The 401(k) plan is the most flexible of the three plans, and generally allows owners and employees alike to contribute the most money. However, as an ERISA-qualified plan, it also requires a good deal of paperwork to administer. A more basic version, the Solo 401(k) plan, offers the same benefits but is much less expensive and easier to set up and maintain. However, as the name implies, it is designed for sole proprietors, freelancers, consultants, independent contractors, and businesses with no owners other than the principal and a spouse.
The 401(k) allows for both pre-tax employer contributions of up to 25 percent of an employee's compensation and employee contributions of up to $18,000 per year through salary deferral, which are usually before tax. Some plan sponsors choose to make a Roth option available, in which case employee deferrals are before tax, but distributions in retirement are tax-free. Employees age 50 or older may contribute an additional $6,000.
The 401(k) allows for high potential deferrals, especially for owners and highly-compensated workers. However, you have to provide the same matching contribution percentage benefit for owners, key employees and rank and file employees alike. You can't discriminate against lower-paid employees.
- You can begin penalty-free withdrawals at age 55 if you've left the company's service or are no longer in the work force. Other plans make you wait until age 59½ before you can begin taking penalty free withdrawals (except under IRC Section 72(t).)
- Relatively high contribution limits
- Secure against creditors
- Complicated to set up and maintain (except Solo 401(k)s)
- Solo 401(k)s are not appropriate if you plan to hire full-time employees in the future.
SIMPLE IRA stands for Savings Incentive Match Plan for Employees Individual Retirement Account. They're designed to be an easier and simpler alternative to the 401(k) for business with fewer than 100 employees. Employees can choose to defer up to $12,500 of compensation each year as of 2017. Those age 50 and older can contribute an additional $3,000 per year. Employers must generally match employee contributions dollar-for-dollar up to 3 percent of compensation, or a 2 percent non-elective contribution for all employees - even if they don't contribute.
- No filing requirements. The SIMPLE is much easier to set up than the 401(k).
- Offers employees substantial potential tax deferral - though not as much as the 401(k).
- Employers can have no other retirement plan
- Employers must commit to meeting the matching requirements, even if business is slow.
- Fees for early withdrawal are as high as 25 percent.
SEP stands for Simplified Employee Pension plan. Employers may make pre-tax contributions to SEP accounts for each employee up to 25 percent of compensation, or $54,000, whichever is less, as of 2017. Employees do not make contributions to SEPs - this is a purely employer-funded plan.
Again, employers cannot discriminate in favor of management - they must contribute the same percentage of compensation to all eligible employees over age 21. An eligible employee is one who has worked for the employer for three out of the past five years and who has earned at least $600 in compensation for the year.
- Easy to set up
- Employees cannot shelter large amount of their own income from taxation.
Businesses may qualify for a tax credit to offset the costs of establishing small business retirement plans worth up to $1,500 over three years.