If you are the owner of a small business, you can set up a retirement plan for your employees and for yourself. By doing so, your business can make contributions to set aside money for your own retirement, as a self-employed individual, and for your employees’ retirement. At the same time, you take advantage of certain tax benefits that can reduce the income tax burden for your business, for your employees, and for you personally.
Types of plans
There are basically three different types of retirement plans for small businesses that have been designated by the Internal Revenue Service (IRS) to receive special tax treatment:
SEP (Simplified Employee Pension) plans
SIMPLE (Savings Incentive Match Plan for Employees) plans
SIMPLE IRA plans
SIMPLE 401(k) plans
Qualified plans (including Keogh or H.R. 10 plans)
Tax benefits
The potential tax benefits that can be gained by setting up one of these plans are:
Your business can take a tax deduction for qualified contributions to the retirement plan.
By making elective contributions to their retirement accounts, your employees can defer part of their taxable compensation, lowering their income tax in the current year.
You personally can also defer part of your net earnings from self-employment by contributing to your own retirement account.
Earnings on the contributions are generally tax free until you or your employees receive distributions from the plan.
Your business can take a tax credit for part of the cost of setting up the plan.
How each type of plan works
With a SEP plan, you can make contributions directly to individual retirement accounts set up for each of your employees. These can be the employees’ traditional Individual Retirement Accounts (IRA), or Individual Retirement Annuities (SEP-IRA) that you set up for each eligible employee.
Under a SIMPLE plan, employees can choose to contribute part of their salary to a retirment account rather than receiving it as part of their pay. You, as their employer, then make matching or nonelective contributions. There are two types of SIMPLE plans: the SIMPLE IRA plan and the SIMPLE 401(k) plan.
Qualified plans are more complex than the SEP and SIMPLE plans, but they are generally more flexibile and there may be increased contribution and deduction limits in some cases. These plans are sometimes referred to as Keogh or H.R.10 plans. There are two basic kinds of qualified plans: defined contribution plans and defined benefit plans. In a defined contribution plan, a certain amount is contributed to the employee’s retirement account and benefits are based on the amount contributed and accumulated in the employee’s retirement account. In a defined benefit plan, the benefits are pre-determined, and contributions are made based on what is needed to provide those benefits.