If you’re starting to feel as though your business has outgrown its current retirement plan, you’re not alone. As time passes and their workforce evolves, small business owners often find that the SEP IRA or SIMPLE IRA they originally implemented is no longer a good fit for their goals.
That doesn’t mean you made a mistake starting out with either a Simplified Employee Pension (SEP) or a Savings Incentive Match Plan for Employees (SIMPLE) IRA. Because they’re easy to establish and inexpensive to maintain, both of these plan types can be worthy options when you’re launching a small business.
But if your business is growing and changing, and you feel you need a plan with more flexibility, it may be time to consider the benefits of transitioning to a 401(k).
Why a 401(K)?
401(k) plans offer some important advantages for both employers and employees, including:
1. Increased Employee Contributions
The biggest difference between an SEP IRA and a 401(k) plan is that employee deferrals are not allowed with an SEP. Only employers can make contributions to this type of plan.
With a 401(k), an employee can contribute up to $20,500 to his or her retirement savings in 2022, or $27,500 if they’re 50 and older. This offers a real opportunity for employees and employers who are eager to minimize income taxes while also saving money for retirement.
SIMPLE plans allow employee contributions, but the maximum amount is lower than for a 401(k). In 2022, employees can contribute up $14,000 to a SIMPLE IRA, or $17,000 if they’re 50 and older.
2. More Employer Contribution Options
A 401(k) plan also can offer an employer more flexibility and control when it comes to employer contributions.
With a 401(k), employers may vary their contribution amount from year to year, and they can set their own vesting schedule for when employees have access to those contributions.
With an SEP or SIMPLE IRA, all contributions are immediately 100% vested, and employer contribution requirements can be more rigid. (Although with an SEP, the employer can decide whether to make contributions from year to year.)
3. Profit-Sharing Options
There are several profit-sharing strategies employers may choose from with a 401(k), each of which distributes funds in a slightly different way.employers more discretion—and flexibility—if they wish to provide different profit-sharing amounts to various employee groups each year.
4. Employees Can Make Roth Contributions
Employers with a 401(k) plan can elect to accept Roth 401(k) contributions, giving employees the ability to save to the same plan on both a pre-tax and after-tax basis. As Roth accounts increase in popularity, this can be an attractive benefit to offer both current and future employees. (Of course, it’s also a plus for employers who would like a pre-tax savings option.)
A Roth option is not allowed as part of an SEP or SIMPLE IRA plan.
5. Coverage Requirements May be Stricter
All three plan types have requirements regarding which employees must be allowed to participate and who can be excluded. (For example, employers with any of these plans can require that an employee be 21 or older to participate.)
However, 401(k) plans may be written to exclude more employee groups than the other plans, which can give an employer more control over the cost of matching contributions. Employees who haven’t worked at least 1,000 hours in the previous year can be deemed ineligible for a 401(k), for instance, which means many seasonal workers and part-time employees could be excluded. Employee groups also could be excluded from participation based on the type of compensation they receive, their job title and other factors—as long as the plan’s eligibility requirements are considered reasonable and nondiscriminatory by IRS standards.
6. Control Over Employee Withdrawals
With an SEP or SIMPLE IRA, withdrawals are permitted at any time. But those withdrawals are subject to federal income taxes, and if the employee is younger than 59½, he or she likely will have to pay a 10%—or greater—early withdrawal penalty as well.
With a 401(k), employers have more control over when and how much employees can withdraw from their accounts before they retire.
Withdrawals from a 401(k) typically are permitted only under specific circumstances (such as experiencing a financial hardship or reaching a certain age). But plan participants who need access to their funds may have the option of borrowing a portion of their account balance through a 401(k) loan.
Borrowers must pay interest on the loan amount, but the interest and payments go back into their own 401(k), which keeps their money growing for retirement. Another plus: By using a loan instead of a withdrawal, employees can avoid paying income taxes and the 10% early withdrawal penalty.
Ready to Make a Change?
If you think you’re ready to transition to a 401(k), it’s a good idea to get the ball rolling as soon as possible. It could take several months to set up the plan the way you want it, and timing is an important factor, especially if you currently have a SIMPLE IRA.
A SIMPLE IRA generally must be the only qualified plan a business contributes to during a calendar year—you can’t run both plans at once. So, if you choose to switch to a 401(k), you must terminate the SIMPLE at the end of one year and move to a 401(k) the next.
Similarly, if you established an SEP using IRS Form 5305, you cannot maintain the SEP and a 401(k) in the same year.
There also are rules regarding when SIMPLE and SEP participants must be notified of a change and when employees can roll over the balance from the old plan to the new 401(k).
Your Octavia Wealth advisor can be an important resource if you have questions about the pros and cons of various qualified plans or the process of converting your company to a 401(k). Schedule some time with us today to review your current plan. We can talk about whether it’s still a good fit for your business or if it’s time to consider something new.401ksep ira