As a business owner, you have a lot on your plate. You are focused on serving customers, managing employees, controlling expenses, and keeping your company moving forward. Retirement planning can easily fall to the bottom of your list.
But the retirement strategy you choose for yourself, and potentially your employees, can have a meaningful impact on your long-term financial picture.
Tax-qualified retirement plans can help you and your employees save for retirement while offering potential tax advantages. Depending on the plan, contributions may be tax-deductible for the business, employees may be able to contribute on a tax-advantaged basis, and investment earnings may grow tax-deferred.
What Are Tax-Qualified Retirement Plans?
Before looking at individual options, it helps to understand what makes a retirement plan “qualified.”
A tax-qualified retirement plan is a retirement arrangement that meets requirements established by the Internal Revenue Code. In return for meeting those requirements, the plan may receive certain tax benefits.
Qualified plans generally fall into two broad categories:
- Defined-benefit plans
- Defined-contribution plans
The primary difference comes down to what the plan is designed to provide.
A defined-benefit plan generally determines retirement benefits using a formula that can consider factors such as salary history and length of employment. A defined-contribution plan, on the other hand, builds retirement savings through contributions and investment selections, with the eventual account value depending on factors such as how much is contributed and investment performance.
With that foundation in mind, let’s look at seven retirement options business owners should understand.
1. 401(k) Plans
A 401(k) is one of the most familiar tax-qualified retirement plan strategy available to businesses. It is a type of defined-contribution plan that allows employees to save for retirement through the employer’s retirement program.
Employees can generally contribute a portion of their compensation to their accounts, while employers may also make contributions depending on the plan’s design.
Because contributions and investment selections can influence the eventual retirement balance, employees generally have an important role in building their retirement savings.
For you as a business owner, a 401(k) can serve two purposes: helping you prepare for your own retirement and providing a valuable benefit to your employees.
Why consider a 401(k)?
A 401(k) may help you:
- Provide employees with a structured way to save for retirement
- Encourage consistent retirement contributions
- Offer an additional employee benefit
- Build your own retirement savings
- Create a long-term benefits strategy as your company grows
Defined-contribution plans such as 401(k)s are also commonly used by businesses as part of their efforts to attract and retain employees.
However, choosing a 401(k) should involve more than simply asking whether you can offer one. You should also consider plan design, costs, employee participation, contributions, administration, and your company’s long-term financial capacity.
2. Profit-Sharing Plans
What if you want your retirement strategy to involve employer contributions rather than relying entirely on employee salary deferrals?
A profit-sharing plan may be an option worth exploring.
Profit-sharing plans are a type of defined-contribution arrangement. The business makes contributions to the retirement plan according to the terms of the plan.
Despite the name, contributions don’t necessarily mean that employees receive a direct percentage of the company’s profits every year. The specific contribution formula and allocation rules depend on how the plan is established.
For a growing business, profit-sharing can provide another way to build retirement benefits while incorporating employer contributions into the overall compensation strategy.
A profit-sharing plan may help you:
- Provide an additional retirement benefit
- Make employer contributions to employee retirement savings
- Strengthen your overall benefits package
- Support employee retention
- Build retirement savings for yourself and eligible employees
The key is determining whether the structure works with your company’s cash flow and long-term objectives.
3. Money-Purchase Pension Plans
A money-purchase pension plan is another type of defined-contribution retirement arrangement.
Unlike a traditional profit-sharing arrangement, where contributions can be structured around the plan’s specific provisions, a money-purchase pension plan generally establishes contributions through a predetermined formula.
That means you need to understand your required contribution obligations before choosing this type of arrangement.
For business owners, the structure may be appealing when you want a more predictable employer contribution commitment rather than a retirement plan that is entirely dependent on discretionary contributions.
Consider questions such as:
- How consistent is your business cash flow?
- How much can the company realistically contribute?
- What retirement benefits do you want to provide?
- How many employees will participate?
- How might the plan work as your business grows?
A retirement plan should support your company’s financial health—not create a burden that becomes difficult to maintain.
4. Defined-Benefit Pension Plans
Defined-benefit plans work differently from defined-contribution plans.
