S Corporation Retirement Plans: Rules and Options

An S corporation’s structure introduces specific rules for retirement planning. This guide outlines the available plan options and the regulations that govern them.

Determining Compensation for Plan Contributions

The basis for all retirement plan contributions within an S corporation is the W-2 wages paid to employees, including owner-employees. All calculations for employer contributions and limits on employee deferrals are tied directly to the salary reported on an employee’s Form W-2, ensuring a clear measure for plan funding.

A defining characteristic of S corporation income is the distinction between salary and shareholder distributions. While owners may receive income as distributions of company profit, these amounts, reported on a Schedule K-1, are not considered compensation for retirement plan purposes. For example, if an owner-employee receives a $60,000 salary and $100,000 in distributions, only the $60,000 W-2 wage can be used to calculate retirement contributions.

A specific rule applies to shareholders who own more than 2% of the company regarding health and accident insurance premiums. When the S corporation pays for these premiums, the cost must be included in the shareholder-employee’s gross wages on their Form W-2. While these amounts are not subject to Social Security or Medicare taxes, they are considered part of the W-2 compensation for calculating retirement plan contributions, which increases the owner’s contribution base.

An owner’s strategy for setting their own salary has a direct impact on their retirement saving potential. A low salary may minimize payroll taxes but will concurrently limit the amount the owner and the company can contribute to a retirement plan. Balancing these considerations is part of financial planning for any S corporation owner.

Available Retirement Plan Options for S Corporations

S corporations have access to a variety of retirement plans, each with distinct features tailored to different business sizes and goals. The choice of plan will depend on whether the business is owner-only or has employees, and the desired contribution levels.

SEP IRA

A Simplified Employee Pension (SEP) IRA is an employer-contribution-only plan. The S corporation can contribute up to 25% of an employee’s compensation, not to exceed $70,000 for the 2025 tax year. Contributions are not mandatory each year, offering flexibility. If the S corporation contributes for any employee, it must contribute the same percentage of compensation for every eligible employee, making it well-suited for businesses wanting to make substantial contributions.

SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA involves both employee and employer contributions. For 2025, employees can contribute up to $16,500, with an additional $3,500 catch-up contribution for those age 50 and over. The employer must either make a matching contribution up to 3% of the employee’s compensation or a non-elective contribution of 2% for every eligible employee. A SIMPLE IRA is a good fit for S corporations with 100 or fewer employees that want a plan with employee participation and lower administrative complexity.

Solo 401(k)

The Solo 401(k) is designed for owner-only S corporations, which may also include a spouse who is an employee. This plan allows the owner to contribute as both an “employee” and an “employer.” As the employee, the owner can defer up to 100% of their W-2 compensation up to the annual limit of $23,500 for 2025. As the employer, the S corporation can contribute up to 25% of compensation, with total combined contributions not to exceed $70,000 for 2025, plus catch-up contributions. Solo 401(k) plans can also permit Roth contributions and participant loans.

Traditional 401(k)

For S corporations with multiple employees, the traditional 401(k) offers high flexibility and contribution potential. It allows for higher employee salary deferrals than a SIMPLE IRA and gives the employer discretion over profit-sharing contributions. These plans are subject to annual nondiscrimination testing to ensure they do not disproportionately favor highly compensated employees. To bypass this testing, an S corporation can adopt a safe harbor 401(k) design, which requires a mandatory, fully vested contribution, such as a 3% non-elective contribution or a specified matching formula.

Defined Benefit/Cash Balance Plans

Defined benefit and cash balance plans are an advanced strategy for profitable S corporations, particularly those with older owners looking to maximize savings. Unlike other plans, these define a future pension benefit and use actuarial calculations to determine the large annual contributions required to fund it. For 2025, the annual benefit payable at retirement can be as high as $280,000 per year. These plans are more complex and costly to administer, and the S corporation makes all contributions.

Establishing and Administering Your Plan

Once a retirement plan is selected, the S corporation must follow specific steps to formally establish and then administer the plan. This process involves gathering information, completing legal documents, and adhering to deadlines for both plan setup and funding.

The initial step involves gathering information for the plan provider, including the business’s Employer Identification Number (EIN). For each participating employee, the company must collect their full name, date of birth, Social Security number, hire date, and W-2 compensation figures.

Next, choose a financial institution or third-party administrator (TPA) to act as the plan custodian, which will hold the plan’s assets. The S corporation owner then completes and signs a plan adoption agreement. This legal document formally establishes the plan and its rules.

Several deadlines apply to plan establishment. A traditional 401(k) can be adopted up to the S corporation’s tax filing deadline for a given year. However, for employees to make salary deferrals for that year, the plan must be established by December 31. A safe harbor 401(k) must be established by October 1 of the year it is to be effective. Employer contributions are due by the tax filing deadline, including extensions.

Employee salary deferrals are handled through payroll deductions and must be deposited into the plan trust as soon as administratively feasible. The Department of Labor provides a safe harbor rule for plans with fewer than 100 participants, deeming deposits made within seven business days to be timely. Employer contributions are made via separate transfers to the plan custodian.

Special Considerations for S Corporation Owners

Reasonable Compensation

The IRS requires that S corporation shareholders who provide services to the business must be paid a reasonable salary before receiving distributions of profit. This rule ensures that owners pay their share of employment taxes. “Reasonable compensation” is based on facts and circumstances, considering factors like the owner’s experience, duties, and what comparable businesses pay for similar services. Because retirement plan contributions are based on W-2 wages, an artificially low salary set to minimize payroll taxes will also restrict the amount an owner can save for retirement.

Plan Loans

Certain retirement plans, like 401(k)s, may permit participants to take loans against their vested account balance; this feature is not available in SEP or SIMPLE IRA plans. A participant can borrow up to 50% of their vested balance, not to exceed $50,000. The loan must be repaid in substantially level payments, with interest, over a period of five years. An S corporation owner is subject to the same loan provisions as any other employee. For 401(k)s, interest paid on a loan secured by elective deferrals is not tax-deductible.

Prohibited Transactions

Retirement plans are governed by rules against prohibited transactions, which prevent self-dealing between the plan and a “disqualified person,” such as the business owner or fiduciaries. Prohibited transactions include actions like borrowing from the plan outside of formal loan rules or selling personal property to the plan. Engaging in a prohibited transaction subjects the disqualified person to a 15% excise tax on the amount involved for each year the transaction remains uncorrected. The transaction must be undone, and the plan must be made whole for any losses.