Retirement plans for U.S. startups 

Decrease your downside risk, make employees happier, and save money 

Introduction

You’ve started your own business and growth is on the horizon. As you look toward the future, your eyes are set not only on immediate success, but also on building long-term wealth for your company, your employees, and yourself. A retirement plan can help make all of these things happen.

As an entrepreneur, your business’ results will dominate your financial outcomes over the short-to-medium term, so it can be tempting to allocate all of your concern to the business. Setting up a retirement plan allows you to take intelligent risks with your business. It preserves your ability to shoot for the stars at your current and future endeavors. Without a funded retirement plan, you might be forced into a lower-variance job mid-career if your early ventures don’t pan out.

In addition to the benefits for yourself personally, retirement plans are increasingly becoming a standard offering as you begin to hire more employees. When asked, 76% of millennials said that “retirement benefits offered by a prospective employer will be a major factor in their decision on whether to accept a future job offer.” Having a retirement plan in place can go a long way in attracting high-caliber staff.

The tax incentives for offering a 401(k) can be tremendous for businesses and business owners - not just employees. A 401(k) can allow for a company to reduce its taxable income while simultaneously reducing the taxable income of all employees at the company. Ultimately, it becomes a way to attain, and subsequently maintain, sound finances.

Retirement plans are complicated. Start with all the joys of financial planning. Mix in arcane decisions like pre-tax versus post-tax contributions. Top with complicated compliance testing rules. Now, stir while weathering a blizzard of acronyms.

We’re here to explain the ecosystem in plain language so that you can make the correct decision for your business.

Retirement planning is heavily dependent on the legal and tax environment for each country. This article concentrates on information for privately funded retirements in U.S. companies, particularly startups and other Internet-enabled businesses. If you need legal or tax advice specific to your situation, you should speak to your lawyer or accountant.

What is a retirement plan, anyway?

A retirement plan:

  • is an investment account—the owner invests in stocks, bonds, or similar financial products with the funds

  • is owned by an employee—in contrast to traditional pensions, employees own the contents of their plan at all times rather than them being held in trust by the employer

  • is sponsored by an employer—the tax benefits are available to businesses, not individuals generally

  • is earmarked for retirement—money in the account is owned by the beneficiary, and not by the business or any government, but tapping it prior to retirement might cause prohibitive penalties

Governments have a vested interest in ensuring their citizens save for retirement. As an incentive to get businesses onboard with promoting retirement saving, they offer businesses substantial tax benefits to establish and maintain retirement plans for their employees.

Surprisingly to some owner-operators, these benefits are available for very small businesses, even for small businesses where all employees are owners, and the benefits are substantial.

Why care about retirement?

With a workplace retirement plan, you can not only provide an immediate benefit to yourself and your employees, but you can also focus on building diversified, long-term wealth in a variety of ways:

Create portable capital: To encourage retirement saving, the IRS allows plan holders several options to roll over funds, retain account balances, and defer paying taxes until retirement age. That means funds aren’t just tied to one company or one business: it follows you wherever you go. Startup founders and employees live with a high rate of business failure and less likelihood of multi-decade tenures than staff at pension-granting employers, and accordingly need retirement options which tolerate frequent change in employers.

Protect against career risk: Entrepreneurs are at a higher risk than similarly-situated employees of suffering sustained periods of low income either when starting a business or during periods of business underperformance. Contributing to a retirement plan early in your career and continuing to contribute generously in good years allows you to stay on the happy path to retirement even if you suffer sustained mid-career income volatility. If you do not have a nest-egg happily compounding upon itself, a failed startup or two in a row can markedly constrain your future career options; you might be forced to take a safe job just to afford retirement as opposed to continuing with the career you enjoy.

Protect against industry risk: If you are a young entrepreneur or professional in technology, a supermajority of your wealth is de facto invested in the technology industry: it is your future earnings from wages. While the industry is presently booming, it is not guaranteed to continuously boom for your entire working career. During the last major tech bust (after the dot-com era), many professionals similar to yourself suffered prolonged unemployment or took a substantial career downgrade when switching to a new field. A generously funded retirement plan makes you less dependent on the industry you presently work in.

