Many business owners tend to think of 401(k)s as the standard retirement plan solution, but it may not always be the right fit. There are different retirement plan options available to meet a variety of business needs, each providing tax advantages to employers and in some cases their participants. Below are the pros and cons of the most popular 401(k) and IRA options for small businesses.
What is the difference between offering a 401(k) vs. an IRA?
Investment options
- 401(k)s are plan solutions that employees are offered in larger organizations which allow employees to defer a percentage of their income, typically pre-tax, into a retirement savings account. Contributions are then put into various assets selected by the plan provider (often mutual funds). Plan providers control the options for investments, which in some cases can limit the participant’s ability to diversify their retirement portfolio.
- Individual Retirement Accounts (IRAs) can be opened by anyone, including small businesses, and are typically held by a bank, investment firm, or an IRA custodian. IRAs tend to be more flexible than 401(k)s and they cost less to administer. Traditional investments like stocks, bonds, and mutual funds can be held in an IRA, however, the account holder can also wrap in alternative assets like real estate, private placements, and precious metals.
Matching contributions
While similar, there are subtle differences between IRAs and 401(k)s when it comes to employer contribution limits and matching opportunities. The exact contribution limitations per plan are broken down in the chart further below.
One of the benefits of a 401(k) plan is the employer is allowed to customize the matching percentage that they offer to eligible participants, which can create an affordable and flexible option for any small business. Additionally, a SIMPLE IRA is easier to set up and administer than a 401(k) and includes a matching contribution feature. The SIMPLE IRA also has fewer rules and greater contribution limits compared to a regular IRA, but the matching feature is not as flexible as a 401(k).
With any business retirement plan there will be a tax benefit to the employer that offers the retirement option to their eligible participants.
Comparing retirement options
Outside of standard 401(k) plans, there are three popular retirement plan options for small business owners: Solo 401(k), SEP IRA, and SIMPLE IRA.
A Solo 401(k) is similar to the traditional 401(k) but geared towards those that are self-employed with no employees. The self-employed individual typically represents both the employee and the employer, and each party can contribute to the plan. The employee defers a percentage of their income, which provides them with a personal tax deduction; the company matches a percentage which provides a deduction to the business. Solo 401(k) plans typically have lower set-up and administrative costs as compared to a 401(k).
A SEP (Simplified Employee Pension) IRA is a retirement plan where each employee has an individual IRA associated with the SEP. These are often best suited for family businesses or businesses where there are no rank-and-file employees, such as an independent contractor or self-employed business owner (sole proprietorship, corporation, or a partnership). In this plan, if an employer contributes for themself, they must also make a contribution for all employees. Contributions aren’t required every year and can vary in amount. This detail makes it a good option for start-ups or other small businesses where profits may fluctuate. With a SEP IRA, the company can contribute up to 25% of compensation (capped at $61,000). So, for a self-employed individual with high income, quite a bit can be added to the IRA each year in the form of contributions.
The SIMPLE (Savings Incentive Match Plan for Employees) IRA is for a business entity that has 100 or fewer employees. Much like a 401(k), employees can defer a portion of their salaries and receive an employer match of up to 3%. Alternatively, employers may make non-elective contributions to all employee accounts rather than matching contributions. Once SIMPLE IRAs are funded, they are completely vested to the employee.
Below is a chart with a breakdown of these four options:
The Department of Labor provides a comprehensive breakdown of each type of retirement plan for small businesses.
Expanding investment options with self-directed IRAs
Investors are increasingly seeking options for their retirement savings — and the ability to hold alternative assets, along with traditional investments, can be appealing. SEP IRAs and SIMPLE IRAs allow plan participants greater control over their investments and their retirement portfolio with the option to hold alternative investments in a self-directed IRA (SDIRA).
Alternative investments allow investors to diversify outside of traditional stocks so they may hold assets that offer greater diversity to a retirement portfolio such as Pre-IPO companies, real estate, private stock, secured/unsecured debt, and ESG-focused investments. Because they aren’t traded on the public market, alternatives can help offset stock market volatility. While there is typically more risk involved, there is also a greater potential for returns.
Every small business is unique. Fortunately, there are different retirement options available so each employer can determine the correct ‘fit’ for their business and their employees.