The small business retirement plans—SEP IRA, SIMPLE, 401(k)—can sound a bit like alphabet soup, but taking some time to understand the key differences between these different plans—such as contribution limits and eligibility requirements—is important and will help you set up the right retirement offering for your small business.

Retirement Plan Options for Small Businesses

Even if you’re running the company from top-to-bottom without the support of a human resources department, you can establish an excellent retirement plan for yourself and your employees, with the hopes of creating a safe nest egg for their retirement.

SEP-IRA

A SEP-IRA is one investment tool intended for the self-employed, small business owners (with or without employees), and freelancers. Easy to set up and maintain, contributions are tax-deductible and investments grow tax-deferred until distributions begin, at which point they are taxed as income. The “SEP” part of “SEP-IRA” stands for “simplified employee pension”; these plans are meant as an alternative to traditional employer-sponsored plans that might have higher set-up and operating costs. With a SEP-IRA, the employer makes contributions on the employee’s behalf — employees cannot contribute to the plan.

That said, not everyone is eligible for a SEP-IRA. Here are the rules:

• The plans are designed for self-employed people and small business owners with very few employees; you must contribute to all eligible employee’s plans, and your contributions to their plan must be an equal percentage to the contributions you make for yourself
• Eligible employees must be 21 or older, have worked for you or your business for at least three of the last five years, and earned at least $650 in 2022 (or $750 in 2023).
• The contribution limit for SEP-IRAs is $66,000 in 2023, but the total contribution amount cannot exceed: the lesser of 25% of compensation or $66,000.
• There is no catch-up contribution for those age 50 and older.

Main Benefits

• Contribution limits are high—$66,000 for 2023
• As the name suggests, they are simple to set up and administer—contributions are immediately vested
• You don’t need to contribute every year
• A provision in the SECURE Act 2.0 now allows for Roth SEP IRAs, so you can pay taxes on contributions now in order to withdraw tax-free during retirement

Drawbacks:

• No catch-up contributions for 50+
• RMD rules apply when you turn 73 and will change to age 75 in 2033.

Contribution Limits: Contributions made by employers must not exceed the lesser of 25% of the employee’s compensation, or $66,000.

Withdrawal Rules: As with traditional 401(k) accounts, you can withdraw money from your SEP IRA any time you wish, however you will face a 10% tax penalty if you withdraw before you turn age 59 ½. There are a handful of circumstances that allow the penalty to be waived, which include:

• Accountholder’s death
• Disability
• Eligible higher education expenses
• A $10,000 withdrawal for first-time home buyers
• Eligible medical expenses
• Health insurance premiums during periods of unemployment
• Accountholder is a military reservist called for active duty

While your early withdrawal, if it fell into one of these qualifying events or circumstances, would not be subject to the 10% penalty, you would still need to pay income tax on it.

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SIMPLE IRA

The SIMPLE (Savings Incentive Match Plan for Employees Individual Retirement Accounts) IRA is a retirement plan for self-employed people and small-business owners with 100 or fewer employees. The SIMPLE IRA, as its name suggests, is relatively easy to set up, with low start-up costs, and can be established through financial institutions such as Fidelity, Merrill Edge, and TD Ameritrade. In addition, it requires minimal paperwork: just an initial plan document and annual disclosures to employees.

If you are a small-business owner, the contributions you make for your employees are tax-deductible. Basic eligibility rules are as follows:

• Employers must have 100 or fewer employees
• Self-employed people or sole-proprietors are also eligible
• To participate, basic eligibility rules that that employees must have earned at least $5,000 in compensation during the last two calendar years, and should expect to earn $5,000 in the current year; that said, employers can choose to modify these requirements to be less restrictive
• Employers must match employee contributions, at least 1% and up to 3%, or make nonelective contributions for employees who do not contribute themselves.

Main Benefits:

• Easy to set up and administer
• Vesting is instant—employees own the matching contributions and can take them whenever they leave, regardless of tenure at the company
• Higher contribution limits than regular IRAs
• Tax credit for businesses who set up a SIMPLE IRA with automatic enrollment for workers
• Roth option now available, thanks to the SIMPLE Act 2.0

Drawbacks:

• Lower contributions limits than 401(k) plans
• Only for businesses with 100 or fewer employees; if your business is looking to grow, you might need to change plans later on

Contribution Limits: In 2023, employees can contribute up to $15,500 per year, with those over 50 allowed an additional catch-up contribution of $3,500. Starting in 2024, employers can contribute an additional 10% of salary (up to $5,000) to each eligible employee whose wages are $5,000 or more.

Withdrawal Rules: The SIMPLE IRA withdrawal rules are the same as the ones for other IRAs. With the SIMPLE IRA, you do not pay taxes on contributions, however you will pay income tax when you receive distributions during retirement. Withdrawing early (before you turn 59 ½) will result in a 10% penalty, unless you are withdrawing for one of the handful of special circumstances allowed. Required minimum distribution (RMD) rules apply once you turn 73.

If you have a Roth SIMPLE IRA, you’ll pay taxes on contributions, but can withdraw tax-free during retirement.

401(k)

401(k) retirement plans are one of the most popular out there, as they have enormous amounts of flexibility. That said, compared to SIMPLE IRAs and SEP-IRAs, the paperwork to get set one set up and running is more complex. In addition, these plans often have higher fees, but the total cost will depend on the features of your specific plan. To create a 401(k), you usually need to:

• Open a trust to hold the plan’s assets
• Document your plan, which includes specifics about which employees are eligible, how employer contributions will work, and more
• Share the plan details with all employees

If your business has over 100 employees, you will likely need a 401(k) as your employer-sponsored plan; SIMPLE IRAs are only an option for businesses with fewer than 100 employees. Beyond the initial set-up requirements, there are no eligibility requirements—other than owning a business—to starting a 401(k).

