SEP, SIMPLE IRA or 401(k): picking a retirement plan for a small business

The quick way to tell them apart

A SEP suits an owner who wants to make flexible, employer-only contributions with almost no paperwork. A SIMPLE IRA suits a business with 100 or fewer employees that wants workers to save from their own paychecks, with a required but modest employer contribution. A 401(k) suits a business that wants the most features and is willing to accept more administration and annual filings. The best fit depends on who should contribute, how steady your profits are and how much complexity you are prepared to manage.

Business owners in Dallas ask me this question more than almost any other, usually after a good year or after a valued employee asks whether the company offers a plan. The good news is that the choice is less complicated than the alphabet soup makes it look. Each plan answers a few practical questions differently, and once you know your own answers, one usually stands out.

Four questions to answer before comparing plans

Before looking at plan rules, get clear on what you actually want the plan to do. Owners who skip this step often pick a plan because a friend has one, then find it does not match how their business runs.

• Do you want employees to be able to save from their own paychecks, or will contributions come only from the business?
• Are your profits steady enough to commit to a contribution every year, or do they swing?
• How many employees do you have now, and how many do you expect in a few years?
• How much administration and annual filing are you willing to take on, or pay someone else to handle?

The SEP: simple and flexible, but only the employer pays in

The IRS describes the Simplified Employee Pension as a plan that a business of any size, even a self-employed person, can establish. Only the employer contributes; employees cannot add their own salary deferrals. The flexibility is the main attraction: the IRS states that you do not have to contribute every year, which helps a business whose profits rise and fall.

The trade-off is fairness by design. The IRS explains that the employer must contribute equally for all eligible employees, meaning the same percentage of pay for each. Eligibility rules set by the IRS cover employees who are at least 21, have worked for the business in at least three of the last five years and earned at least a minimum amount; an employer can choose less restrictive rules but not stricter ones. For a solo owner or a business with few eligible employees, that is rarely a problem. For a business with many long-tenured staff, the cost of contributing for everyone can add up.

Paperwork is light. According to the IRS, an employer generally has no annual filing requirement for a SEP, including Form 5500, and a SEP can be set up for a tax year as late as the business's tax return due date, including extensions.

The SIMPLE IRA: employees save, the employer matches

The SIMPLE IRA is built for small businesses, generally those with 100 or fewer employees, according to the IRS. Employees can choose to have part of their pay deferred into the plan, which shares the responsibility for saving between the business and the worker. The IRS notes that the employer cannot maintain any other retirement plan at the same time.

The employer contribution is required, not optional. Each year, the IRS explains, the employer must choose between a matching contribution of up to 3 percent of pay and a 2 percent nonelective contribution for each eligible employee. Employees are always fully vested in SIMPLE IRA contributions. That predictability is a strength for budgeting and a weakness if profits fall sharply in a given year.

Timing needs attention. The IRS states that a new SIMPLE IRA can generally take effect on any date from January 1 through October 1 of a year, provided the employer did not previously maintain one, with an exception for businesses formed after October 1. Like the SEP, it generally has no annual Form 5500 filing.

The 401(k): the most features, the most upkeep

A 401(k) can be set up by a business of any size, and the IRS notes that the employer can also have other retirement plans. Employees defer part of their salary, and the IRS points out that employees are always fully vested in their own deferrals, while employer contributions may follow a vesting schedule. That vesting option can help a business reward employees who stay.

The cost is administration. The IRS explains that a 401(k) generally requires testing to show benefits do not favor highly compensated employees, that this testing can be complicated, and that an annual Form 5500 filing is required. Costs may be higher than with more basic arrangements, and features such as loans and hardship withdrawals add work for the employer. The IRS also mentions that a pre-approved plan document can reduce administrative headaches and expenses.

Side by side, in plain terms

Laid out together, the differences come down to who pays in, how fixed the commitment is and how much upkeep the plan needs. Use this as a starting point, then confirm current limits and rules on the IRS website or with a professional, because contribution limits change from year to year.

• Who contributes: SEP, employer only; SIMPLE IRA, employees and employer; 401(k), employees and optionally employer
• Employer commitment: SEP, optional each year but equal for all eligible; SIMPLE IRA, required match or nonelective each year; 401(k), depends on plan design
• Business size: SEP and 401(k), any size; SIMPLE IRA, generally 100 or fewer employees
• Annual Form 5500: generally none for SEP or SIMPLE IRA; required for a 401(k)
• Setup timing: SEP, as late as the tax return due date with extensions; SIMPLE IRA, generally effective January 1 to October 1

What I usually see work for different owners

A self-employed consultant or a husband-and-wife business with no other employees often starts with a SEP, because it is quick to open, contributions can flex with income and there is little paperwork. A growing service company with a handful of employees who want to save from their own pay often fits a SIMPLE IRA, since it gives workers a real benefit with predictable costs. A business that is larger, plans to grow, wants a vesting schedule or has owners who want more design options often looks at a 401(k).

There are other choices, too. Nonprofits and certain public employers may use 403(b) or 457 plans, and Primerica lists payroll deduction plans as complimentary for employers, which let employees save into IRAs through their paychecks. For a very small business that is not ready to commit to a formal plan, ask whether that is a sensible first step.

Be honest about your own goal as the owner, too. Some owners mainly want to shelter more of their own income; others mainly want a benefit that helps them hire and keep good people. The first goal often points toward the plan that lets the owner contribute the most for the least cost, while the second points toward a plan employees can see and use from their own paychecks. Most owners want some of both, and the plan design should reflect which matters more.

Mistakes that cost owners money

In my experience, the most expensive mistakes come from treating the plan as a one-time setup rather than something to manage. The rules are not hard, but they do have to be followed every year.

Most of these are avoidable with a short annual check: confirm who is eligible, confirm the contribution formula was followed, confirm any required filings were made and confirm the plan still fits the size and profits of the business. If the business has changed a lot, the right plan may have changed with it.

• Opening a SEP for yourself and forgetting that eligible employees must receive the same percentage
• Adopting a SIMPLE IRA after the timing window or while another plan is still in place
• Choosing a 401(k) for its features without budgeting for testing and annual filings
• Ignoring the 100-employee threshold for a SIMPLE IRA as the business grows
• Not coordinating plan contributions with the business's tax planning

Bring your tax professional into the decision

Plan contributions affect the business's taxes and the owner's personal return, so the choice should not be made in isolation. Talk to a CPA, such as Joe Hockaday, about how contributions would be deducted and how they fit your projected income. Your own retirement savings matter as well; if you also want a personal account, the trade-offs are covered in opening a Roth IRA on your own. And if you or your employees have older workplace accounts from previous jobs, the options for those are laid out in what an old 401(k) rollover involves.

Setting up a plan with me

I work with business owners around Dallas on 401(k), 403(b), 457, SEP and SIMPLE IRA plans and payroll deduction plans. We start with your four answers: who should contribute, how steady profits are, how many employees you have and how much administration you will accept. From there I explain which plan fits and why, help with the setup and enrollment, and make sure employees understand what they are being offered.

I am a registered representative of PFS Investments Inc., and products are offered only in the states where I am licensed. Investments carry risk and no return is promised. If you are still deciding whether to work with an advisor at all, start with what to ask a financial advisor before hiring. A first conversation carries no obligation.

Questions people ask me