We know that business owners enjoy saving money on taxes. What better way to start than with a retirement plan? In this article, we look at the Defined Benefit Plan vs SEP IRA.
Thankfully, you have many options as a business owner when you’re looking for retirement structures. You can start with a simple basic plan like a traditional or SEP IRA. From there, you can graduate to more sophisticated plans like 401(k)s and defined-benefit plans.
Which plan is best for you? It depends. This article will discuss these plan options and compare a defined benefit plan to a SEP IRA. Let’s get started!
Table of contents
What is a SEP IRA?
A SEP IRA, or Simplified Employee Pension Individual Retirement Account, is a retirement savings account designed for small business owners and self-employed individuals.
In a SEP IRA, the employer contributes to the account on behalf of eligible employees, including the business owner, if they are self-employed. The contribution is typically a percentage of the employee’s income up to a specific annual limit set by the IRS.
SEP IRA contributions are tax-deductible for the employer, and the funds in the account grow tax-deferred until retirement. Withdrawals from the account in retirement are then taxed as regular income.
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SEP IRAs are relatively simple and flexible retirement savings vehicles, as they do not require the same administration and reporting level as other retirement plans. However, they have some limitations, such as the fact that contributions must be the same percentage of compensation for all eligible employees and that withdrawals before age 59.5 are subject to a 10% penalty in addition to regular income tax.
What is a defined benefit plan?
A defined benefit plan is a type of retirement plan in which an employer promises to pay a specific amount of retirement income to an employee, typically based on a formula that takes into account the employee’s salary and years of service with the company. The employer is responsible for funding the plan and managing its investments to ensure that it has sufficient assets to pay the promised benefits when employees retire.
In a defined benefit plan, the amount of retirement income that an employee will receive is predetermined, hence the name “defined benefit.” This is different from a defined contribution plan, such as a 401(k), where the employer contributes a set amount of money to the employee’s retirement account, but the actual retirement income the employee will receive depends on the performance of the investments in the account.
Defined benefit plans can provide employees with a secure retirement income stream, as they are guaranteed by the employer. However, they are also more complex and expensive for employers to administer and fund than defined contribution plans, and may require additional regulations and reporting. Some defined benefit plans may also have vesting requirements, which means that employees may need to work for a certain number of years before they are entitled to the full benefits.
Advantages of a SEP IRA
Here are a few SEP advantages:
- Tax-deductible contributions: Employers can deduct the contributions they make to a SEP IRA from their business taxes, which can help to reduce their overall tax liability.
- Higher contribution limits: SEP IRAs have higher contribution limits than other types of individual retirement accounts, such as traditional or Roth IRAs. In 2023, employers can contribute up to 25% of an employee’s compensation or up to $61,000 (whichever is less) to a SEP IRA.
- Easy to set up and administer: SEP IRAs are relatively easy to set up and administer, with fewer administrative requirements and costs than other types of employer-sponsored retirement plans.
- Flexibility in contributions: Employers have flexibility in deciding how much to contribute to their employees’ SEP IRAs each year, based on business profits and cash flow.
- Potential employee retention: Offering a SEP IRA as part of an employee benefits package can help to attract and retain employees, as it provides a valuable retirement savings option and shows that the employer is invested in their employees’ long-term financial security.
Advantages of a Defined Benefit Plan
- Guaranteed retirement income: A defined benefit plan provides a guaranteed retirement income to employees, typically based on a formula that takes into account their salary and years of service. This can provide greater financial security and stability in retirement than other types of retirement plans. Take a look on the illustration.
- Employer-funded: The employer is responsible for funding the plan and ensuring that there are sufficient assets to pay the promised benefits. This takes the investment risk off of the employee and provides a stable, reliable source of retirement income.
- Tax advantages: Employer contributions to a defined benefit plan are tax-deductible, reducing the employer’s tax liability. Employees typically don’t pay taxes on their contributions to the plan until they start receiving distributions in retirement.
