Simplified Retirement Plans

A retirement plan is generally available for every business type. Traditional qualified plans receive the lion’s share of attention, but certain alternatives may be appropriate for small businesses and the self-employed. Article 4 of BaldwinClarke’s business retirement plan series discusses simplified options.

Business retirement plans are intricate beasts. This series has covered plan innovations, selection considerations, and regulatory requirements. Such topics might intrigue a room of financial professionals, but BaldwinClarke understands that entrepreneurs are most concerned about the bottom line. This piece spotlights an important plan category: simplified retirement plans.

Previous articles covered the advantages and pitfalls of traditional qualified plans. Some offer significant flexibility (401(k)s, profit sharing plans), and others allow substantial contributions (pension plans).[1] While these features can be attractive, compliance requirements are a major deterrent. Fortunately, simplified alternatives are available.

Simplified retirement plans are readymade plan templates for small business owners and the self-employed. Popular examples include Safe Harbor 401(k)s, Solo 401(k)s, SEP IRAs, and SIMPLE plans. The plan designs differ, but all provide one key advantage. Simplified retirement plans eliminate many compliance obligations associated with traditional qualified plans.

Author’s note: Readers learn unique funding rules throughout this series. BaldwinClarke’s upcoming “Plan Contribution Guidebook” applies these rules to common business scenarios.

Safe Harbor 401(k)s

The 401(k) has emerged as the predominant retirement plan for businesses nationwide. Earlier articles explained why – flexible employer contributions, employee deferral features, and intuitive plan designs should appeal to employers of all types. However, tedious rules scare some away. The Safe Harbor 401(k) seeks to overcome this problem.

This series detailed several rules for traditional 401(k)s. Nondiscrimination and top-heavy tests are among the most demanding. These tests compare plan participation rates, contribution amounts, and balances among employees. Strict ratio standards ensure that the 401(k) plan serves owners and the rank-and-file – after all, qualified plans are designed to benefit all eligible employees equitably. Failure to satisfy these tests may result in corrective distributions or plan termination.

The Safe Harbor 401(k) offers a streamlined option to business owners. This plan has the same contribution ceiling ($66,000 in 2023) and tax deductibility as a conventional 401(k). However, Safe Harbor 401(k)s effectively bypass nondiscrimination tests and top-heavy rules. In exchange, nearly all employees must be able to participate. Employers also forfeit contribution flexibility.

Safe Harbor 401(k)s require annual employer contributions. Companies satisfy this with an employer match (4%) or a non-elective deferral (3%). [2] All employer additions vest immediately.

Contrast this framework with conventional 401(k)s, which typically feature discretionary contributions and vesting schedules. Safe Harbor 401(k)s offer a clear tradeoff: employers commit to annual contributions and the IRS eases its rulebook. Safe Harbor 401(k)s suit stable businesses that prioritize employee retention and plan simplicity.

Solo 401(k)s

Solo 401(k)s are a popular option for business owners with no employees. The owner’s spouse can also participate if he or she is an active participant in the business.

Solo 401(k)s avoid both nondiscrimination and top-heavy tests. The reasoning is simple. Regulatory guardrails protect rank-and-file staff at larger entities, but these rules are irrelevant for certain companies. Many mom-and-pop businesses have no full-time employees. Similarly, contract workers and freelancers operate independently. [3]  

Solo 401(k)s allow entrepreneurs to make large, discretionary additions each year. Annual limits mirror other 401(k) plans, though the formula is unique. Recall that the Internal Revenue Code distinguishes between employee deferrals and employer distributions. Solo 401(k) participants can contribute a combined $66,000 (2023) from both buckets. The exact limit depends upon income level.

Calculations aside, Solo 401(k)s are a boon for the self-employed. These plans are relatively easy to administer with the guidance of an experienced advisor or CPA. Moreover, Solo 401(k)s accommodate significantly larger contributions than IRAs and other savings vehicles. As discussed, suitable candidates may include owner-operated businesses, freelancers, and the self-employed.

SEP IRAs

SEP IRAs are another common solution for business owners. The chassis closely resembles a qualified profit-sharing plan. However, SEP IRAs avoid nondiscrimination testing and offer additional flexibility.

