What is the best option for small businesses to save for retirement while also saving on taxes?

Small business owners are constantly making decisions that affect not only their company’s bottom line but their own livelihood as well. So, a common question small business owners ask when talking about finances is, “What’s the best saving option to allow me to save both for retirement and on taxes?

A quick, easy way to put money aside while saving on taxes is to open some type of small business retirement plan—and there are several types of plans that can meet the company’s needs. Some of the most common are a 401(k) plan, a SIMPLE IRA plan, or a SEP IRA plan. Any one of these three can help a small business owner meet the dual goals of retirement savings and tax deferral.

What options do small business owners have for saving for retirement?

A SIMPLE IRA plan is a way for a start-up type employer to offer their employees a retirement plan in a low-cost manner, which enables their employees to make deferral contributions to the plan. It’s important to keep in mind, however, SIMPLE IRA contribution limitations are much lower than that of a 401(k) plan. The employer must make mandatory contributions, as defined in the statute, which can be either a flat percentage to employees across the board or a match of individual contributions at a higher rate.

A SEP IRA is another low-cost way to start a retirement plan. One advantage, in addition to its very low administrative cost, is the ability for the plan to be set up after the end of the fiscal year. However, only the employer can make contributions to the plan and they must be uniform across the board. That being said, employer contributions are not required for any given year. These contributions are made at the employer’s discretion and can be deposited in a lump sum after the end of the fiscal year.

There are a couple of disadvantages both SIMPLE IRA‘s and SEP IRA’s face. Both plans include the requirement of immediate vesting for all employer contributions and neither allows for employees to take loans from their accounts.

Why a 401(k) may be a better fit for small businesses than an IRA

A traditional 401(k) plan offers several advantages over SIMPLE IRA’s and SEP IRA’s when it comes to setting up a retirement plan. The employer enjoys much greater flexibility in the design of the plan—including eligibility requirements, vesting schedules, employee loan options, and employer contribution decisions.

Traditional small business 401(k) plans provide a structure allowing both the owners and the employees to defer on a larger portion of their compensation—affording them greater tax savings. A 401(k) plan is a type of profit sharing plan and can be configured to allow the employer to make discretionary profit sharing contributions—in addition to employer matching contributions. A 401(k) plan may also allow the employer access to better investment choices with lower associated fee costs.

This added flexibility in plan design, along with potentially increased administrative costs, comes with additional rules and regulations. Among these, the plan must undergo discrimination testing, which may limit the amounts owners and other high-earning employees may contribute. 

For many employers, these disadvantages are outweighed by the increased flexibility a 401(k) plan provides. Additional benefits of 401(k) plans include the ability to offer employee loans, add Roth accounts, make discretionary employer contributions, contribute larger amounts than other retirement savings options, and utilize additional catch-up contributions for those over age 50.

4 reasons small business owners should consider offering a 401(k) plan to employees

Let’s face it—as a small business owner, you wear many hats. On Monday, you may be the HR person, Wednesday you’re the sales team, and on Friday you’re forging relationships and working on new business opportunities. You love that every day is different and keeps you on your toes, but you have a hard time fitting any extra tasks into your day. And while you believe in helping your employees work towards their retirement goals, there’s just no time left in the day to research and manage a 401(k) plan.

Or so you thought. Offering a 401(k) plan to employees doesn’t have to be terribly time consuming for you, the business owner. And we think the benefit of doing so is highly worth the short amount of time you’ll spend starting the plan.

Why small business owners should offer a 401(k) plan

1. Service providers focus on small businesses

You don’t need to feel like a small fish in a big sea. There are 401(k) plan service providers whose area of expertise is focused entirely on small businesses. They understand you have a business to run, and a 401(k) plan may not be your highest priority at the moment. These service providers can offer fully-bundled packages that may help you with the tools, knowledge, and plan management activities that you don’t have time to oversee. They can make sure you have quality, diversified investment options that maintain an appropriate risk tolerance relative to your retirement horizon, and most importantly, help you and your employees save for retirement on a regular basis.

2. Employee retention and financial wellness

Offering a 401(k) retirement plan is a smart way to recruit and retain employees in a highly competitive work environment. An ongoing retirement savings plan enriches the benefits you offer employees, and surely they’ll appreciate the opportunity to protect and invest in their financial future. You’ll feel like you are doing the right thing by helping them take control of their retirement and making them more likely to meet their own retirement goals. And because of tax-deferred compounding, 401(k) plans become an efficient way for both you and your employees to personally save and invest for retirement.

3. Flexible 401(k) plans fit the culture and future goals of the company

Flexible plan options give small business owners more opportunities to align a retirement savings plan with company core values and culture. Employers can enforce eligibility restrictions, select a vesting schedule, and offer matching contributions. Plans can also allow profit sharing, automatic enrollment features, and for participants to take out loans against their 401(k) savings. Plus, participants can invest in their retirement through convenient salary deferrals that are generally not taxed until funds are distributed.

