401(k) Versus IRA for Small Business

401k and IRA compared

Depending on who you ask, only 10% to 20% of small businesses offer retirement plans—and that’s a huge problem. Nearly 60 million people work for small businesses, so that means about 48 million people aren’t saving for retirement with an employer-sponsored plan.

And if you’re a small business owner without a retirement plan, you’re missing one of the most efficient ways to lower your tax dollars and build a retirement nest egg.

Fortunately, it’s easier than ever to set up a retirement plan. Changes in the tax code combined with innovative financial technology created a perfect storm for small business owners; a retirement plan for 10 employers can cost as little as $1,000 a year to administer, and the IRS gives you a credit for half of that for the first three years. The biggest problem for small business owners is deciding whether a 401(k) or IRA is the best option for their company.

401(k) versus IRA: What’s the difference?

Both 401(k) plans and IRAs offer tax-deferred growth, tax-deductible contributions, and the 50% tax credit for your plan administrative costs for the first three years. From there, the similarities end.

A simplified employee pension plan, or SEP-IRA, works for businesses with any number of employees. Employees aren’t allowed to contribute to a traditional account; only the business owner can make contributions.

A savings incentive match plan for employers, or SIMPLE IRA, is for small businesses with up to 100 employees. Both the employer and employees can make contributions and the employer matches the employee’s contribution.

There are several different types of 401(k) plans; which one you choose depends on whether or not you have employees other than the business owner and the owner’s spouse. Of the different plan types, a 401(k) plan has the highest contribution limits (25% of salary up to $56,000 a year in 2019, plus up to $19,000 in deferred salary with an extra $4,500 a year for those aged 50 and over).

The following chart explains the differences between a 401(k) plan and an IRA.

 SEP-IRASIMPLE IRA401(k) Plan
Who is eligible?Self-employed people, small business owners with employeesBusinesses with 100 or fewer employeesAn employer/owner with one or more employees
Who can contribute?Employer only, although employees can put their IRA contributions in the accountMandatory employer contributions, employee contributions optionalEmployee, although employer may also make contributions
Contribution limitsUp to 25% of salary to a max of $56,000; owner must contribute the same percentage of salary to employees’ accounts as he contributes to his own2% mandatory contribution by employer even if the employee doesn’t contribute, or matching contribution up to 3% of salaryDepends whether traditional or solo; combined employer and employee contributions can’t exceed $56,000 ($62,000 for those age 50 and over)
Administrative burdenMinimal, no form 5500 filing or contribution discrimination testing, employee notification of any employer contributionsMinimal, no form 5500 discrimination testing; annual employee notificationsHigher; annual form 5500 filing, plan amendments for legislative changes
Access to fundsAnytime, but taxes and penalties apply to premature distributions under age 59-1/2Anytime, but 25% penalty in first two years, plus taxes and 10% penalty for premature distributions before age 59-1/2Options for loans and hardship withdrawals; taxes and penalties apply to premature distributions prior to age 59-1/2
Key advantagesFlexible contributions if cash flow is an issue; low administrative costs and obligationsLow cost and administrative burden, employees share responsibility for retirement savings, high contribution limitsHigh contribution limits, employer contribution is optional, vesting schedule set by employer
Key disadvantagesEmployees can’t contribute; employer contributions must be the same for all employees (by percentage)Mandatory employer contributions, lower contribution limits, no Roth optionCompliance testing, higher administrative expense depending on the type of plan

Things to consider about 401(k) versus a Traditional IRA for small businesses

Before you contact your account to help you set up a retirement plan, answer the following questions so you make the right choice.

When will you fund the plan?

Most plans have an elective employee contribution or deferral, and the employer contribution, except for the SEP-IRA, which is funded by employer contributions only. Businesses have until their tax-filing deadline to fund a SEP but must fund 401(k) plans by January 31st for the previous year.

Do you want to take advantage of catch-up contributions?

SIMPLE IRAs and 401(k) plans allow you to contribute above the annual limit to help you “catch up.” If you’re aged 50 or over, you can sock away an extra $6,000 a year in these two retirement plans. However, since SEP IRAs are funded by employer only contributions, there is no catch-up allowance with this type of plan.

Will you add more employees in the future?

If your business employs just you or you and your spouse, a SIMPLE IRA or solo 401(k) may be the best option. However, if your business grows and you want to add employees, the calculation changes a bit.

All employees who work at least 1,000 hours a year are generally eligible to participate in your retirement plan. However, a SEP IRA gives you extra time to bring on new employees. Employers can restrict new employees from joining the plan until they have worked at least 1,000 hours in three of the last five years.

Do you want the option to borrow from your plan?

Although it’s generally a bad idea to borrow against retirement savings, it’s better than taking a premature withdrawal. Only 401(k) plans can be structured with a loan program; IRA withdrawals are subject to a 10% penalty and normal income taxes.

Choosing between an IRA or 401(k) isn’t a black and white decision. Tax and benefits laws change all the time, so what is true of retirement plans today may change with new legislation next year or the year after. Your income and cash flow may fluctuate considerably from year to year.

Your accountant has a big-picture view of your business finances and which plan type makes the best sense for your situation. Before you choose a retirement plan, schedule some time to discuss your options so you aren’t locked into a retirement plan that doesn’t work for you and your business over the long term.