When it comes to setting up a retirement plan, many small business owners end up wondering which is best – a 401(k) or an IRA. The answer used to be pretty simple. Even though 401(k)s generally offered more flexibility to small business owners and higher pre-tax savings limits, they used to come with big administrative headaches. Despite their drawbacks, IRAs used to be a popular choice because they were simpler to set up and administer.
Today, 401(k)s can be as easy to administer as IRAs
But times they are a-changin’… There is a new breed of 401(k) specifically designed for small businesses that offer the administrative simplicity of IRAs with the flexibility and higher savings potential of a 401(k). These new 401(k)s can integrate with your existing payroll and allow small business owners to delegate the day-to-day administration headaches to professional 401(k) fiduciaries. Thanks to technology, they are now available at half the typical cost.
401(k)s: 3 key advantages
Once the administrative question is taken off the table, we can focus on the 3 key advantages of a 401(k):
- Employees can save more
- Business owners don’t have to fund employees’ accounts
- More protection from creditors and bankruptcies
In this post, I’ll explain the differences between the two, so you can make an informed decision. We’ll review popular small business retirement plan options – SEP IRAs, SIMPLE IRAs, and 401(K)s and then summarize the key differences.
Small business 401(k)s
A 401(K) is a retirement savings plan that you set up for you and your employees. The IRS calls them “defined-contribution pensions” which is just a fancy (nerdy) way of saying that employees decide how much of their own money they want to contribute (currently capped at $18k for people under 50 and $24k for people over 50).
Employers have the option to contribute
But, and here’s the cool part, as business owner, you *have the option *to add money to employees’ accounts too. And this option is flexible – you can match only what employees put in or you can give every employee a flat contribution. Most importantly, since funding employee accounts is an option – you have the flexibility to increase, decrease, or eliminate a company contribution as you see fit. Small business IRAs, however, aren’t as flexible and will require you to fund employee accounts (see below).
Employee + Employer contributions let owners shelter $53k from taxes
If your goal is to max out your personal retirement savings or lower your personal taxes, 401(k)s really excel. If you were to max out both the employee and employer contribution, then you’d be saving a whopping $53k if you’re under 50, and $59k if you’re 50+. I call this a super-charged 401(k), there are a few tricks to make this happen, which I’ll describe in my next blog post.
Protect your retirement savings…
One really cool thing about 401(k)s is that they protect your retirement savings from bankruptcies, creditors, and lawsuits. Without going into too much detail, in most cases, your retirement savings will stay yours even if you go bankrupt, if creditors start pounding on your door, or if you end up on the losing end of civil litigation. Unfortunately, IRAs don’t offer the same protection.
Small business IRAs
An IRA is an Individual Retirement Account. The name may imply that an employee needs to start this account, but an employer can set up and fund an IRA for employees. There are two types of IRAs that are relevant to small business employers: SIMPLE and SEP. Both are relatively simple to setup and administer, but they come with significant strings attached and generally don’t have the same legal protections as 401(k)s.
SIMPLE IRAS – Employers must contribute
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is one option for employers that anticipate running a smaller company with stable finances. Why “stable finances”? Well, the business owner is required to contribute to the plan each year (generally, either 2% of salary to all employees or a 3% match to participating employees). Employees can then make their own contributions up to the IRS limit ($12,500 for 2015 or $15,500 for people 50+).
The biggest advantages of a SIMPLE IRA is the ease with which you can set one up and manage it. The biggest disadvantages are mandatory contributions required from the employer and higher penalties for early withdrawal.
SEP IRAs – Fully funded by Employer
A SEP (Simplified Employee Pension) IRA is as easy as a SIMPLE IRA to set up but allows you to save a heck of a lot more ($53k or 25% of salary, whichever is less). However, unlike a 401(k) or SIMPLE IRA, a SEP is generally entirely funded by the employer. Moreover, the employer must provide the same contribution rate to each employee. So if you want to save 20% of your salary, you’ll have to contribute 20% of each employee’s salary into their account. Clearly, this can get very expensive if you are setting up the retirement account so that you can maximize your personal retirement savings.
But beware… IRAs lack 401(k) legal protection
Unlike 401(k)s, however, IRAs generally don’t provide the same level of protection from creditors and lawsuits, and how much, if any, is protected can vary state to state. So, umm… if you go this route, pay your bills on time and don’t get sued (or at least hire great attorneys).
What is best for you? 401(k) vs. IRA
Basically, it all comes down to whether you have employees and whether you want to protect your personal retirement savings from bankruptcy and creditors.
If you don’t have any employees and don’t need the additional legal protection of a 401(k), a SEP is a good option to consider. You can generally sock away just as much pre-tax as you could with a 401(k), and (since you don’t have employees) you won’t have to contribute a ton to employees just to max out your personal account.
If you do have employees or want to protect your savings from bankruptcies, lawsuits, etc., then definitely give next generation 401(k)s a closer look. They allow you to:
1. Maximize total pre-tax savings:
Save up to $18k pre-tax as an employee or up to $53k if you also make company contributions.
2. Have the option, not the obligation, to fund employee accounts:
The key point here is that unlike a SIMPLE or SEP IRA, the business owner can fund their own retirement account without having to put money into employee accounts. If you do decide to contribute to employees, you won’t be locked into making minimum annual contributions like you are with a SIMPLE IRA.
3. Enjoy greater protection from bankruptcy and creditors:
401(k)s are protected from creditors, bankruptcies and civil litigation. SEP and SIMPLE IRAs, on the other hand, have less protection in bankruptcies and generally have limited protection against civil litigation and other creditors (it get’s complicated and can vary state by state).
I hope this helps. So what seems best for you? Is there a question or issue I didn’t cover? Just let me know!