Retirement Plans for Small Business Owners
As a small business owner, you’ve got a million things on your mind at any given time. Too often, we focus on things right in front of our faces, neglecting to plan for the long run. Take a step back, and for today, let’s think about life after business. This is harder than it sounds for those of you grinding day in and day out. However, there is a light at the end of the tunnel.
True, retirement may not be a top priority for many of you. But the sooner you begin to plan for it, the sooner you’ll have clarity in your financial future. When it comes time for you to retire from your business, hopefully, you’ve set aside some savings in addition to the value of your business. Fortunately, the tax code allows for several different ways for business owners to save for retirement in tax-sheltered accounts. In this post, we’ll explore many of the various retirement plans that may benefit not only you, the small business owner but also your most valuable asset, your employees.
Types of Retirements Plans for Small Business Owners
The (Traditional) Individual Retirement Account (IRA)
One of the most common retirement accounts used today is the traditional IRA. Generally speaking, the money you put IN to the plan is deductible from your total income on your tax return. (There may be situations where you are not eligible to deduct contributions to a traditional IRA.) The money will grow tax-free inside of the traditional IRA. You also generally won’t owe any tax at all until you take money OUT of the account.
For the year 2020, the maximum contribution you can make to a traditional IRA is $6,000. If you are over the age of 50, the IRS allows you to contribute an additional $1,000. This is known as a catch-up contribution. A great thing about an IRA account how easy they’re to set up at just about any bank or custodian. You don’t even need to own a business to make contributions to this type of account.
The Roth IRA Retirement Plan for Small Business Owners
The Roth IRA is the second type of retirement account we’ll discuss. This type of account dates back to the late 1990s and named after Senator William Roth. There are similarities and some key differences between the Roth IRA and the traditional IRA. For instance, the Roth IRA has the same contribution limits as a traditional IRA. These are $6,000 for 2020 with an additional $1,000 if over the age of 50. You can establish a Roth IRA easily at a bank or custodian, just like the traditional IRA. Where things start to diverge is in the tax structures. Money going IN to a Roth IRA is not deductible from your total income. That’s because the money goes in on an after-tax basis. The Roth IRA money grows tax-free, and when you make a withdrawal from the Roth, the withdrawal is TAX-FREE.
Not everyone can contribute to a Roth IRA. In 2020, if you are a single tax filer with income (modified adjusted gross income) above $124,000, or if married filing joint, income above $196,000, your contributions may be limited or disallowed. The deadline to make contributions to both a traditional or a Roth IRA is the date your tax return is due (generally April 15).
Learn More About Roth vs. Traditional IRAs on The Guided Retirement Show
Our Founder and CEO, Dean Barber, and Partner, CFP® and CPA, JoAnn Huber, have done a couple of episodes on our podcast The Guided Retirement Show. You can find links to their episodes below. We encourage you to give these a listen or watch to learn more about the importance of tax planning.
► IRAs vs Roth IRAs Pt. 1 ► IRAs vs Roth IRAs Pt. 2 ► What Retirees Need to Know About Roth Conversions
The SIMPLE IRA Retirement Plan for Small Business Owners
Now that we’ve covered some of the more basic retirement accounts let’s move on to the retirement accounts geared towards business owners. The Savings Incentive Match Plan for Employees (SIMPLE) is available for small businesses with 100 employees or fewer. An employer that wishes to establish a SIMPLE plan for his or her business needs to complete an IRS Form 5304-SIMPLE or 5305-SIMPLE. As the employer, there is a requirement to contribute to your eligible employee’s accounts of either:
- A matching contribution of up to 3% of the employee’s compensation, or
- A 2% non-elective contribution. This means that even if the eligible employee chooses not to contribute to their own SIMPLE IRA, the employer is still required to make the 2% contribution.
Compared to the traditional IRA’s annual contribution limit of $6,000 (for 2020), the SIMPLE IRA allows an employee to contribute up to $13,500 per year. It may allow for employees over the age of 50 to contribute an additional $3,000. The money going IN to the account is generally tax-deductible. Taxation on that money will only occur when withdrawn from the account, similar to a traditional IRA. There is no Roth option for a SIMPLE IRA.
SIMPLE IRAs are easy to set up with minimal paperwork (read that as simple). Therefore, they’re an excellent choice for employers who don’t want to spend a lot of time or money setting up and maintaining a retirement plan for their businesses. This type of plan may be a good fit for employers who want to save more than what the traditional IRA allows for, or for employers with a group of employees that they want to start helping with saving for retirement.
The SEP IRA
The next retirement plan we’ll look at is the SEP (Simplified Employee Pension Plan) IRA. The SEP IRA is available to businesses of any size, even self-employed business owners, and allows employers to contribute up to 25%(!) of each employee’s pay. Like the SIMPLE IRA, the SEP IRA is easily established by filling out a form 5305-SEP. It is also inexpensive to set up and operate. Whereas with the SIMPLE allowing both employees and employers to contribute to an employee’s plan, the SEP IRA is made entirely of employer contributions.