Automatically diversify a portfolio over time: Many retirement account providers offer automatic rebalancing among asset classes. The ebb and flow of the markets can result in a particular asset class, such as stocks, becoming quite valuable in the short-term, resulting in you being “overexposed” to it relative to the optimal allocation given your risk preferences. Your retirement plan can keep a sensible allocation automatically, without you having to actively manage it.

Why consider setting up a retirement plan?

A retirement plan is good for you, good for your employees, and good for your business.

Benefits to your business and beyond

A business’ contributions to a retirement plan are generally tax-deductible to the business. This includes matching contributions, where the business encourages employees to save their own money by “matching” the money with the business’ funds (effectively increasing their compensation). Taxes on both contributions and investment gains can be deferred until retirement.

When you and your employees retire and start withdrawing money, you will each be taxed at ordinary income rates on the money you withdraw. This will often be at a substantially lower rate than you were paying during your working career, because (since you won’t be earning a salary in retirement) your investment income will be taxed in the lower brackets, rather than sitting “on top of” your peak earning years and being taxed in the highest brackets.

As an added bonus, small business owners may also qualify for a tax credit on top of contributions to their employees retirement accounts. Qualifying new companies with at least one employee can get a $500 tax credit each year during the first three years in business for setting up a 401(k).

Personal tax benefits

As an owner of a business, you are likely also going to be eligible to contribute to your business’ retirement plan. This can save you substantially on your personal tax bill, similarly to how the mechanics work for employees. You can also simultaneously decrease the taxable income of your business (if it is taxed separately from you).

It is worth noting that the contribution limits for business owners are extraordinarily generous.

A tool for hiring and retention

If rapid growth is in your future, hiring is going to be essential. A 401(k) plan is a great way to attract and retain talent. Almost 97% of large corporations offer 401(k) plans; employees of them rightly consider them “standard.” Only 16% of small businesses offer 401(k) plans. This is unfortunate; it compounds small businesses’ frequent inability to match salary offers with additional financial risk.

As part of a startup or early-stage company, your messaging regarding financial outcomes improves markedly by offering a 401(k) plan. You likely offer your employees material amounts of equity, and this has attractive upside potential. Offering a 401(k) plan as well insulates your employees from perceived downside risk. This helps to communicate that you make prudent financial decisions to younger workers (who are in an ideal career stage to start saving if they haven’t already) while also alleviating a major concern of many more experienced candidates (whose financial security in retirement may be a top-of-mind issue).

Oregon has launched a state-sponsored retirement plan and several states (California, Connecticut, Maryland, and more) are considering offering one. State-sponsored plans will likely obligate you to either provide your own retirement plan, enroll your employees in the state-sponsored plan, or secure an opt-out from your employees.

The state-sponsored plans generally do not have as high of a contribution limit as company-sponsored plans ($18,500 vs $5,500 for individuals under age 50). Company-sponsored plans usually offer a wider choice in investment options and lower expense ratios. (Expense ratios are the percent of assets that your employees will pay every year out of their retirement accounts. Higher expense ratios mean directly lower investment returns and, therefore, less money to retire on.)

Accordingly, if you are in the position to offer your employees a company-sponsored plan, it may be a better offer than defaulting them to the state-sponsored plan.

Pre-tax or after-tax

Depending on a plan’s rules, a plan participant can contribute with pre-tax dollars, after-tax dollars, or both.

This sounds complicated but it isn’t. Almost everything you purchase in day-to-day life is paid for with after-tax dollars. When you hear “post-tax dollars”, just think “regular money.”

A pre-tax contribution is slightly different: it’s deducted from your salary before taxes are, effectively decreasing your taxable income in the current year.

Regardless of whether you contribute pre-tax dollars or after-tax dollars for a retirement account, every dollar which comes out of the retirement plan gets taxed exactly once (assuming the money stays in until retirement). Pre-tax dollars and all investment gains get taxed after you retire; post-tax dollars get taxed when you earn them during your working career.

