Many Americans have access to a retirement plan through their employer. But what if you’re a small business owner? Self-employed workers including startups, business owners, and contractors like technology consultants and realtors, are responsible for choosing their own retirement plan. These types of workers are also subject to higher taxes so they usually have an increased interest in reducing earned income. By choosing their own plan, self-employed workers are hopefully benefiting from more choices, lower fees, and better tax planning.
Why even bother with utilizing one of the available retirement plans? Under IRS tax code, many plans allow for a reduction of earned income and provide tax deferred growth for your investments, making them more attractive than holding your savings in traditional taxable brokerage account. For the purpose of this article, let’s discuss the four most popular. Remember that if you’re self-employed, there are several other methods to plan for retirement in addition to these discussed.
The Individual Retirement Arrangement (IRA) is one of the most popular retirement accounts for both W2 and self-employed workers because of its simplicity and the ease of establishing an account. It’s also one of a few plans that IRS rules allow to be established after the end of the calendar year. You can create on right up to the tax filing deadline, which increases the traditional IRA’s popularity, especially if you’re looking for a last-minute tax deduction as you file your income taxes. One feature of the IRA worth noting is that it’s considered an individual’s plan meaning you can contribute to it and still participate in some of the other plans in the article. For 2014, the maximum that can be contributed* is $5,500 with a $1,000 catch up contribution if you’re over 50.
The Simplified Employer Pension IRA (SEP IRA) is a plan funded by the employer for its employees. The advantage of this plan over the IRA is that the contribution limit* is higher at $52,000 for 2014. The disadvantage of the SEP is that contributions are limited to 20% of a self-employed person’s income and everyone employed at your company receives the same amount of salary deferral. If you compensate yourself 10% in the SEP, then you have to defer 10% of everyone’s salary. For this reason, this place is usually utilized by one or two person operations. There are no catchup provisions for SEP IRA’s.
The SIMPLE has an employee contribution limit* of $12,000 for 2014 plus the employer usually matches dollar of dollar up to 3%. For the self-employed, the SIMPLE has an advantage over the SEP because contributions aren’t limited by the cap of 20% of income. Contributions are limited by the amount of income a self-employed person earns for the year. (e.g. if your business only earns you $8,000, then you can on contribute $8,000.) The SIMPLE is popular with businesses that have multiple employees because it requires the employee to contribute like a 401k, but unlike a 401k, it doesn’t require as much IRS reporting. There is a provision for a $2,500 catch up contribution.
“A one-participant 401(k) plan is sometimes referred to as a “solo-401(k),” “individual 401(k)” or “uni-401(k).” It is generally the same as other 401(k) plans, but because there are no employees other than your spouse who work for the business, it is exempt from discrimination testing.” – IRS Documentation
The Solo 401k is designed to be easy for a self-employed individual with no employees, but maybe a spouse working for the business. The advantage this plan has over the others discussed here is that it has no testing for discrimination, which refers to restrictions on “top-heavy” 401k plans where senior management comprises most of the assets in the plan.
That means that a solo 401k participant can contribute $17,500 as an employee and then they can contribute up to 25% of their self-employed income. You can think of the last part as the businesses ‘match’ of your contribution, like in a traditional 401k plan, except that it’s all your self-employed income. The employee portion of the contribution could be made as a ROTH 401k, but the ‘match’ is a salary deferral, like a traditional IRA. For 2014, the contribution limit* is $52,000! That’s a substantial amount to contribute, but it is also a substantial reduction in taxable income.
These are four popular retirement plans I see small business owners utilize, but there are several other ways to save and plan for retirement. I would recommend working with your financial advisor and CPA to determine what would be best for you. If you’re looking for more information on what was discussed here, check out Publications 590 and 560 from the IRS or consult with your CPA.
*Contribution limits are subject to a variety of IRS rules and income limitations. Consult your with your accountant to see if you can qualify for any of the listed retirement accounts.
Image credit: aag.com