Instead of focusing primarily on how much is contributed to an individual account, a defined-benefit plan establishes retirement benefits according to a formula. Factors can include salary history and duration of employment.
This distinction is important for business owners because the employer generally takes responsibility for managing the plan’s investments and associated investment risk.
Defined-benefit plans can provide a structured retirement benefit, but they can also involve more complexity than simpler retirement savings arrangements.
Why might you consider a defined-benefit plan?
A defined-benefit plan may be worth discussing if you:
- Want to establish a predetermined retirement benefit
- Have relatively predictable business finances
- Are interested in making substantial retirement contributions
- Want to provide a structured pension benefit
- Are planning several years ahead for retirement
Because these plans can involve significant planning and ongoing responsibilities, professional advice can be particularly important before establishing one.
5. Traditional IRA
Not every retirement account you use as a business owner needs to be an employer-sponsored plan.
A Traditional IRA is a tax-deferred retirement savings account. Depending on your circumstances, contributions may be deductible or nondeductible. Whether you qualify for a full or partial deduction can depend on factors including your income and whether you have access to an employer-sponsored retirement account.
Investment earnings in a Traditional IRA generally grow tax-deferred, meaning you don’t generally pay taxes on those earnings each year as you would with many taxable investments. Taxes are generally paid when money is withdrawn.
When might a Traditional IRA make sense?
You may want to consider how a Traditional IRA fits into your overall retirement strategy if you are:
- Building additional retirement savings
- Looking for tax-deferred growth
- Evaluating your current versus future tax situation
- Combining personal retirement savings with a business retirement plan
Your IRA strategy doesn’t necessarily have to stand alone. It can be considered alongside an employer-sponsored retirement plan and other investments as part of a broader retirement strategy.
6. Roth IRA
A Roth IRA takes a different approach to taxation.
You contribute after-tax money to a Roth IRA, meaning you pay taxes on the money before contributing it. In exchange, qualified withdrawals can generally be made tax-free.
This can make a Roth IRA an interesting option when you’re thinking about how your tax situation could change between your working years and retirement.
For example, you may prefer to pay taxes on certain retirement savings today rather than potentially paying taxes on withdrawals later.
Roth IRA considerations
A Roth IRA can offer:
- After-tax contributions
- Tax-free growth when requirements are met
- Tax-free qualified withdrawals
- Another way to diversify the tax treatment of your retirement savings
Income limits, contribution rules, and withdrawal requirements apply, so your eligibility and circumstances should be reviewed before making contributions.
7. Defined-Contribution Plans
The seventh option is actually a broader category that includes several retirement arrangements, including 401(k), money-purchase pension, and profit-sharing plans.
With a defined-contribution plan, the focus is generally on contributions made to an individual retirement account rather than promising a specific retirement benefit.
The eventual value of the account can depend on:
- Employee contributions
- Employer contributions
- Investment selections
- Investment performance
- How long the money remains invested
This makes defined-contribution plans fundamentally different from defined-benefit plans.
For a business owner, this structure can provide flexibility in how retirement benefits are offered to employees. Companies of different sizes can use defined-contribution plans to help employees prepare for retirement and make their benefits package more competitive.
How Should You Choose Between Retirement Plans?
Knowing the different types of tax-qualified retirement plans is a good starting point, but the real challenge is deciding which strategy fits your business.
There isn’t one answer that works for every business owner.
Consider Your Number of Employees
A retirement plan for a business with five employees may look very different from one designed for a company with 100 employees.
Think about eligibility, participation, contribution levels, and how the plan will work for employees at different stages of their careers.
Look at Your Business Cash Flow
Before committing to an employer-sponsored retirement plan, look carefully at your company’s finances.
Ask yourself:
- Can the business consistently make employer contributions?
- How might contributions affect cash flow?
- What happens during a slower year?
- Is the business expected to grow?
- Will your retirement strategy remain affordable as your workforce expands?
The goal isn’t simply to choose a plan with attractive features. You need a strategy you can realistically maintain.
Think About Your Own Retirement
As a business owner, it’s easy to focus entirely on your employees and forget about your own retirement.