One might wonder which is more effective. It depends on a variety of factors, including one’s present income tax bracket, one’s sources of income during retirement, the arc of one’s career, and (potentially) one’s view on whether tax rates or rules will change over the next few decades.

Your personal tax or financial advisors can help you math out which is likely the best for your personal situation. Speaking generally, most early-stage businesses have not achieved their maximum level of success and most employees in the tech industry will have higher assets and income during retirement than they do presently. These factors tend to make after-tax contributions more effective over the long term.

Considerations for launching a retirement plan

Your business should probably have a retirement plan but now might not be the best time to institute one. It depends on which stage your business is at:

Staying afloat: Your first priority should usually be keeping the lights on. If you’re facing potential cash flow crunches on monthly basis and are barely meeting overhead expenses, then a workplace retirement plan likely isn’t top of mind. Stabilize your cash flow situation (or secure adequate investment) before funding employee benefits. Health insurance should come first, as it is the most valued benefit by employees.

Growth stage: Once your business is able to cover health-related expenses of your employees, has a more predictable cash flow, and is working with more acceptable debt interest rates, then you should start considering a workplace retirement plan. There is unfortunately no hard-and-fast rule here, but a great rule of thumb is a mentality shift in the way you think about your employees - both current and future - in general.

When you have proof of concept and your company is gaining traction, hiring the best quality talent, and retaining the talent you currently have, becomes increasingly important to your business. This is when it generally makes sense to initiate a retirement savings plan, as it is a powerful to attract new employees and show current employees you care about their long-term well-being, while also keeping bottom line business goals in mind.

Picking between the different flavors of plan

There are at least a half dozen different flavors of retirement plan available. Choosing between them strikes some entrepreneurs like alphabet soup. We’ll break it down for you.

If you’re a sole proprietor, and don’t have plans to expand your headcount, you should consider a Solo 401(k).

Solo 401(k)s are 401(k) plans with just one member (you, the business owner), and like regular 401k plans, they offer the option to contribute with pre-tax or post-tax dollars.

In 2018 you can contribute up to $18,500 ($24,500 if you’re 50 or older) as an employee, and you can also contribute 25% of your net self-employment income for the year as an employer. The combined cap is a (very generous) $55,000. That implies plausibly tens of thousands of dollars of tax savings.

You don’t need to contribute the max every year (and likely won’t be able to hit that max in the first years of your business anyway).

Even better, a Solo 401(k) allows you to also team up with a spouse. When a spouse derives income from the sole proprietorship, he or she is allowed to make contributions equal to those of the business owner. If your business achieves significant success, this means there’s a potential to save up to $110,000 as a married couple every year for retirement.

The contribution limit of the Solo 401(k) is unbeatable, and accordingly it is an excellent choice for businesses which have no plan to hire any full-time employees.

If you’re a business owner who plans to expand headcount, you have many more options.

If you’re planning on hiring full time employees, you have several options. Contribution limits are as of 2018.

SEP IRA - Only an employer can contribute (up to 25% of employee salary capped at $55,000). This can be a great option for a company with a single owner or a few co-founders, as it has fewer compliance requirements and thus less administrative burden, in addition to having an extremely high contribution limit.

401(k) - You can choose plans for pre-tax (“Traditional” 401(k)s) and post-tax contributions (“Roth” 401(k)s). Both the employer and the employee can contribute, up to a combined max of $55,000 (with no more than $18,500 coming from the employee).

The SIMPLE IRA, described in its substantial complexity by the IRS. It offers an employee contribution limit of $12,500, is only available to employers with 100 or less employees, and mandates (low) employer-provided contributions.

(For completeness: there is also a 403(b) plan, but availability is very limited. Most entrepreneurs and startup employees can ignore it.)

So what should a business pick?

Businesses should consult with their financial advisors before making major decisions. Most businesses with non-founder employees are best served by 401(k)s. A business with no non-owner employees can take advantage of the SEP IRA’s lower administrative burden.

