Why Should a Small Business Owner Have a 401K Plan and What Are the Best Savings Options? (Updated Sept. 2024)

Topics: Financial Planning, Employee benefits, Diversification, Spousal contributions, Tax Savings, Solo 401K, Simple IRA

In a blog I recently updated, I asked the question: How Much Should I Save for College?

We continue to discuss the savings theme, though this time narrowing in on those that have taken on the challenge of self-employment. Being your own boss is great. Make your own hours, no one to answer to. But then no one else to shoulder the responsibility or workload. An article I read suggested there are more than 30 million Small Business in the U.S. While the upside of owning your own business can provide great motivation, the risks may sometimes outweigh the reward, and the potential for failure is high. About 20% of Small Businesses fail in Year 1 and half in the first 5 years. Just 35% of Small Businesses succeed on average in the first 10 years of operation. However, if you can find the right mix of products, services, employees, clients and financing to keep things going, there are some appealing rewards. The government wants to help those who help others. The tax code is written to favor those who provide jobs (and housing) – so Small Business owners that create jobs for others (and real estate investors who provide housing). You can see this by the way business owners can save in tax-deferred accounts (and how real estate investors benefit from tax-advantaged cash flow via depreciation). We will get into real estate in other posts, so for now we will review why Small Business owners should have a Retirement Plan and some of the more common methods they can use to save for retirement. If you have questions about your retirement goals or other financial questions, send me an email: matt@mhb-advisory.com. And please check out our recently updated Business Services section on our website for services related to your company retirement plans, or click here if you’re just curious about your net worth.

On a personal note

I consider myself an entrepreneur. About seven years ago, I started more seriously contemplating a move into providing personal financial service, a change from my career catering to large institutions and away from the spreadsheets. I craved more personal interaction, in addition to teaching and serving. In spite of my efforts I could not get those things working where I was, so I announced my departure on June 13, 2018. I had managed my own money, so it seemed like a fairly easy transition to provide that service for others. However, actually managing money was not where I spent most of my time, likely how many entrepreneurs live their lives – running a business is much different than doing the one thing you were passionate enough about to start the business in the first place. So the startup process consisted of getting licensed to officially be able to perform the functions required on my job, registering in the states where I live and seek to work, designing and building a website, understanding the technology that would ultimately help me do a better job, and many other things – all of which I didn’t fully appreciate beforehand and which left less time for client interaction than I would have suspected. I also discovered several ways of how not to do things, the wrong systems and technologies, the wrong relationships and that I underestimated both my startup costs and ongoing expenses related to running this business. But I’m still here! I don’t even have to manage any employees (but also there’s no one else to do the grunt work but me). So, as a single-employee business, my savings vehicle of choice is the solo 401K. I’ll provide more information on that and other retirement savings options, but I wanted to first offer some insight on why your Small Business needs a Retirement Plan.

Why should business owners have a Retirement Plan?

If you’re busy running your business, you don’t need something else added to your To Do list. If you need some guidance in establishing your company’s Retirement Plan, I can help. If you’re not sure why you need a Plan, I outline five reasons why you should think about it.

Planning for the Future

I read an article that said 60% of Small Business owners are not saving enough for retirement. I assume it’s because they’re like me and continue to invest in their business and thus invest in themselves in that manner. Saving money personally can be difficult in the startup phase and certainly well after that as you shift focus from survival to growth. However, a Retirement Plan can jump start personal savings for both employers and employees with company owner benefits beyond what an employee can receive (more on this later). Furthermore, savings can be automated and regular to support dollar cost averaging (investing the same dollar amount regularly and removing uncertainty of price and timing from the equation – buying more shares when they are cheap and fewer when they are expensive).

Employee Benefits and Retention

If a potential employee is choosing between two similar opportunities – one with a 401K and one without – I would think the benefit of the 401K would be obvious. A Retirement Plan offers incentives to both obtain and retain employees, promoting a favorable work environment. Furthermore, the 401K in this instance provides an opportunity to the employee to educate themselves in terms of long-term Asset Management through saving and investing for retirement.

Diversification/Hedge Your Bets

As I mentioned previously, most entrepreneurs continue to invest in their company, investing in what they know. However, a cyclical downturn could be detrimental to both their income and asset base. Not to frighten anyone, but I recall the stories of the Enron fallout – those that lost their jobs and their retirement in a very short timeframe from things out of their control (they were largely invested in Enron stock). The good news about self-employment is that you can’t fire yourself, but if business slows, you want to have some diversification, so a Retirement Plan invested outside of your primary business could provide a safety net. The argument against diversification is basically, “Put all your eggs in one basket and protect it fiercely.” The thought is that you can’t be wealthy without focusing on the one thing that you do best and that you continue to devote all your attention and learning to. Sorry but too much is out of our control, so I’m going to continue to preach diversification.

