 2% nonelective contribution
- Employer contributions must be 100% immediately vested
- Employer cannot have any other retirement plan
- Easy to set up and operate
- Low administrative costs
- Flexible annual contributions – good plan if cash flow is an issue
- High contribution limits – Maximum contribution is the lesser of:
- 25% of the employee's compensation, or
- $58,000 (for 2021)
- No discrimination testing or Form 5500 required
- Employee contributions are not allowed
- Employer must contribute equally for all eligible employees
All three of these options offer the following benefits to your business and employees:
- Employer contributions are tax-deductible.
- Tax credits and other incentives for starting a plan may reduce costs.
- A retirement plan can attract and retain better employees.
- Employee contributions can reduce current taxable income.
- Contributions and investment gains are not taxed until distributed.
- Contributions are easy to make through payroll deductions.
- Compounding interest over time allows small regular contributions to grow to significant retirement savings.
Three simple questions
When choosing between a 401k or an IRA-based plan, you should answer three questions:
- Do my employees need the higher contribution limits offered by a 401k plan?
- Does my business need the design flexibility of a 401k plan?
- Do my employees need access to their account prior to retirement for emergencies?
If you answered yes to all three of these questions, a 401k plan is likely the best choice for your business.
Know your options
All small business retirement plan types have pros and cons. Understanding their differences is an important exercise. Sponsoring the wrong plan type can be a costly mistake. Choosing an IRA-based plan over a 401k plan can cost your business key employee talent, while making the opposite choice can cost you unnecessary time and expense.
If a 401k plan is right for your small business, the next step is determining the professional help your plan needs. Too many small businesses start shopping for a 401k plan before they know their options.
About Eric Droblyen
Eric Droblyen began his career as an ERISA compliance specialist with Charles Schwab in the mid-1990s. His keen grasp on 401k plan administration and compliance matters has made Eric a sought after speaker. He has delivered presentations at a number of events, including the American Society of Pension Professionals and Actuaries (ASPPA) Annual Conference. As President and CEO of Employee Fiduciary, Eric is responsible for all aspects of the company’s operations and service delivery.