S Corporation Owner Retirement Plan Options

An S corporation allows business owners to receive income as both a salary and shareholder distributions, a structure that directly impacts retirement planning. For S corp owners, understanding the available retirement plan options is key to building a secure financial future.

The Foundation of S Corp Retirement Contributions

The foundation of S corporation retirement planning is that contributions can only be based on the owner’s W-2 wages. Shareholder distributions, which are profits passed to the owner, are not considered earned income for retirement plan purposes and cannot be used to fund these accounts.

This rule requires S corp owners to pay themselves a “reasonable compensation” as a W-2 salary. The IRS mandates this to prevent owners from avoiding payroll taxes by taking most of their income as distributions. A lower salary reduces payroll tax liability, but it also limits the amount that can be contributed to a retirement plan.

For example, consider an owner with business earnings of $150,000. If they take a $60,000 W-2 salary and $90,000 as a distribution, retirement contributions are based only on the $60,000 salary. A plan allowing a 25% employer contribution would cap that contribution at $15,000 (25% of $60,000).

This link creates a strategic decision for the owner. A higher salary enables greater retirement savings but also incurs higher payroll taxes. Finding the right balance between current tax obligations and long-term savings goals is a primary consideration.

Retirement Plans for the Owner-Only S Corp

For S corporation owners who are the only employee, or whose only other employee is a spouse, several retirement plans are available. These plans are designed for significant savings, and the best choice often depends on the owner’s income, age, and savings goals.

Solo 401(k)

The Solo 401(k) is a retirement plan for an owner-only S corp that allows the owner to contribute in two capacities: as an “employee” and as an “employer.” This dual contribution structure enables substantial savings. The plan is a traditional 401(k) tailored for a business with no employees other than the owner and their spouse.

As the “employee,” the owner can contribute 100% of their W-2 compensation up to the annual limit of $23,500. Owners age 50 or over can make an additional catch-up contribution of $7,500. A higher catch-up of $11,250 is available for those aged 60 through 63.

As the “employer,” the S corporation can make a profit-sharing contribution of up to 25% of the owner’s W-2 compensation. The total combined employee and employer contributions cannot exceed an overall limit of $70,000, which increases with catch-up contributions. Many Solo 401(k) plans also offer a Roth option for the employee portion, allowing for after-tax contributions.

For example, an owner under age 50 with a $100,000 W-2 salary could make an employee contribution of $23,500. The corporation could then add an employer contribution of $25,000 (25% of $100,000). This results in a total annual contribution of $48,500.

SEP IRA

The Simplified Employee Pension (SEP) IRA is known for its administrative simplicity. Contributions to a SEP IRA are made only by the employer; there is no employee contribution component. This can limit the total contribution potential compared to a Solo 401(k) at lower salary levels.

The S corporation can contribute up to 25% of the owner’s W-2 compensation, not to exceed the overall annual limit. A primary advantage of the SEP IRA is its flexibility, as the owner can decide how much to contribute each year, from the maximum down to zero.

For example, if an owner has W-2 compensation of $80,000, the maximum employer contribution is $20,000 (25% of $80,000). To reach the maximum annual contribution limit, the owner would need a W-2 salary of at least $280,000. These plans are easy to establish.

Defined Benefit Plan

For high-income S corp owners who want to save aggressively, a Defined Benefit plan is an option. This plan works like a traditional pension, promising a specific benefit to the owner in retirement. Contributions are calculated by an actuary to ensure the plan can meet that future promise.

These plans allow for much larger tax-deductible contributions than 401(k)s or SEP IRAs, often exceeding $100,000 annually. The contribution amount depends on the owner’s age, expected retirement age, and the promised benefit. Due to their complexity and the need for an actuary, these plans are more expensive to set up and maintain.

They are best suited for consistently profitable businesses that can handle mandatory annual funding. An owner might choose this plan if they are over 50 with a high, stable income and want to maximize savings before retirement.

Retirement Plans for S Corps with Employees

When an S corporation has employees, the retirement plan options must be structured to benefit all eligible staff. This introduces new rules and shifts the focus to equitable treatment for the team.

SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is designed for small businesses with 100 or fewer employees. It is a straightforward plan involving contributions from both the employee and the employer.

Employees can contribute up to $16,500 from their salary. Those age 50 and over can contribute an additional $3,500 as a catch-up contribution. These contributions are made on a pre-tax basis.

Employers must make a contribution each year through one of two options. The first is a matching contribution of dollar-for-dollar up to 3% of the employee’s compensation. The second is a non-elective contribution of 2% of each eligible employee’s compensation, regardless of whether the employee contributes. All contributions are immediately 100% vested.

Traditional 401(k)

A Traditional 401(k) plan is a flexible option for S corps with employees but has more administrative responsibilities than a SIMPLE IRA. These plans allow for higher employee contribution limits, including the standard employee deferrals and catch-up contributions available in a Solo 401(k).

The plan can include discretionary employer matching and profit-sharing contributions, giving the business flexibility. However, these plans are subject to annual nondiscrimination testing. These tests ensure the plan does not unfairly favor highly compensated employees.

Administrative duties include managing complex plan documents and filing annual reports like Form 5500. Despite the complexity, a Traditional 401(k) can help attract and retain talent due to its higher contribution limits and design flexibility.

SEP IRA with Employees

A SEP IRA can be used by businesses with employees, but a pro-rata contribution rule applies. As with an owner-only SEP, only the employer makes contributions.

This rule requires the employer to contribute the same percentage of compensation for every eligible employee as they do for themselves. For example, if the owner contributes 10% of their W-2 salary, they must also contribute 10% of each eligible employee’s compensation. An employer cannot contribute a different percentage for themselves than for their employees.

This requirement can make the plan expensive for a business with many employees. The contribution percentage is flexible year-to-year, but the chosen percentage must be applied uniformly. Eligibility can be restricted to employees who are at least 21 and have worked for the business in at least three of the last five years.

Key Administrative and Setup Considerations

Setting up and maintaining a retirement plan involves several procedural steps. These administrative details ensure the plan is established correctly and remains in compliance.

Choosing a Provider

The first step is selecting a financial institution to act as the plan provider. Brokerage firms, mutual fund companies, and insurance companies offer small business retirement plans. These institutions provide plan documents, investment options, and administrative support. The choice of provider will influence the plan’s investment options, fees, and level of support.

Plan Establishment Deadlines

To make contributions for a tax year, the plan must be established by a deadline. For a Solo 401(k), the plan must be established by December 31 to make employee contributions for that year. If only making employer contributions, a Solo 401(k) can be established up until the business’s tax filing deadline for the prior year. SEP IRAs can be set up as late as the business’s tax filing deadline, including extensions.

Funding Deadlines

Funding deadlines also vary by plan and contribution type. For a Solo 401(k), employee deferrals must be elected by the end of the calendar year. The actual deposit can often be made up to the business tax filing deadline. Employer contributions for both Solo 401(k)s and SEP IRAs can be made up until the S corporation’s tax return deadline of March 15, or September 15 with an extension.

The Setup Process

Opening a retirement plan account involves completing a plan adoption agreement, which is the legal document that establishes the plan. The business owner will need to provide the company’s Employer Identification Number (EIN). For plans with employees, each eligible employee will open an individual account that the employer funds with contributions.