If you are self-employed or own a small business, you still have a number of retirement plan options available to you. Below, you’ll find out all about our list of the top four retirement plans for small business owners and self-employed individuals. Each plan comes with its own unique set of pros and cons, and each will be discussed below.
- There are four retirement plan options for small businesses – SEP & SIMPLE IRAs, Solo 401(k) and Defined Benefit Plan
- If you have no full-time employees (other than a co-owner or spouse) the Solo 401(k) is the obvious choice
- If you have employees, the other plans offer their own unique benefits
In passing the 1996 Small Business Job Protection Act, Congress implemented the Savings Incentive Match Plan for Employees, more commonly known as a SIMPLE IRA. This type of retirement plan can be set up by any U.S. business with fewer than 100 employees. The SIMPLE IRA has a lower deferral limit than a 401(k) plan, but unlike a 401(k) plan, the SIMPLE IRA uses an IRA-style trust to hold contributions for each employee. In 2023, the annual employee deferral for a SIMPLE IRA is limited to $15,500 per year, with a $3,500 catch-up contribution allowed for those at least age 50.
Pros of a SIMPLE IRA
- Easy setup: It is incredibly easy to set up a SIMPLE IRA plan using forms provided by the IRS. In essence, form 5304-SIMPLE can be used if you’ll allow your employees to choose where to invest their contributions themselves. Form 5305-SIMPLE is the correct option if you plan to choose the financial institution for everyone on the plan. Once you set up the plan and notify your employees, you’re ready to get started.
- Affordable setup: It is also cheap (maybe even free) to set up a SIMPLE IRA. What small amounts it may cost may also be written off as a business expense on your taxes.
- Affordable maintenance: While your employees may incur some small costs for an investment adviser, you aren’t likely to need to pay anything for plan maintenance. Under a SIMPLE IRA, no plan administrator is required, and the IRA custodian is responsible for all IRS reporting.
- Easy maintenance: The name SIMPLE is more than just a moniker. Year-end paperwork is surprisingly easy to understand and complete. Maintaining this type of plan is more than simple.
- Higher limits: More is always better, right? A SIMPLE IRA offers higher contribution limits than a traditional or Roth IRA. Here, employees can contribute up to $15,500 for 2023, up from $14,000 in 2022. A $3,500 ($3,000 for 2022) catch-up contribution is also allowed for employees age 50 and older. Importantly, employers are required to contribute 3 percent of each employee’s total compensation.
- Matches are deductible: Money that you put into an account for your employees is tax deductible as a business expense.
Cons of a SIMPLE IRA
- Limited to small companies: This plan is designed for small businesses. If you expect your business to grow to one with more than 100 employees, you’ll have to change plans down the road.
- Contributions count against your 401(k) contributions: If you’re running a small business on the side, but still contribute elsewhere to an employer’s 401(k) program, this isn’t the best option for you. In other words, contributions to a SIMPLE IRA count against the annual contribution limit for your 401(k), seriously limiting your overall retirement savings options.
- Big penalties may apply: With most (but not all) retirement accounts, you’ll pay a 10 percent penalty if you withdraw early. But with the SIMPLE IRA, the penalty can be as high as 25 percent! Timing remains an issue here, as for two full years, you can’t roll your money into a new account without incurring this steep penalty.
- Accounts must be open by October 1: If you’re looking for a way to cut your tax bill late in the year, the SIMPLE IRA won’t do the trick. You must open an account by October 1 to make contributions for that tax year.
- Mandatory contributions: As an employer, you are required to make certain contributions to your employees’ accounts every year, even if your business isn’t going especially well.
- Low contribution limits: In contrast to other options for small businesses and the self-employed, the SIMPLE IRA has very low contribution limits. This can hurt you if you’re trying to save big for retirement.
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1978’s Revenue Act implemented the Simplified Employee Pension IRA (SEP IRA), which provided for a contributory retirement account, primarily for small businesses. A SEP IRA is essentially a profit-sharing plan. In 2023, the maximum SEP IRA contribution is $66,000 and must be made in a pretax form. Contributions are based on a percentage of income/salary (20%, or 25% if W-2) and must be made to all eligible employees.