What to look for in a plan and a provider

Investment options: seek low-cost index funds and ETFs

Check the list of available investment options that a 401(k) provider offers. Broadly speaking you will find either low-cost index funds or higher-cost actively managed funds. The index funds will, over the long run, generally outperform the actively managed funds by the difference in their fees. This conclusion is backed by decades of data (see this summary by the Financial Times). The improvement to investment returns by minimizing fees over the length of an employee’s career is enormous. You picking a provider who makes low-cost funds available can save every individual participating tens of thousands of dollars over the long run.

The prevailing prices for funds for different asset classes vary, but as an example, index funds investing in U.S. equities can charge fees as low as four basis points ($4 on every $10,000) per year. Actively managed funds in the same asset class can easily cost 20 times as much.

Plan fiduciary

A fiduciary is someone who is bound by law to put your interests before their own. There are many 401(k) providers who are not fiduciaries. This could result in them recommending suboptimal products in return for fees paid by the providers of those products. You will likely get the best deal from someone who is bound to your best interests, rather than those of the highest bidder. (A fun wrinkle of this field: they’re bidding with your money.)

Scalable HR support

As the owner of a small business, you should generally spend your time on the points of highest leverage for increasing your revenue. This will almost never be filing HR paperwork.

You can, theoretically, self-administer a 401(k) plan or hire full-time staff to do it for you. You should probably choose a 401(k) provider instead. Ideally, select a service that can grow as your business grows. Look for a company that offers comprehensive 401(k) administration, including compliance testing, auditing, meeting IRS deadlines, and tax forms.

Plan design flexibility

Every business has unique needs and challenges: designing a plan that will maximize the benefits for both employers and employees is crucial. Take the time to find out what are the needs of your employees and what are their retirement saving goals. You want to provide a plan that is truly valuable to your employees so that they are excited to participate in it, and one that can help you plan for your current state and into the future.

Low fees and costs

The Department of Labor breaks plan fees into four categories:

  • Asset-based: expenses based on the amount of assets in the plan, represented as percentages or basis points. This also usually lumps in "custodial fees,” typically around 2-3%.

  • Per-person: expenses based upon the number of eligible employees or actual participants in the plan. These can range from $8 to $750+ per month per person.

  • Transaction-based: expenses based on the execution of a particular plan service or transaction.

  • Flat rate: fixed charge that does not vary, regardless of plan size.

For startup owners, a flat rate model allows one to have the most control over expenses. While 23% of small business owners feel that a 401(k) is too expensive, there are increasingly affordable options that offer a higher caliber of services than were available just a few years ago.

Should you or not match your employee contributions?

There are four key benefits for matching employee contributions:

  • Giving tax-free bonuses: You could give an employee a $5,000 bonus, but at a 15% tax rate she would only receive $4,250. Additionally, your business would have to pay employment taxes on that bonus. Contributing $5,000 to her retirement account has the same motivational effect but results in more money for her future and usually a lower total cost for your business.

  • Reducing taxable income for the business: Matching contributions are a deductible business expense.

  • Passing compliance testing: Retirement plans are regulated by Non-Discrimination Testing and Safe Harbor policies to ensure that the benefits do not overly flow to highly-compensated employees or owners. If you match contributions in a specific way, you can be exempt from some of these tests.

  • Encouraging and modeling responsible behavior: Matching employee contributions gives employees a reason to start or continue saving, and actively encouraging that shows a general level of care to your employees. Attracting and retaining employees requires you to demonstrate trust and commitment, and acting with responsible stewardship helps to signal to employees that you are trustworthy across other contexts as well.

Keep in mind the applicable rules for matching contributions; you can’t match in such a fashion as to exceed combined employer and employee contribution limits, and you can’t violate the non-discrimination testing provisions. These are particularly thorny issues for highly-compensated employees (such as e.g. founders). Often, entrepreneurs outsource their 401(k) plan management to a third-party provider that is well versed on all applicable regulations and can make sure that all i’s are dotted and all t’s are crossed.

Summary

If your business is on a successful trajectory, it should likely offer a retirement plan at some point. There are a plethora of affordable, flexible options available, allowing you to generate wealth for all employees and owners over the long-term while keeping most of your active concern on the day-to-day and year-to-year management of the business.

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