4. Future tax savings for your business

Don’t always assume a 401(k) plan is something you can’t afford. Not only are there cost-effective retirement plan options, but the tax savings often make up a portion of the costs. If you are establishing a plan for the first time, your company can receive a three-year tax credit for 50 percent of the startup cost, up to $500 per year. This tax credit can offset setup and administrative fees of the plan. And if you make an employer contribution to the plan, you can deduct it on the company’s federal income tax return.

Selecting a 401(k) plan to offer your employees as a small business owner may seem like a daunting task, especially when you already struggle to find an extra minute of time in the day. Luckily, there are affordable options out there that can align your retirement vision with business goals—all while providing a high-value benefit to employees and increasing the likelihood that you and your staff will meet your personal retirement goals.

Does automatic enrollment increase the number of 401(k) plan participants?

The Law of Inertia: A body in motion will stay in motion and a body at rest will stay at rest unless an external force acts upon it. While originating in the world of physics, the Law of Inertia is amazingly applicable to the world of retirement planning. As plan sponsors and financial advisors know, getting people who are not already saving to start saving requires a force nearly equal to the gravitational field of a planet. And getting people to save more than they are already saving is an accomplishment of galactic proportions.

How to increase the number of participants in a retirement plan

In traditional retirement plans, participants have to actively enroll in the plan to begin saving. The Law of Inertia tells us that this may not be the best way to get people to start saving, but what’s the solution? Automatic enrollment.

Automatic enrollment achieves the miracle of getting people to start saving. In a plan with auto enrollment, employees who don’t want to participate are required to proactively opt out, while employees who do nothing are, you guessed it, automatically enrolled in the plan. Employees who are somewhat interested in saving in the plan will be more likely to continue participating than they are to go out of their way to un-enroll, thus increasing participants. Again, bodies in motion.

By automatically enrolling eligible employees in their retirement plan, sponsors make use of inertia to encourage saving. Recent statistics from the Department of Labor show that 30 percent of eligible workers do not participate in their employer’s provided retirement plan, but when automatic enrollment was utilized, this number drops to less than 15 percent [1].

So, auto enrollment gets people to start saving. But how do you get them to save more? Behavioral economists Richard Thaler and Shlomo Benartzi devised an ingenious method to help overcome participant inertia, initially called the SMarT plan, or Save More Tomorrow plan. In the SMarT plan, the contribution rate for participants would automatically increase periodically, incrementally raising participant deferral rates over time. Now called automatic escalation, 60 percent of plan sponsors are utilizing this increased savings technique [2].

Do automatic enrollment and escalation really work?

It seemed like automatic enrollment and escalation had inertia beat. Participation rates were dramatically higher, and everyone was happy that people were saving! But a closer look shows that inertia may be plaguing plans with automatic features in a different way.

Automatic enrollment requires that a plan set a default contribution rate at which to enroll participants who don’t make an active election. A Vanguard survey revealed that the most popular default contribution rate is 3 percent (with some plans using an even lower default rate)—much lower than what most people need to save to achieve a secure retirement [3]. Automatic escalation isn’t that helpful, either; a one or two percent increase each year will take a long time to get to the 12 to 15 percent of salary most people should be saving to reach their retirement goals.

Maybe the Law of Inertia should be rewritten to read: a contribution rate at rest will stay at rest. Participants tend to leave their contribution rates at the default level set for them, usually woefully low. And with automatic escalation, workers are even less likely to increase their savings themselves, since they assume it is being taken care of for them. There is an unintended implicit inference that the rate set by the plan is an optimal rate, and participants treat that default rate as a recommendation. But of course, it’s not usually optimal at all. The study by Vanguard showed that 40 percent of plans with automatic enrollment had inadequate contribution rates, and even after five years in the plan, participants’ contribution rates were still less than 9 percent of pay [3].  

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Structuring automatic enrollment and escalation in a small business retirement plan

Automatic features can be a force for overcoming inertia to help people save for retirement, but plan sponsors need to structure their automatic enrollment and escalation strategies carefully. Choosing a higher initial default contribution rate, including an employer match, and escalating in greater increments are all ways to boost the power of these features. Jean Young of Vanguard’s Center for Retirement Research suggests a starting default contribution rate of 6 percent, with a 50 percent employer match up to 3 percent of pay. That’s an initial 9 percent savings for the participant. Then, an automatic escalation of 2 percent per year raises the saving rate above 12 percent within three years.

Employers might also consider providing education or advice to help participants understand how much they need to save. Educational materials, gap analyses, and retirement savings calculators can all help reinforce the message that participants need to calculate a savings goal to understand how much to save rather than rely on a default contribution rate.

Inertia will always be a factor when it comes to getting people to save for retirement, but there are also lots of external forces that have positive effects. Integrating automatic enrollment and automatic escalation with your employer-sponsored retirement plan may just be the push participants need get the momentum moving in the right direction and put them on the path to financial freedom.