The best retirement savings plan alternatives for small businesses

I learned years ago that the biggest benefit from 401(k) plans is turning spenders into savers because savings come off the top. Many participants have told me they successfully accumulated substantial savings that would not have happened without the 401(k); therefore, it is important that more employers help their employees become savers.  

Retirement savings have helped drive the economy and made employees less dependent on the government. The many different types of employer-sponsored savings plans and personal IRAs have probably resulted in more than $20 trillion of savings. These plans turned mutual fund entities into the financial giants they are today, and they also created a big need for wealth managers. 

This is all good. However, nearly half of the nation’s private workforce does not receive any help from their employers. Therefore, many states are now requiring that they offer an employer-sponsored plan. Oregon, the first state to do so, is requiring that every employer in the state offer a retirement savings plan.

Read more: Millennials shouldn’t count on full Social Security benefits. Here’s how retirement advisers can help

Oregon established its own payroll-deduction IRA to help employers set up a plan at no expense to the employer. This was necessary because none of the financial organizations were providing support for payroll-deduction IRAs.

California also is requiring employers with at least five employees to have a plan. Illinois, New Jersey, Maryland, Connecticut, New Jersey and many others are either already requiring employers to have a plan or will be doing so shortly. There are significant fines for those who fail to do so.

Employees in state-run plans are auto enrolled into Roth IRAs. Some states give participants the opportunity to shift to a pretax IRA, but some do not. Last month, I explained in an Ask an Adviser column the reasons why Roth after-tax contributions are not the best option for most retirement savers. Here’s a recap of those reasons:

• The tax breaks enable retirement savers to grow their nest eggs 20% to 50% faster with pretax savings. Having a substantially larger nest egg is important at age 50 and beyond due to the many uncertainties savers may encounter.
  
• Savers win with Roth contributions only if they are in a higher tax bracket when they withdraw the money. Tax rates are lower today than when Roth contributions were introduced. Most retirees also have less taxable income when they retire.
  
• The government may decide to tax some of the tax-free build up like it did with Social Security benefits.

State and federal governments are pushing to expand Roth pretax savings because they want the taxes now rather than later. This is the primary reason why contributions to state plans go into Roth IRAs. It is also the reason why the House of Representatives included two new Roth IRA provisions in the recently passed Secure Act 2.0. It will require all catch-up 401(k) contributions to be Roth contributions and permit employees to have matching contributions be Roth contributions.  
Read more: Advisers in conversation: Creating lifetime income in retirement

Financial advisers and brokers should be concerned because the longer-term goal of the state plans is for these to be lifetime accounts. California law permits the CalSaves plan to accept other IRA contributions, including rollovers. 

It is possible for a small business to set up a payroll deduction IRA on its own without the business or employees having to pay any charges other than the applicable mutual fund fees. Doing so is a bit involved since the administrative process is not fluid and there is little participant support. Funding mutual funds that do not require a $1,000 minimum initial investment also is a challenge. 

Thankfully, a payroll-deduction IRA entity has emerged, which makes it easy to start a payroll deduction plan. Icon Savings Plan will pay an attractive finder’s fee to those who send them clients. The company’s fees are competitive with the state-run plans and the investment fees are lower. Financial advisers and brokers should partner with them rather than let small businesses end up in state-run plans by default. Doing so will also help build relationships with small-business owners that may produce bigger future financial benefits. 

Read more: The pros and cons of pretax vs. after-tax Roth contributions

SEP-IRAs also should be considered by sole proprietors and micro businesses consisting of mostly family members. Setting up a SEP-IRA properly enables employer contributions to be exempt from federal, state and local income/wage taxes and avoid all FICA (Social Security/Medicare), unemployment and workers’ compensation taxes. A Simple-IRA also is a great option to be considered and, of course, a traditional 401(k).

Working through all these alternatives is challenging. In light of these state mandates and the evolving marketplace, I recently updated my 401(k)s for Dummies series of books to become 401(k)s and IRAs for Dummies. It includes a couple of chapters that will help small employers understand their options. I also provide support to small businesses that are having trouble finding the help they need. 

State lawmakers realize there’s a dire need to close the nation’s retirement-savings gap, and they have only the best of intentions. However, their approach is misguided and so it’s up to financial advisers and brokers to help steer small businesses without a plan in the right direction and help their employees amass enough savings to be able to retire.