The employer can set restrictions on who is eligible to participate in the plan, but this cannot be more restrictive than what the Form 5305-SEP allows. When establishing a SEP IRA, the employer must use the same contribution percentage for all eligible employees. The SEP IRA allows for a whopping $57,000 of contributions (for 2020), allowing for some significant saving opportunities for employers who have high incomes and the ability to save that much. There are, however, some calculations you or your accountant will need to do to determine how much you’ll be eligible to contribute, and the IRS publication 560 will walk through those in detail. The SEP IRA contributions, similar to the SIMPLE IRA contributions, are made on a pre-tax basis.
The SEP IRA may be a good fit for self-employed individuals who have the ability and desire to save more than what is allowed in a traditional IRA or a SIMPLE IRA. In addition to those who don’t want the hassle of establishing and maintaining a more complicated retirement plan, like a 401(k).
The 401(k) Retirement Plan for Small Business Owners
We’ll now start to explore the more complex retirement plans, beginning with the 401(k) plan. The 401(k) plan is a type of profit-sharing plan that allows employees to contribute a portion of their wages to an account established for retirement. The plan also allows employers to make contributions to their employees’ accounts in the form of matching contributions or non-elective contributions.
For the calendar year 2020, the contribution limit for employees is $19,500. For employees over the age of 50, there is a catch-up contribution of up to $6,500, bringing the total annual contribution limit to $26,000. Any matching contributions made by the employer do not count toward those limits. However, there is a limit for combined employee-employer contributions. Those limits are $57,000 for 2020 ($63,500 if an employee is over the age of 50). You can even design a 401(k) plan to allow employees to save to a Roth 401(k).
401(k) Plans are Complex
The 401(k) plan is undoubtedly more complex than the previously mentioned plans. There are more filing requirements and expenses, third parties involved, and plan nondiscrimination testing.
Let’s take a look at some of the third parties involved in a typical 401(k) plan. If you’re starting a 401(k) plan for your business, funds are in a bank or custodian. That bank or custodian is where the investments occur. Next, you’ll have a record keeper responsible for keeping track of every penny within your 401(k) plan. They’ll maintain records of which deposits belong to which employee, who made the deposits (employee deferrals or employer contribution), and which dollars are from deposits, and which dollars are from the growth of the investments. You’ll also need a third-party administrator (TPA). The TPA has a ton of responsibilities, including designing your plan, ensuring your plan stays in compliance with the IRS, filing tax returns and forms, and preparing statements for your employees.
Your plan will also be subject to nondiscrimination testing. These are annual tests that, according to the IRS, are there to “verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.” Essentially, the IRS wants to make sure you’re not setting up this 401(k) plan to take advantage of the significant contribution limits for yourself, and not also providing an equitable benefit to your employees.
Learn more about the 401(k) in our 401(k) Survival Guide.
The Solo 401(k)
What if you don’t have any employees, but still like the features of the traditional 401(k)? Enter Solo 401(k). This plan goes by a few nicknames: Individual 401(k), solo-k, one-participant 401(k). These plans will generally follow the same rules and requirements as a regular 401(k) plan but specifically for self-employed individuals and (possibly) their spouses. You (the employee) will make contributions to your account, which could be matched by yourself (the employer). Like the SEP IRA, you’ll need to refer to IRS Publication 560 to calculate the maximum contributions you can make for yourself. The contribution limits are the same as the traditional 401(k). As long as you do not have any employees, the 401(k) testing requirements aren’t applicable.
The SIMPLE 401(k)
A third type of 401(k) plan is the SIMPLE 401(k). This is sort of a combination of the SIMPLE IRA and the 401(k) plan. One of the nice features of the SIMPLE401(k) is that even if you have employees (and to use the SIMPLE 401(k) plan, you’ll generally need 100 or fewer employees), aren’t subject to nondiscrimination testing with regards to your contributions. The catch is the requirement to make some sort of employer contribution (which is different than the regular 401(k) plan, where an employer match is not a requirement). The required contribution for employers is either:
- A matching contribution up to 3% of each employee’s pay, or
- A non-elective contribution of 2% of each eligible employee’s compensation.
Your employees will be fully vested in both their own and your contributions to their accounts. This means if they choose to leave your business at any time, they take their funds with them.
The contribution limits to a SIMPLE 401(k) are lower than that of a regular 401(k) plan. The maximum contribution in 2020 for employees to a SIMPLE 401(k) is $13,500. A catch-up contribution is allowed for employees over the age of 50.
The SIMPLE 401(k) may be a good choice for small businesses (with 100 or fewer employees) that like the features of a 401(k) plan, but don’t necessarily want to deal with the annual testing requirements (and costs associated with paying a TPA to do those).
Choosing the Right Retirement Plan for Small Business Owners
If you’re an employer or a small business owner trying to figure out the best plan for your business, you can work with a financial planner to work through each available option’s pros and cons. The right plan can do several things for you and your employees, including:
- Provide income tax savings
- Help fund future retirement goals
- Attract and retain valuable employee team members
If you’re ready to begin or want a second opinion about your business’s existing retirement plan, we can work with you and your team. Reach out to us by scheduling a complimentary consultation below or giving us a call at (913) 393-1000. We look forward to helping you.
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Investment advisory services offered through Modern Wealth Management, Inc., an SEC Registered Investment Adviser.
The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.