So you are on your way to becoming a startup success story. You have passed the seed stage and are gaining traction. Maybe your company only has a handful of employees, but is already a lucrative lifestyle business or maybe your baby has parlayed its Series A funding into rapidly scaling revenues.
Either way, you’ve gone from living blissfully on a shoestring budget to a harboring a growing sense of resentment toward the tax man. Watching nearly half of every hard-earned dollar that appears as gross wages on your W-2 get siphoned off (FICA-Med, state & federal income tax, property tax, sales tax, etc.) can do that to you.
Even if you have been diligently socking away the $5,500 annual contribution limit to a Traditional or Roth IRA, as your income rises, you begin to pine for ways to keep more of what you earn. It’s about this time that retirement plan discussions enter the picture.
In addition to being a valuable employee benefit, from the founders’ perspective, it can be a wonderful way keep more of what you earn. If Uncle Sam wants to give you a powerful incentive to save and invest for your future, why not take advantage?
IRA-Based Retirement Plans Offer Low Cost, Investment Flexibility, and Administrative Simplicity
Historically, the recommended approach to establishing a business retirement plan has been to start by considering the least complex, lowest cost plan types and to move up in administrative complexity and cost only as the size and interests of the business dictates.
For companies with fewer than 20 or so employees, this has often meant adopting either of the IRA-based plans – the Simplified Employee Pension (“SEP-IRA”) or the Savings Incentive Match Plan for Employees (“SIMPLE IRA”). The former is a de facto scaled down version of an employer-funded profit sharing plan while the latter is effectively a less robust version of a 401(k) plan.
Relative to traditional IRAs, SEPs and SIMPLES may allow the business owners and plan participants to make significantly larger pre-tax contributions. Relative to qualified retirement plans (e.g., 401(k) profit sharing plans, etc.), SEPS and SIMPLES do not come at the expense of enlisting the services of a third party administrator to maintain plan compliance and make annual IRS Form 5500 filings.
Not Your Father’s 401(k)
Despite these advantages, emerging companies—even ones with just one or two employees—are choosing the 401(k) as their first employer-sponsored retirement plan more often. The reason for this trend can be traced to an expansion of plan features and a liberalization of contribution and portability rules since the early 2000s.
Roth 401(k) options, loan provisions, vesting schedules, and safe harbor matching are examples of features that may lead some small businesses to eschew SEPs and SIMPLEs in favor of a 401(k). Recent rule changes permitting the conversion of Roth 401(k) and after-tax non-Roth IRA contributions to individual Roth IRAs upon retirement or separation of service and incentives to transfer traditional IRA money into existing 401(k)s offer examples of how portability between plan types may also be tipping the benefits balance in favor of 401(k)s.
Self-Directed Investment Accounts – An Attractive Option for Small Company 401(k) Plans
One of the biggest objections that small businesses have to 401(k) plans is that the investment options are often limited and expensive relative to the uber-flexible self-directed IRA accounts employed in SEPS and SIMPLEs. However, over the past couple of decades platform costs have been declining, and, for businesses with fewer than 15 or 20 employees, self-directed investment accounts are also an option, though they may boost administration costs.
In contrast to the rigid, limited plan structures of a generation ago, today’s 401(k)s are dynamic and offer participants a much greater degree of flexibility and autonomy in managing their investment and distribution decisions. They also offer much higher contribution limits. With all of the new features and functionality, the cost of establishing and maintaining a 401(k) plan—typically as much as $2-3,000 per year for a small plan—is often far outweighed by the tax savings to the founders and the value of the plan as a tool for attracting and retaining great employees.