Main Benefits:

• Contribution limits are higher
• Catch-up contributions are allowed
• Available to businesses of any size
• Employer-matching contributions are optional
• Some plans allow employee loans

Drawbacks:

• More work to create and administer
• Higher maintenance fees
• Require non discrimination testing and annual tax reporting

Contribution Limits: Employees can contribute up to $22,500 to their 401(k) in 2023; the total limit on employer and employee contributions is $66,000. Those age 50 and over are eligible for catch-up contributions: $7,500 in 2023—with the catch-up contribution factored in, the total allowable contribution amount, for both employer and employee, is $73,500.

Withdrawal Rules: To avoid the 10% tax penalty, you should aim to withdraw from your 401(k) only after turning 59 ½, unless you meet the IRS’ special criteria for early withdrawals. Required minimum distribution rules apply for 401(k) accounts—you will need to start receiving distributions after turning 73, if you have not done so already. Finally, some employers allow employees to take out a loan against their 401(k) contributions—these employees are borrowing against their future contributions. If an employee takes out a loan but leaves before the loan is repaid, they typically must repay it in a lump sum or pay the 10% penalty.

Defined-benefit plans

Defined-benefit plans, sometimes known as pensions, are less popular now than they used to be—companies have largely replaced them with 401(k) accounts. These plans establish a fixed, guaranteed benefit for employees during retirement, rather than having the benefit be dependent on the performance of the investments in the 401(k).

There is no single formula for a defined-benefit plan. Typically, they are based on a per-company basis, and factor in things like the employee’s tenure at the company, salary, and age. An employer can model a formula based on the employee’s average salary from the past three years, or the last six; each company is different. Alternatively, a business may offer a flat dollar benefit, such as $500 for each year the employee worked with the employer. Most often, an employee does not contribute to the plan, but sometimes they do. In addition, the eligibility and vesting requirements to participate in the plan are defined by the company; as an employer you can determine if an employee is still eligible for any benefit if they leave their job before the vesting period has ended.

There are no contribution limits, however the IRS states that the annual benefit for a participant in a defined benefit plan cannot exceed the lesser of 100% of the employee’s average compensation for their three highest consecutive working years or $265,000.

Main Benefits: Can entice talented employees to work for your company, as these plans are employee-friendly and becoming increasingly rare

Tax benefits: because there is no contribution ceiling, you might be able to see a huge tax deduction for your business Control over eligibility and vesting

Drawbacks:

• The employer is on the 100% on the hook for the benefit payout
• Require annual filings, set-up filings, and annual actuarial assessments, which can be costly
• Businesses must contribute to a defined benefit plan for five years to receive tax benefits

Contribution Limits: There are no set contribution limits, however there is a limit to how much the benefit can be upon payout.

Withdrawal Rules: Each plan has its own terms for when the funds are accessible, but usually at a “typical” retirement age of 62 or older. Some plans allow employees to receive a lump sum distribution rather than payments at regular intervals.

Which Retirement option is best for small businesses?

If your business has fewer than 100 employees, it might make sense to look at the SEP IRA and SIMPLE IRA as options—both plans are easy and inexpensive to set up. Here are a few other scenarios to think through:

• If you want the highest contribution limits: 401(k)
• If you want to attract top talent with a handsome benefits package: Defined benefit plan
• If you want to set up the retirement account in a week: SEP-IRA
• If you have fewer than 100 employees and want to encourage employee contributions: SIMPLE IRA
• If you want the highest tax breaks available: Defined benefit plan

Why set up a retirement plan for your small business?

As a small business owner, you need to plan for your own financial future—there's no corporate HR department handling it for you. To ensure you can comfortably retire from your business, you’ll need to establish and contribute to a retirement plan. In addition, a retirement plan offered to your employees can help attract and retain talent, and help them be financially stable in their later years as well. Finally, these plans offer tax benefits, as the contributions you make to your employees’ plans are tax-deductible, up to a certain limit.

Alternative retirement plan options for self-employed

In addition to a couple of the options outlined here, there are other retirement plans for those who are self-employed, including:

• Solo 401(k): The Solo 401(k) is for a self-employed person who has no other employees, except for a spouse, assuming they are on payroll.
• Traditional IRA: Very easy to set up, you can open an IRA in minutes and start making tax-deferred contributions.
• Roth IRA: Also simple to open, the Roth IRA allows you to make taxed contributions now so you can take tax-free withdrawals later—a wise move if you think you’ll be in a higher income bracket during retirement.

Frequently Asked Questions

How much should I save for retirement?

Your specific retirement goals should be determined by your specific, unique vision for your retirement (Where do you want to live? How much do you want to travel? Do you have special health considerations?) and the help of a financial advisor, but generally speaking, saving 15% of your income each year is advisable. More is always better, though, and will help prepare you for any emergencies.

How do I set up a business retirement plan?

Many companies offer small business retirement plans. Look into the offerings from places such as Charles Schwab, Fidelity and similar wealth management firms. You should also chat with your accountant to cross all the t’s and dot the i’s when opening a retirement plan; make sure to maximize your deductions!

Can you start a retirement fund on your own?

Absolutely. SIMPLE IRA, SEP-IRA, and IRA accounts are all easy to open on your own—you can probably get it up and running in just a few days. More complicated accounts, especially if you have many employees, should be opened with the blessing and guidance of a financial advisor and accountant, and some—like 401(k) and defined benefit plans—require much more paperwork.

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