- Vesting and benefit portability: Defined benefit plans can offer vesting schedules that ensure that employees who work for the company for a certain amount of time are entitled to the full benefits. In addition, some defined benefit plans offer benefit portability, allowing employees to take their vested benefits with them if they leave the company before retirement.
- Social security integration: Defined benefit plans can be designed to integrate with Social Security, providing additional retirement income to employees who qualify for Social Security benefits. This can help to supplement retirement income and provide a more comfortable retirement for employees.
|Defined Benefit Plan||SEP IRA|
|Mandatory contributions||Optional contributions|
|Funding as high as $400k annually||Funding caps around $60k|
|Large administrative costs||Minimal administration fees|
|Permanent plan design||Easy termination|
How to determine which plan is best for you?
Take a look at these 5 steps to analyze the two plans:
- Determine funding requirements
Defined benefit plans are great when you want to make substantial tax-deductible contributions. But if you want to get smaller amounts in, stick with a sept IRA. There’s no need to spend a couple of thousand dollars a year if you only want to get up to $30,000 or so into a plan. Just be careful if your funding requirements change. Many steps do not combine well with defined benefit plans, so you could find yourself requiring an excess removal.
- Analyze self-employment tax
Remember that a defined benefit plan can often get 100% of your W-2 contribution. This is limited to 25% for a sap IRA. You will notice that you can get much larger contributions for a much lower W-2 amount. Remember, you still have to meet the reasonable compensation rules. So make sure to review with your CPA and see if there’s a way to lower your employment taxes while increasing your retirement contribution as a percent of your W-2.
- Review compliance options
Remember that SEP plans have no 5500 requirements and no plan document maintenance. So if you are a one-person business, these plans require minimal administration. Defined benefit plans come with many administrative headaches. But defined benefit. plans are well worth the headache if your contribution is $75,000 or more.
- Determine plan cost
Define benefit plans can be expensive. It usually costs a couple of thousand dollars a year to set up and usually around the same amount for annual administration. Don’t spend the money if you only want a marginal retirement contribution. Just make sure you look out into the future and analyze what you think your funding goals will be down the road.
- Consider 401(k) options
If you have an existing 401(k) plan, it will not combine with a sap. But it will generally combine well with a defined benefit plan. The important part is that the profit-sharing is reduced to 6% rather than the standard 25% of W-2. Consider this if you want to make larger contributions, thanks to the employee deferral provision of a 401(k). Defined Benefit Plan vs SEP IRA.
A defined benefit plan is a retirement structure that offers a specific benefit upon retirement. The company makes annual contributions to the plan. Upon retirement, the employee can take a lump sum, distribute, roll the proceeds over to an IRA or other qualified plan, or receive monthly amounts through the remainder of their lives.
Very large companies typically established these plans. However, high-income businesses have used them more in recent years, including sole proprietors, S-Corps, C-Corps, and partnerships.
A SEP is a relatively simple retirement structure for self-employed individuals. It allows the company to contribute up to 25% of compensation. The company gets a tax deduction for the annual contributions.
They are easy to set up and have very minimal annual administration tasks. They are great starter plans but will not allow for the large, substantial contributions you’ll receive under a defined benefit plan structure.
Defined Benefit Plan vs SEP IRA
So there you have it. This post looked at the defined benefit plan vs. a SEP.
Ultimately, if you want rather small contributions from $10,000-$30,000, a SEP is the best option for you. It also is easy to set up and has very minimal administration.
But if you want to get $75,000 plus in retirement, that a sept won’t do it for you. You’re going to have to graduate up to a larger plan. Fortunately, defined benefit plans can accommodate annual contributions often over $300,000.
The defined benefit plan is undoubtedly the most complex retirement structure. They are relatively expensive to set up, and you must engage an administrator to manage the duties of the plan.
But if you’re looking for significant contributions, you can’t go wrong with a defined benefit plan. It might be the retirement home run you’ve been looking for.