How Retirement Plans Can Aid Your Small Business Growth
New Capital offers Guideline’s 401(k) plans to clients for their businesses. If you are interested in exploring a new 401(k) plan for your business or in changing your current 401(k) plan provider, please contact Catherine Bahr at cbahr@newcapitalmgmt.com.
There are 33.2 million small businesses, and they employ 61.7 million of the 158 million American workers. While 95% of large private sector firms offer a retirement plan, retirement coverage by small businesses ranges from as low as 48% up to 77%, with smaller firms being less likely to provide coverage. There are easy solutions to the challenges faced by small businesses that do not offer retirement plans. And many of these solutions provide tax benefits and help employees save for a financially secure retirement. The following is a high-level overview of some of the reasons small businesses should provide retirement benefits for their employees.
How Employer Plans Benefit Small Businesses
Between 69% and 96% (depending on business size) of businesses that offer retirement plans say that offering a retirement plan is important for attracting and retaining employees. This reason seems valid, as a potential new hire might see a retirement plan as the tiebreaker between two competing employers. Additionally, once one has recruited and trained an employee, it is often more cost-effective and good for business continuity to keep that employee instead of training a new one. But there are other benefits as well, including:
Deduction for employer contributions up to allowable limits
For qualified businesses, a tax credit of up to $5,000 for three years for the ordinary and necessary costs of starting an employer plan. This tax credit can help small businesses cover the cost of setting up the retirement plan and hiring an advisor or other professional to train employees on how the plan works.
Contributions can be excluded from employees’ income until distributed.
Earnings grow tax-deferred.
The business owner, who is also a participant in the plan, would benefit from any tax deferral and tax-deferred growth.
Using a Plan to Encourage Employee Loyalty
An employer may use plan features to encourage loyalty and boost employee morale.
Using a Vesting Schedule
An employer with a high employee turnover rate of one to five years could adopt a plan with a vesting schedule, under which employees will lose a percentage of employer contributions if they leave the employer before a certain number of years. The following is an example of a cliff versus a graded vesting schedule.
Source: www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-vesting. Employers can make schedules less restrictive but not more restrictive.
Under this cliff vesting schedule, an employee would forfeit 100% of the employer contribution unless they have performed three or more years of service with the employer. Under this graded vesting schedule, an employee who leaves after only two years of service would forfeit 80% of employer contributions. Please note an important consideration for plan choice: Vesting schedules may be used for qualified plans, such as profit-sharing plans. However, vesting schedules cannot be used for SEP IRAs and Simple IRAs, as contributions to these plans are always immediately 100% vested.
Using Eligibility Service
An employer can require employees to work for a certain number of years before they are eligible to receive employer contributions. For qualified plans, it can be up to two years, but for service requirements of more than a year, contributions would be immediately 100% vested. Therefore, if the employer wants to implement a vesting schedule, employees must be eligible for employer contributions after performing one year of service.
For SEP IRAs, the employer can require employees to have three years of service before they are eligible to receive employer contributions.
For a qualified plan—such as a profit-sharing plan—an employer may require an employee to work at least 1,000 hours a year to accrue a year of service. Whereas with a SEP IRA, a year of service is any period worked, however short.
Using Discretionary Contribution to Encourage Performance
Contributions to SEP IRAs and profit-sharing plans can be designed to be discretionary, allowing an employer to decide from year to year whether to make contributions—and, if so, how much to contribute. An employer can use this feature to encourage high performance, where they could promise employees contributions of up to 25% of eligible compensation depending on how well the company did financially.
Overcoming Excuses for Not Offering a Retirement Plan
The reasons some small businesses give for not offering a retirement plan vary. But most of these can be easily addressed. According to a report from the Trustees of Boston College, Center for Retirement Research, the following are the most frequently cited reasons by small businesses for not offering a retirement plan.
The business is not big enough. The business not being big enough is the number-one reason given for not offering a retirement plan. But size does not matter, except for Simple IRAs, which have a 100-employee maximum on certain employees. Even a business with one employee can set up and maintain a qualified plan, a SEP IRA, or a Simple IRA.
Cost. Administrative cost is the number two reason, and it can be valid when a business adopts a 401(k) or another qualified plan. But an employer can keep administrative costs low by adopting a SEP IRA or a Simple IRA.
Employees are not interested. This can be easily resolved by holding educational and enrollment meetings for employees. For plans that allow employees to make contributions, explaining the tax benefits—including the savings credit for lower-income employees—can be an effective means of encouraging participation. For SEP IRAs, all employees would need to do is establish their accounts, to which the employer would make contributions.
Administrative complexity and fiduciary liability are included in the other reasons given. But whether these apply depends on the type of retirement plan. To that end, an employer should consult an advisor to ensure the retirement plan fits the business profile.
Small Businesses Might Be a Solution to the Retirement Savings Crisis
Less than 50% of non-retirees think they are on track with retirement savings. And according to an EBRI study, those who work for an employer with a retirement savings plan are more likely to have $25,000 or more in retirement savings vs less than $1,000 for those who do not work for such an employer. Small businesses can help solve this retirement savings crisis because they employ 39% of American workers, yet less than 50% (depending on size) offer retirement savings plans for their employees.
Understandably, starting a retirement plan for a business can be daunting. But cautious business owners can start with a SEP IRA. These are the easiest employer-level plans to establish, and contributions are discretionary, thus allowing the business owner to decide from year to year whether to make contributions. Additionally, they offer a hands-off solution for employers once the contributions are made, as they then become the responsibility of the employee/account owner to manage and invest. I will cover SEP IRAs in future articles in this series.