Consider how much you need to save, when you want to retire, and whether you expect the business itself to provide part of your retirement income.
Your retirement plan should fit into the bigger picture.
If you’re also thinking about eventually transferring or selling your company, retirement planning becomes even more important. The value of your business, personal savings, investments, and retirement accounts may all contribute to your financial future.
Consider Employee Recruitment and Retention
Employees look at more than salary when evaluating a job.
A retirement plan can become an important part of your overall benefits package. Providing employees with an opportunity to prepare for retirement may make your company more attractive to current and prospective employees.
For a business competing for skilled workers, that can be an important consideration.
Don’t Choose a Retirement Plan Based on Taxes Alone
The potential tax benefits of tax-qualified retirement plans can certainly be important, but taxes shouldn’t be the only factor driving your decision.
You also need to consider:
- Your company’s financial stability
- Employee demographics
- Contribution requirements
- Administrative responsibilities
- Investment options
- Retirement goals
- Business growth
- Your eventual exit strategy
The right plan should fit your business rather than forcing your business to fit the plan.
It’s also important to remember that tax rules, contribution limits, eligibility requirements, and withdrawal rules can change. Always review current requirements with qualified financial and tax professionals before establishing or changing a retirement plan.
Build a Retirement Strategy Around Your Business Goals
There is no single retirement plan that works for every business owner. A 401(k) may make sense for one company, while a profit-sharing arrangement, defined-benefit plan, SEP IRA, SIMPLE IRA, or another strategy may be more appropriate for another.
The important thing is to evaluate your options based on your business, your employees, your cash flow, and your personal retirement goals.
Legacy Partners Insurance provides retirement and financial planning services designed to help individuals and business owners establish realistic goals and evaluate strategies for their financial future. Its retirement planning resources include IRAs, retirement needs analysis, and tailored retirement programs.
FAQs About Tax-Qualified Retirement Plans
1. What is a tax-qualified retirement plan?
A tax-qualified retirement plan is a retirement savings plan that meets requirements established under the Internal Revenue Code and may receive certain tax advantages. Examples include 401(k) and defined-benefit plans.
2. Which retirement plan is best for a small business?
There is no single best option for every business. Your employee count, cash flow, contribution goals, business structure, and retirement objectives can all influence which plan may be appropriate.
3. Can a small business offer a 401(k) plan?
Yes. Businesses of different sizes can offer 401(k) plans. A 401(k) can allow employees to make payroll contributions while giving the employer options for making contributions as well.
4. What is the difference between defined-benefit and defined-contribution plans?
A defined-benefit plan is designed around a predetermined retirement benefit, often based on factors such as salary and years of employment. A defined-contribution plan, such as a 401(k), generally builds an account balance based on contributions and investment performance.
5. Are tax-qualified retirement plans tax-deductible for businesses?
Certain employer contributions may be tax-deductible, depending on the type of plan and applicable tax rules. Because tax treatment can vary, business owners should consult a qualified tax professional about their specific situation.
6. Can a retirement plan help me attract and retain employees?
Yes. A retirement benefit can be an important part of an employee compensation package. Offering a company-sponsored retirement plan may help make your business more competitive when recruiting and retaining employees.
7. What is the difference between a Traditional IRA and a Roth IRA?
Traditional IRA contributions may be tax-deductible depending on your circumstances, and earnings generally grow tax-deferred. Roth IRA contributions are made with after-tax dollars, while qualified withdrawals can generally be tax-free.
8. Should I choose a retirement plan based only on tax benefits?
No. Tax considerations are important, but you should also consider employee needs, business cash flow, administrative requirements, contribution goals, and your own retirement objectives.
9. When should a business owner start a retirement plan?
It is generally beneficial to start planning early rather than waiting until retirement is approaching. Starting early can give you more time to contribute, evaluate your strategy, and adjust the plan as your business grows.
10. Where can business owners get help choosing a retirement plan?
Business owners can work with a financial professional to evaluate their business and retirement objectives and compare available options. Legacy Partners Insurance provides financial planning and retirement planning services for business owners and individuals in Glendale and surrounding Southern California communities.