Spousal Contributions

This one is really interesting. Small Business owners receive benefits beyond the average employee as I alluded to (and will discuss more below). Co-owner or owner spouses can also reap benefits of being employed at the company, easily reaching the $23,000 personal limit this year (2024) and receiving additional funds through profit sharing even with a salary well below that of the owner of the company or even the average employee (in certain circumstances). So, a husband and wife could presumably save $92,000 (one maxing out employee and employer contributions totaling $69,000 and the other contributing just the employee limit of $23,000) in retirement savings in a single year, which leads into our next topic.

Tax Savings

The aforementioned $92,000 would reduce taxable income by that amount – the profit-sharing portion would be at the company level while the personal limit contribution of $23,000 would be personal. In the case of spouses, household taxable income would be lower by $46,000! The owner of her own business would see a reduction in taxable income of $92,000 (a mix of personal and corporate), in addition to what was being paid out to employees in profit sharing. Of course, the employees themselves receive the same tax-deferral of up to $23,000 as well, assuming they can meet the maximum contribution the IRA allows.

So what are the types of Retirement Plans?

The way my business is set up, I have a fiduciary duty to the Retirement Plan itself, as well as the Small Business owner, so I’ll focus on the plans that would be more advantageous for Small Business owners to keep the most money in their pocket and their savings on track. These plans allow employees to contribute to their own accounts and remove the burden of the owners to fund the employee portion entirely.

Simple IRA (Individual Retirement Account)

This is exactly what it says – simple. The Simple IRA is generally for companies with less than 100 employees and upfront work is minimal. The company’s administrative cost is near zero and tax filings are not required, helping to reduce overall costs. Employees can save $19,500 ($16,000+$3,500 catch up over 50 years old) and employers can provide a 3% match to all employees, including themselves in a brokerage account at one of many different brokers. However, you are limited in what you contribute to yourself as a business owner relative to other plans.

401K

The 401K is popular among for-profit companies of all sizes. Both major corporations and single individuals can use a 401K. Limitations on personal employee contributions are $23,000 (+$7,500 catch up over 50) and there’s greater flexibility of employers to contribute to employee accounts, including their own, with an absolute dollar max of $69,000 (or $76,500 with catch up) depending on how much employers want to match or provide profit sharing, as well as a complex formula using the overall ages and incomes of all employees. So, to have the ability to really increase savings potential of a business owner, the 401K is a tremendous option. However, to maximize this benefit will require more upfront and ongoing administrative expenses, since there are tax filings and IRS testing requirements to pass, as well as a more in-depth Plan payout analysis, all of which can be handled by a third-party administrator.

Solo 401K

As I mentioned before, this is for very Small Businesses that have a single individual and maybe a spouse or employee with limited hours. The same rules of the 401K apply, so if you have a lucrative business, the potential for you (and your spouse) to reduce taxes and really take advantage of significant retirement savings options through a Solo 401K program might be your best option.

Other plans 

I’ll lump the more pension-related plans together. As I stated, I don’t generally believe these types of plans are in the best interest of most Small Business owners, but every situation is obviously different.

Both the SEP (Simplified Employee Pension) and the Defined Contribution plans offer sizable and favorable contribution opportunities to business owners, but the Plan’s requirements are also more favorable for the employee. The SEP has lower fees than the DC, and if you would like more information on these feel free to reach out.

In summary the information here regarding the type of plan you might want for your company should be considered as a starting point. There are more details and the math to maximize your personal savings and company contribution to reach $69,000 in personal savings is complex. However, there are a lot of reasons to start up a Retirement Plan for your company, and if you are considering it, we should talk. Furthermore, if you aren’t sure how much your existing company Retirement Plan is costing you (and your employees due to expensive investment options), it’s worth having a conversation as well. We can review all the benefits to having a 401K plan and how to maximize your savings.

If you or someone you know has any financial-related questions, I would love to have a conversation, so please feel free to reach out: matt@mhb-advisory.com

And please don’t forget to view our prior blogs:

Why Should I use a Financial Advisor for Asset Management?

How Do I Get Out of Credit Card Debt and Start a Budget?

Are Maximum 401k Contributions Best for My Asset Management Strategy?

Should I Pay Off My Mortgage Early?

How Can Effective Asset Management Help Me Reach Financial Independence?

How Much Money Do I Need to Save for Retirement?

How Much Should I Save for College?

And stay tuned for additional blog posts on retirement savings and other topics.

Best wishes on your financial path!

Matt

This post was created by Matt Beeby, the Founder of MHB Advisory Services. Matt has been working in Financial Services and investing in real estate since 2005, though his investment experience spans nearly two decades. He is a Christ follower, active in both his church and his neighborhood association. Matt enjoys sports and family time. Read more about Matt on his website bio.

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Sources:

https://www.lendingtree.com/business/small/failure-rate/

https://humaninterest.com/blog/why-small-business-owners-dont-offer-a-401k-why-they-should/

https://www.irs.gov/retirement-plans/one-participant-401k-plans

Photos: https://unsplash.com