For example: If an individual at least age 50 made $40,000 as a sole proprietor, they would only be able to contribute 20% of their $40,000 in income ($8,000) in their SEP IRA. Whereas, in a Solo 401(k), the individual would be able to make an employee deferral contribution of $27,000 plus a 20% employer contribution of $8,000 for a total deferral of $35,000. Hence, the Solo 401(k) plan would allow the individual to contribute more than four times what he or she would be able to do in a SEP IRA alone.
Pros of a SEP IRA
- Easy setup: Setting up a SEP IRA is as easy as setting up a SIMPLE IRA. Fill out form 5305-SEP, let your employees know, and get started.
- Affordable setup: Again, because setting up a SEP IRA is easy, there aren’t many administrative costs, and you can write off the setup costs as a business expense.
- Easy maintenance: As with the SIMPLE IRA, administration of a SEP IRA account is simple and inexpensive, if not free.
- Non-mandatory contributions: Employers make all the contributions to a SEP account. Employees are not required to make contributions, and contributions can be flexible as you like.
- Tax-deductible contributions: Any contributions you make to your IRA or your employees’ SEP IRAs are tax deductible as business expenses.
- Contributions don’t affect other accounts: Contributions that you make to an employee’s SEP IRA don’t affect your ability to contribute to other types of IRAs. Even more, employees who also work for another business with separate retirement accounts can still have a SEP IRA with your company.
- Good motivation: Many businesses run a SEP IRA so that the more a business profits, the more the employer contributes. This type of retirement plan can provide good motivation for employees to help boost the company’s bottom line.
- Can be terminated at any time: If your business grows beyond the point where a SEP IRA plan is effective or desirable, or if an employee leaves the business, the plan — and contributions to it — can be easily terminated.
- Larger contributions are possible: Unlike a traditional or Roth IRA, a SEP IRA lets you make larger contributions: $66,000 for 2023, and $61,000 for 2022.
Cons of a SEP IRA
- Employers contribute everything: With a SIMPLE IRA, part of the contributions can be taken out of the employee’s salary. With a SEP, the employer makes 100 percent of the contributions.
- Contribution percentages must be the same: You can’t pay yourself a higher contribution percentage than your employees, which means this is an expensive option if you add employees and want to keep your own contributions high.
- All employees must be included: Every employee who is eligible for this plan must be included, which, again, can make it expensive if you start growing your business.
Related: Tax Deferral vs Tax Free
The Solo 401(k) retirement plan, also known as the Individual 401(k) or Self-Directed 401(k), is a type of 401(k) account for self-employed individuals or the owner of a very small business. It can be a great way to boost your retirement savings.
To be eligible to benefit from the Solo 401(k) plan, a business must meet just two eligibility requirements: the presence of self-employment activity and the absence of full-time employees.
One important concept to understand is that under IRS rules, the business owner and their spouse are technically considered “owner-employees” rather than “employees”. Further, the following types of employees are also excluded from being “employees” under the rules.
- Employees under 21
- Employees that work less than 1,000 hours annually, or can show three consecutive years of 500 hours of annual service
- Union employees
- Nonresident alien employees
Unique Benefits of the Solo 401(k)
In addition to having more investment opportunities, the Solo 401(k) plan is easy and cost effective to administer. It also comes with a multitude of benefits that a sole proprietor or small business owner can easily take advantage of.
High Contribution Limits
If you are eligible for the plan, one of the primary benefits is that you can reach your maximum contributions faster than a SEP IRA. The maximum contribution truly sets the Solo 401(k) apart from the SEP especially when it comes to contribution limits. A SEP IRA is exclusively a profit-sharing plan. The Solo 401(k) is also a profit-sharing plan, but it also comes with the employee-deferral feature.
This employee deferral allows Solo 401(k) investors to contribute to the plan on a dollar for dollar basis. Combined with the employee deferral feature, the profit sharing feature of the Solo 401(k) allows nearly all small business owners to make higher maximum contributions. In 2023, the maximum contribution is $66,000 if you are under 50, and 73,500 if you’re 50 or older. These values mark increases from 2022, where the maximum limits were $61,000, and $67,500 respectively.
Greater Asset and Creditor Protection
If your state opted into the 2005 Bankruptcy Act, your 401(k) comes with unlimited protection from creditors if you go bankrupt. Most states will even protect your 401(k) account outside of bankruptcy if it were to be attacked by creditors. With a Solo 401(k) retirement plan, you may receive even more protection than with a Self-Directed IRA.
