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What’s the Most Tax-Efficient Retirement Plan for Your Business?

10 minute read

Boosting retirement benefits is a fantastic way to secure good talent and retain quality workers. Being able to offer a robust benefits package is especially helpful when there is a labor shortage or if the economy is reporting high levels of employee turnover. But how do businesses even begin the process of selecting the right retirement plan?

So Many Plans to Choose From!

401(k)s, Savings Incentive Match Plan for Employees (SIMPLE) plans, Simplified Employee Pension Individual Retirement Accounts (SEP IRAs), pensions, Employee Stock Ownership Plans (ESOPs), profit sharing plans, stock bonus plans, split-dollar life insurance, executive bonus plans — which retirement plan is best? The answer is different for each business, but there are some plans that are better than others based on the size of your business.

Before we get into the details of specific plans, let’s remind ourselves about the differences between qualified and non-qualified plans.

Qualified Plans Vs. Non-Qualified Plans

A plan is considered “qualified” when it is operated in accordance with the Employee Retirement Income Security Act of 1974 (ERISA). Employers with ERISA-qualified plans must follow a few key operational standards, but in return, they can deduct plan costs and contributions. Non-qualified plans (like split-dollar life insurance plans or executive bonus plans) can still help employees save for retirement, but businesses cannot deduct contributions to those retirement accounts. And that is why we’ll focus only on the most popular qualified plans.

401(k)s

401(k)s are available to any size business, but because they can be costly to operate, they have historically been favored by businesses with more participants. This trend may be coming to an end, though. The Setting Every Community Up for Retirement Enhancement Act, passed at the end of 2019, makes 401(k) plans more affordable by allowing multiple employers to pool their resources and operate shared retirement plans called pooled employer plans (PEPs). Smaller businesses that want the benefits of 401(k)s without the high costs may want to look into PEPs.

401(k) plans allow employees to defer a percentage of their paycheck into their retirement account. Additionally, businesses can elect to match those contributions or make contributions that are unrelated to employee salary deferrals (called nonelective contributions). Like most of these retirement plans, assets in 401(k) plans grow tax deferred, but employees must pay income tax when they take distributions in retirement.

401(k)s are typically funded with pretax dollars, but if the plan allows and the employee is eligible, employees may be able to make Roth 401(k) contributions.

403(b)s

In the most important ways, 403(b)s are like 401(k)s. The main difference is that 403(b) plans are only available to nonprofit and government organizations.

Until the 1990s, 403(b) plans were the only retirement plans available to nonprofit and government organizations. Today, private sector tax-exempt organizations can open other plans, but many still favor 403(b)s because they require less robust nondiscrimination testing. This allows nonprofit organizations to more easily offer retirement benefits to only a subset of their employee roster.

Like 401(k) plans, 403(b) retirement plans:

  • Grow tax deferred
  • Allow employees to contribute with salary deferrals
  • Permit the organization to match contributions or make nonelective contributions to employees’ accounts

And like 401(k)s, they tend to be favored by larger organizations because of their higher operational costs, although some smaller government entities use 403(b)s because they are one of the only options available.

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SIMPLE Plans

SIMPLE retirement plans are typically used by small employers because they are quick to set up and inexpensive to operate. And legally, they are only available to businesses with 100 or fewer employees.

There are two types of SIMPLE retirement plans: SIMPLE IRAs and SIMPLE 401(k)s. Under both types, employers are required to make contributions each year. They can either match employee contributions (up to 3% of their salary), or they can make nonelective contributions of 2% of employee salaries.

There are three main differences between SIMPLE IRAs and SIMPLE 401(k)s:

  1. Self-employed individuals can open a SIMPLE IRA, but they cannot open a SIMPLE 401(k).
  2. Businesses that have SIMPLE IRAs cannot offer any other retirement plan to their employees. Businesses that have SIMPLE 401(k)s may offer another retirement plan, but only for employees ineligible for the SIMPLE 401(k).
  3. SIMPLE 401(k) plans may allow employees to take loans from their accounts. Loans cannot be taken from SIMPLE IRAs.

SEP IRAs

SEP IRAs are available to businesses of all sizes, but they are typically used by smaller employers or self-employed individuals, and that’s for four main reasons.

  1. They are inexpensive to set up and simple to operate.
  2. Employees can only contribute up to $6K to their SEP (or $7K with catch-up contributions). Businesses with more employees may find that their workers would prefer a different type of retirement account that allows them to contribute even more.
  3. Employer contributions are not required, but they must be uniform for all employees. Contributions are based on a percentage of salary, so if the business owner wants to fund their own retirement account, they must be willing to contribute that same salary percentage to their employees’ accounts.
  4. Because SEPs are IRAs, the employee has more control over their investment options, which can be a great draw for smaller businesses.

Profit-Sharing Plans

Profit-sharing plans are available to employers of all sizes. Employers have full discretion in how much they contribute. They can contribute nothing in a profitable year or contribute to the plan in a loss year — it’s fully up to them. The most common method for allocating contributions is based as a percentage of employee salary, but there are other allocation methods to choose from, including:

  • Flat Dollar: Each participant gets the same amount of money, regardless of compensation. This may be ideal for a very small company whose employees are all equal owners in the business.
  • Age Weighted: Participants closer to retirement age get a larger share of profits. These can be good for small businesses whose key employees are older than most other employees.
  • Permitted Disparity (or Integration Method): Contributions are based on compensation that exceeds a percentage of the Social Security Wage Base ($147K in 2022). This allows businesses to slightly favor higher-paid workers but still pass discrimination testing.

Because contributions are discretionary and there are multiple contribution methods to choose from, businesses both large and small can benefit from profit-sharing plans.

Find the Right Plan for Your Business

Even though businesses of a certain size tend to gravitate toward certain retirement plans, there is no reason your business can’t go against the grain. Corvee tax planning software can help you compare the tax benefits of choosing one plan over another to find the best fit for you and your business.

401(k)403(b)SIMPLE IRASIMPLE 401(k)SEP IRAsProfit-Sharing Plans
What business sizes are eligible?Employers of all sizesEmployers of all sizesEmployers with 100 or fewer employees and self-employed personsEmployers with 100 or fewer employeesEmployers of all sizes and self-employed personsEmployers of all sizes
What types of businesses are eligible? (generally)Private-sector businessesNonprofit or government organizationsPrivate-sector businesses and self-employed personsPrivate-sector businessesPrivate-sector businesses and self-employed personsPrivate-sector businesses
What are employee contribution limits in 2022? (generally)Up to $20.5K
($27K if 50+)
Up to $20.5K
($27K if 50+)
Up to $14K
($17K if 50+)
Up to $14K
($17K if 50+)
Up to $6K
($7K if 50+)
$0
Are employer contributions required?OptionalOptionalRequiredRequiredOptionalOptional
Is nondiscrimination testing required?
(generally)
YesSomeNoNoYesYes

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