As a small business owner, you’ve got a heap of tasks that need your attention today. So opening a small business retirement plan may not be on the top of your list.
But here’s an argument for moving it up the priority ladder: Small-business retirement plans provide plenty of financial benefits you and your business can use in the here and now.
Not only are you more likely to reach retirement savings goals when you start saving early, the amount you contribute to your small-business retirement plan could reduce your taxable adjusted gross income, IRS rules say.
A retirement plan can also set you apart from other employers, since fewer than 15% of small businesses offer employees that benefit, the Government Accountability Office reports. When you contribute to your employees’ retirement plans, the tax code rewards you with a potential business expense deduction.
Like many decisions you make for your business, the right approach to choosing a small-business retirement plan is subjective, but it starts with knowing your options. Three common small-business retirement plans are:
SEP IRA: (Simplified Employee Pensions) lets employers and employees contribute to a SEP-IRA, which once funded functions much like a traditional IRA.
SIMPLE IRA: (Savings Incentive Match Plan for Employees) used by companies without other retirement plans. Employers and employees contribute to a SIMPLE IRA.
Solo 401(k) : for business owners with no employees. Employers and employees contribute to a 401(k).
To help you compare the three options, answer these four questions:
- How much do you want to save each year in your own retirement account?
Your age, income, retirement savings goal and how much progress you’ve made toward it all play a role in which small-business retirement plan satisfies your needs.
SEP-IRA: limits your allowable annual contributions to no more than 25% of your adjusted gross income (AGI) for each tax year.Calculating how much you can contribute based on your expected business income and expenses (which may vary each year) can be complicated.
The Main Drawback: If you’ve procrastinated saving for retirement or want to be more aggressive in managing taxable income, the SEP-IRA limits may be too low to fully fund your target savings goal.
Self-Employed 401(k): if you’re a solopreneur, or have only one employee who is also your spouse and you don’t plan to hire employees in the future, this option’s contribution amounts are generous. You could invest up to $53,000 a year for retirement, and make up to $6,000 in additional annual catch-up contributions if you’re at least 50 years old.
The Main Drawback: You’ll have to change retirement plans if you hire employees.
Simple-IRA: As an employee of your own business, each year you can make contributions (with pretax dollars) of up to 100% of your compensation, capped at $12,500 (plus $3,000 in catch-up contributions if you’re at least 50 years old).
Your “employer” self can match the contributions your “employee” self makes, dollar-for-dollar up to 3%. Or, you can decide to contribute 2% of your compensation without having to make an “employee” contribution. One caveat: participating in another retirement plan can change your Simple-IRA maximum contributions, the IRS says.
The Main Drawback: The contribution process is the most complex of the three options.
- Do you want to contribute to employee retirement accounts? Do you want them to be able to contribute to their own accounts?
Fewer than half of Americans nearing retirement have saved for it, according to the GAO’s research. Contributing to your employees’ retirement plans can boost the appeal of your compensation packages and may give you a business expense deduction.
SEP-IRA: Contributions are limited to 25% of compensation, and cannot exceed $53,000 in 2016. You must contribute the same percentage of salary to each employee, IRS rules say. For example, if you contribute 10% of John’s salary, you must contribute 10% for Carrie, Chris and Mark, too. Each year, you choose the rate at which you’ll contribute.
Self-Employed 401(k): The plan isn’t designed for business owners with employees other than a spouse.
SIMPLE-IRA: Employees can contribute up to $12,500 a year (or $15,500 if they’re age 50 or older) via salary deferral (pretax dollars). As the business owner, you choose one of two ways to match your employees’ contributions:
- Offer up to a 3% match for any employee who contributes each year.
- Contribute 2% for all employees who earn at least $5,000 annually, including those who don’t make their own contributions.
The Main Drawback: You must notify employees of what you will contribute and tell them 45 days in advance before you change contribution amounts.
- Are you concerned with retirement plan fees and administrative responsibility?
Feeling bogged down with small business tax reporting and administrative obligations? Not all small-business plans require extensive paperwork.
SEP-IRA: Paperwork is minimal, but you’ll need to notify employees of what you contribute to their accounts (if you do). The plans may not have fees, but if they do, you may qualify for up to a $500 tax credit to cover costs.
Self-employed 401(k): If plan assets are more than $250,000, you’ll have to file an Annual Form 5500 or Form 5500 SF, and report contributions on your tax return.
SIMPLE-IRA: Because employees contribute to these plans by deferring a portion of their salary, paperwork and plan administration may be more complex. You’ll need to notify eligible employees of your intended contributions in advance, and report the contributions on employees’ W-2s. The plan may have annual administration fees and you may be eligible for a tax credit to cover costs.
- How much access to retirement funds do you want?
Retirement savings are intended for use when you reach retirement age generally age 59 ½. But your employees may want to have the ability to tap their retirement accounts early, if they’re faced with a financial crisis.
Tip: If you don’t currently have a personal emergency savings fund, reaching that short-term goal should take precedence over saving for the longer-term goal of retirement. Having an emergency fund reduces the likelihood that a financial predicament would cause you to have to turn to your retirement funds.
Goal Investor’s Emergency Fund Planning Guide can show you how much to set aside each month to build the emergency savings you need.
SEP-IRA: You’ll pay a 10% tax and, potentially, income tax on money you withdraw before you’re 59 ½, unless you qualify for an exception.
Self-Employed 401(k): Same rules as a SEP-IRA.
SIMPLE-IRA: The IRS allows some withdrawals before age 59 ½, if money is used to cover a qualifying event, like financial hardship or to buying a home. If you take an early distribution within two years of funding a SIMPLE-IRA you might owe a whopping 25% tax on your withdrawal, unless you qualify for an exception
Early distributions for other reasons could subject you to a 10% tax.
Use your answers to these questions to open the small-business retirement plan that best meets your needs and start taking charge of your financial future.
This information is provided for educational purposes only and is not intended to provide investment or legal advice. SEI does not claim responsibility for the accuracy or reliability of the information provided.
Neither SEI nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.