Special Exception for Real Estate Investors
For a small business owner who is also interested in investing in real estate or other non-traditional investments, you will really benefit from the Solo 401(k). One of the biggest advantages comes from an exception for using ‘leverage’. By taking a non-recourse loan, you can combine it with a Solo 401(k), use the a loan to purchase property, and you will not trigger the UBIT (or UBTI) tax, which has a maximum tax rate of 37% for 2023. If you were to use a Self-Directed IRA in this example, you would be taxed.
Solo 401(k) Loan
IRAs don’t have a loan feature, but the Solo 401(k) allows you to take a $50,000 (or 50% of your account value (whichever is less)) loan, for any purpose. You can use a Solo 401(k) loan fund your business, make investments, or use it for personal reasons, whatever you need.
Pros of a Solo 401(k)
- More contribution possibilities: By using a Solo 401(k) for yourself and your spouse, if the spouse works as your employee, you can contribute as both an employee and as an employer. Therefore, you can make employee deferral contributions of up to $22,500 (or $30,000 if 50+) for 2023, and still have your business contribute up to 25 percent (20 percent if a sole proprietor or a single member LLC) of your total earnings.
- Flexible contributions: You don’t have to contribute a set amount to a Solo 401(k) each year, so you can contribute less if you have a tough year or more if you have a good year.
- Tax-deductible employer contribution: If you make an employee deferred contribution to this account as an employee, the contribution can be made in pretax or Roth styles.
- Contribute in the next calendar year: If you are a sole proprietor or single member LLC, you can set up a Solo 401(k) by December 31 to make contributions for that tax year all the way up to the April 15 filing deadline (plus extensions). This makes it a good way to shelter some of your income if you need to reduce your tax bill.
Cons of a Solo 401(k)
- More complicated: A Solo 401(k) isn’t as complex as some plans, but it is more complicated than most plans for small business owners. You’ll have to find a plan administrator to set up your plan.
- More expensive: The Solo 401(k) isn’t incredibly expensive, but it will cost you some money to set up and maintain, especially because you need to pay administrator fees.
- Required reporting: Once there is at least $250,000 in your account, you must annually report your benefits through form 5500-EZ.
Defined Benefit Plan
Defined benefit plans, like pensions, are becoming much less common with big businesses. But they remain a great way for small-business owners and the self-employed to save more for retirement than they would otherwise be able to.
Pros of Defined Benefit Plans
- You can contribute a lot of money: This expensive plan is best for business owners who are looking to save a lot of money for retirement and who consistently have money available to save. You can use it to save more than $265,000 a year for retirement.
- Can be combined with other options: Because a defined benefit plan is so different from other retirement savings accounts, you can combine it with a Solo 401(k) and/or a SEP IRA to save even more.
- Reduce tax liability: Defined benefit plan contributions can be written off as business expenses, reducing your business income and personal income, which can decrease your tax rate and your tax bill.
Cons of Defined Benefit Plans
- Costs are high: With this plan, an actuary needs to run calculations to determine minimum funding levels for each employee every year, which can be very costly.
- You have to make the minimum funding: When you set up Defined Benefit Plans, you’re committed to funding it at a certain level to meet the eventual payout, even if your business has a bad year. It’s important to ensure your business can handle the minimums, regardless of cash flow.
- Payouts are limited when you set up the plan: When you set up Defined Benefit Plans, you define your payouts at the start. You can withdraw only a set amount per year during retirement, unless you roll the money into another retirement account.
- They’re not great for more employees: Defined benefit plans are created for your entire company, so payouts depend on how long someone works for you and other factors. If you use this plan for your retirement, you’ll have to offer it for your employees as well, which can get expensive. This is why defined benefit plans have become less popular for larger businesses but may still be a good option for a solo operation or if you plan to only ever have one or two employees.
Being self-employed or a small business owner provides one with the ability to control their own financial future, plus the ability to maximize their retirement savings. For example, a Solo 401(k) plan will allow the self-employed or small business owner to generate over $60,000 in tax deductions every year, plus gain the ability to invest in almost any investment they wish, including real estate and cryptos. Of course, if you have other full-time employees, you have options for your business retirement needs.
Q for You
Which retirement plan are you considering if you are self employed?