In our last article, we met “Luis,” a fictional business owner who asked us a very common question: How do I create a financially secure life for myself (and my family) after I leave my company in Baltimore? In a very personal way, he was asking a broader question: What are the best retirement plans for a small business owner with employees?
As you recall, Luis’ post-exit financial security was not going to come from the sale of his company, and he realized that the cash he was currently saving wouldn’t be enough. He thought that a retirement plan might be the way to go but the number of choices was overwhelming.
Starting with Your Goals: Finding the Best Retirement Plan for a Small Business with Employees in Baltimore
Once Luis understood that the “best retirement plan” for him and his small business depended on his goals—especially his target retirement date and target retirement nest egg—we agreed to collect some information and meet again.
“Did all the info I sent you make sense?” Luis asked as we looked over the stack of papers in front of us.
“It did, and we’ve used your list of assets and non-business assets to create a balance sheet,” we responded as we handed it to him.
His eye went right to the bottom line as he said, “I know I’m going to need more than this, but how much more?”
“That depends,” we began, “on when you want to retire. Have you picked that date?”
“Sonja and I have talked about it,” Luis responded, “and have agreed that—knock on wood—I’ve got eight years left in me.”
“That gives us time to really ramp up your savings through a retirement plan,” we said. “We’ll use your target retirement date to figure out how much money you’ll need after you exit your business. Should we assume that you want to keep your current lifestyle?”
Luis laughed. “I’d like to tell you that we’ll be frugal once the kids are out of college, but I know that won’t happen. There are too many places Sonja and I want to see and I’m not counting on all our kids staying local. So yes, let’s assume the same lifestyle. Right now, I’m taking home $180,000.”
“That works. We’ll use that number, figure in your life expectancies, factor in a safe withdrawal rate, estimate the increase in the value of your current assets and come up with the dollar value of assets you need when you retire,” we promised. “Once we do that, we’ll know what the retirement plan you pick must achieve. Today, let’s talk about the best types of retirement plans that might work for you and your small business.”
“Great,” Luis answered. “I want to set something up and check this off my list.”
Getting into the Nitty Gritty: Past Experience and Questions about Your Business
“Let’s start with a few questions about your experience with retirement plans.” We asked, “Have you ever had one?”
“Nope. When I was younger and the business was too,” Luis said, “I just didn’t think that much about retirement. I was too busy running the company.”
“Got it. So, let’s ask you just a few more questions,” we suggested.
Had Luis ever had a retirement plan, we would have asked about why that plan no longer existed. We’d ask what he had liked and not liked about it. Since he had never had a retirement plan, we asked:
- How much are you willing to contribute for employees?
- Do you want contributions to be tax deductible?
- What level of complexity are you willing (or able) to manage?
- Most retirement plans require distributions at certain ages, regardless of whether you are working or not. Would you consider one of those plans?
- If your choice was between: a) making bigger contributions and b) simple plan administration, which would you pick?
- Will having a retirement plan help you recruit new employees?
- Will the company pay the plan expenses or will the participants?
The answers to these questions point us toward the plans that suit a particular owner and his or her business. In this case, we needed to see what the best retirement plans for a small business with employees would be.
1. How much are you willing to contribute for employees?
If your answer is, “As little as possible!” our next question is, “Do you want to decide how much to contribute to an employee’s retirement or are you comfortable with a formula that bases the amount you contribute for employees on what you contribute for yourself?”
As an employer, you determine the amount you contribute to profit sharing plans, defined contribution 401(k) plans, SIMPLE 401(k) plans and Safe Harbor 401(k) plans. Employees can make pre-tax contributions to these plans as well. A Simplified Employee Plan (SEP) is similar in that it allows employers to decide how much to contribute to an employee’s account. A SIMPLE IRA plan allows employees to make pre-tax salary deferrals and employers to match the employee’s contribution regardless of whether employees make their own contributions.
2. Do you want contributions to be tax deductible?
If deferring the taxes an owner will owe on the interest, dividends and capital gains in an account is important, traditional IRAs and 401(k) plans offer that tax deferral as well as a tax deduction on the initial contribution. Roth IRAs add tax-free distributions in retirement and tax-deferred growth.
3. What level of complexity are you willing (or able) to manage?
Defined benefit plans require more administration expertise than defined contribution plans, but the fact that employers may receive higher contributions for themselves may offset administration costs. If your business qualifies, you may also receive a tax credit (of 50% of “normal” costs to set up and administer the plan—up to $500 per year) for setting up a SEP, SIMPLE IRA or qualified plan.
4. Most retirement plans require distributions at certain ages, regardless of whether you are working or not. Would you consider one of those plans?
Remember when we asked Luis about his target departure date? We do so for two reasons: 1) to calculate the value of his assets on that date, and 2) because most retirement plans (e.g., IRA, SIMPLE IRA, SEP and IRA) require minimum distributions to owners at age 70 1/2 regardless of whether you are working or not.
5. If you have to choose between making bigger contributions and simple plan administration, which would you pick?
If the majority of your employees are highly paid, you may be able to contribute more to your own retirement via a 401(k) plan, but the administration of a 401(k) is not for the faint of heart. These plans are subject to discrimination testing by law, so founders’ and executives’ benefits may be reduced. To peek into your plan, the Department of Labor will use the Form 5500 you’ll file each year; forms that you’ll want a professional plan administrator to complete.
6. Will having a retirement plan help you recruit new employees?
In industries or in cities that compete for employees, a retirement plan can make your company an employer of choice. So, given Luis’ company location in Baltimore, Maryland—a retirement plan could be an attractive benefit.
Both 401(k) and SEP IRA plans give employers the ability to contribute to their own retirement and are attractive to employees. If most of your employees are lower-wage (or part-time) workers who won’t be putting much into their retirement plan, the existence of these plans will not help recruiting.
7. Will the company pay the plan expenses or will the participants?
For most owners, the answer to this question depends on who has the largest percentage of cash (or contributions) in the plan—the owner or the employees. If, for example, you are the major participant, we generally recommend that the company pay for the administration of the retirement plan (a tax-deductible expense) so that your plan account grows more quickly. When employee contributions make up the majority of a retirement plan’s assets, owners are less enthusiastic about “paying for” the plan. In that case, we recommend that the plan collect an administration fee from each participant to cover the plan’s operating expenses.
Turn to a Professional to Find the Best Retirement Plans for Your Small Business with Employees in Baltimore
Your answers to these seven questions help us make the best retirement plan recommendations for your small business with employees, whether in Baltimore or elsewhere. As always, our recommendations are designed to best suit your exit goals and plan preferences. If you’d like to sit down with one of our experienced retirement planners to talk through your goals and plan preferences, give us a call.