Qualified profit-sharing plans are common among companies, but these plans have caveats. Although employers can skip contributions in down years, the IRS requires recurring and substantial additions to keep the plan active.[4] This vague regulatory standard means contributions must be consistent (recurring) and significant (substantial). Qualified profit-sharing plans are further encumbered by ongoing nondiscrimination and top-heavy testing. SEP IRAs have no such requirements.

SEP IRAs are simple, adaptable, and easy to adopt. Employers make contributions when profits are high and skip contributions when profits fall. Suitable businesses establish SEP IRAs by simply filing a streamlined Form 5305-SEP. Annual contributions are deductible.[5]      

Three primary rules govern SEP IRAs. Firstly, business structure determines the contribution limit. In 2023, self-employed individuals can contribute the lesser of $66,000 or 20% of Self-Employment Income. Owners of corporations, on the other hand, can contribute the lesser of $66,000 or 25% of W2 wages.

The second rule protects employees. All SEP IRA participants must receive the same contribution percentage. In other words, a 20% contribution to the owner’s account automatically triggers a 20% contribution to each employee’s account. This rule impacts each company differently. For sole practitioners, the requirement is irrelevant. For companies with several staff members, it may be a deciding factor.

The third rule involves employee tenure. SEP IRAs can exclude employees with less than three years of service.[6] This is advantageous to businesses with low retention rates, such as those operating in the construction, technology, and retail sectors. These companies can reward long-term employees and exclude transient workers.

SEP IRAs offer conditional discretion to businesses. Owners can contribute as desired, but eligible employees must receive an equal percentage. SEP IRAs can be appropriate for businesses with fluctuating revenues, many new hires, or significant staff turnover.

SIMPLE Plans

Fittingly named, SIMPLE Plans round out the list of simplified options. These plans have two unique restrictions. They are limited to companies with fewer than one hundred employees. In addition, the sponsoring employer cannot maintain any other qualified plan, 403(b), or SEP IRA. There are two variations: SIMPLE IRAs and SIMPLE 401(k)s. Both plans avoid nondiscrimination requirements and top-heavy testing.

SIMPLE IRAs allow employee deferrals and mandate employer additions. Employee contributions are limited to $15,500 per year (2023). While this contribution ceiling is lower than other plans, the IRS requires employers to match 3% of the employee’s compensation.[7] If the employee does not contribute, the company must instead contribute 2% of each participant’s salary.

SIMPLE 401(k)s share the same characteristics as their IRA counterpart with one key advantage. These plans enjoy unlimited creditor protection – an attractive feature for businesses with significant liabilities. It is worth noting that traditional qualified plans, such as conventional 401(k)s, provide similar protection with more flexible contribution requirements.

SIMPLE Plans have clear drawbacks. Contribution limits are attractive yet unexceptional. Regulations require owners to fund each participant’s account every year. Moreover, companies typically cannot maintain another retirement plan. Indeed, many businesses opt for other retirement plans.

SIMPLE Plans endure because they are incredibly straightforward to adopt. Employers merely file IRS Form 5304 or 5305-SIMPLE. This step is relatively painless compared to the qualified plan process. SIMPLE Plans opened before October 1^st become effective in the current plan year.

Eligibility rules can also be advantageous. Strict participation standards exclude short-term employees and limit company costs. SIMPLE Plans must benefit employees earning more than $5,000 in any previous two years and the current year. While most salaries satisfy this threshold, employers with short-term staffing models might stand to benefit. Certain factories, farms, and construction sites draw from rotating labor pools for daily projects. SIMPLE plans may exclude these workers, while benefiting owners and other permanent employees.

Keep it Simple

The financial industry groups retirement plans under various categories. There are pension plans, flexible plans, simplified plans, and others. But readers learned that plan designs can differ greatly within these categories. Solo 401(k)s suit sole-practitioners and mom-and-pop shops. Meanwhile, Safe Harbor 401(k)s, SEP IRAs, and SIMPLE Plans can serve larger teams. Each has unique funding rules and eligibility requirements.

The plan selection process involves conflicting considerations and preferences. When nuance thwarts decision-making, companies should undergo a basic thought exercise. Who is the plan designed to benefit? What are our contribution objectives? Do we prioritize flexibility or simplicity? Guiding questions provide footing. An experienced advisor can lend direction.

Companies should identify their goals and select a plan category that suits them. Simplified retirement plans might benefit owners focused on the business rather than the minutiae. Other plan categories fulfill different objectives.