When you start your own business, no one else can tell you how to do what you do, and that’s a great feeling. But on the other hand, no one is looking out for you, especially when it comes to savings and retirement planning. You’re on your own, but fortunately, there are some great, simplified, tax-deferred vehicles designed specifically for small businesses. This week, I’d like to highlight some of the options.
SEP IRA
SEP IRA stands for Simplified Employee Pension Individual Retirement Arrangement. You should only use it if you want to provide retirement benefits to all of your employees. In this plan, you make contributions to each employee’s account. Your employees don’t contribute anything. However, employees can invest in their own personal IRA accounts.
For 2018, the maximum amount you can contribute to these accounts can be either 25% of the participant’s compensation or $55,000 whichever is less. Your employees are always 100% vested in these funds. It’s the ultimate vehicle for giving “free money” to your employees.
What if you don’t have any employees? In that case, there are other restrictions on how much you can deduct. If you operate as an S-Corp, you deduct 25% of your salary (pass-through profit does not count towards this amount). If you’re a Single Member LLC, you must make a special computation to figure the maximum amount of profit sharing contributions. In this instance “earned income” means net earnings from self-employment after deducting both:
- one-half of your self-employment tax, and
- contributions for yourself.
The IRS has a step-by-step worksheet for this calculation in Publication 560, but effectively the math works out to a max of 20% of earned income instead of 25%. Sites like Bank Rate and Fidelity also have calculators you can use.
You can deduct these contributions as business expenses and choose when you want to contribute. In other words, there is no contribution requirement. Many small employers like this added flexibility their cash flows are so variable.
Generally, your employees are eligible for a SEP IRA, as long as they are over 21, have worked for you in at least three of the last five years and received compensation of at least $500 for the tax year.
Solo 401k
A solo 401k is like a SEP IRA in that it allows you to contribute a lot of money towards your retirement. However, because it allows you to contribute both as the employer and the employee, the solo 401k can increase the amount you’re able to put away for retirement.
As the employee, you can to contribute as much as 100% of your income, up to a maximum of $18,500 for 2018 ($24,500 if you’re 50 or older) of your income.
As the employer you can also contribute up to 25% of your salary if you’re set up as an S-Corp or the 20% calculation used above if you’re a sole proprietorship or single-member LLC.
The combination of all contributions—employee and employer—can’t exceed a maximum of $55,000 in 2018 ($61,000 if 50 or older).
The ability to contribute both as an employee and employer makes the solo 401k more advantageous than the SEP IRA. For example, if you made $50,000 for 2018, you’d be able to contribute $27,793 to a solo 401k, whereas you’d only be able to contribute $9,293 to a SEP IRA. Another advantage of the Solo 401k is that you can have both a pre-tax (traditional) or post-tax (Roth) option. The SEP IRA only allows for pre-tax contributions.
A couple things you have to keep in mind with the Solo 401k. In order to enroll you have to be a sole owner or a partnership with no common-law employees (that’s an employee other than an owner, a business partner or a shareholder of a corporation and their respective spouses). Additionally, Solo 401k plans have to be set up by year end — that is, December 31st— while SEP IRAs can be set up by the following year tax deadline, including extensions.
SIMPLE-IRA
If you do have employees, and want to set up a retirement plan that allows employee contributions, you can look into setting up a SIMPLE IRA.
SIMPLE IRA stands for Savings Incentive Match Plan for Employees Individual Retirement Arrangement. This plan not only allows for employer contributions, but it also gives employees a chance to contribute. You can think of this plan as a starter 401k, without all of the administrative hassle.
The employer has two contribution options: 1) Match up to 3% of each employee’s compensation, or 2) make a non-elective contribution of 2% of each eligible employee’s compensation. As in the other plans, your company can deduct these contributions as a business expenses. Your company is required to contribute every year the plan operates. This year, employees can contribute up to $12,500 per year and $15,500 if they are age 50 or above.
Employees don’t have an age-restriction or minimum amount of years of work to qualify for an account. However, the employee must earn a minimum amount specified by the employer during any two proceeding years and expect to earn at least $5,000 in the current year. In addition, only businesses with fewer than 100 employees can use this plan.
Easy setup, maintenance, and administration
All of these plans are relatively inexpensive to set up and easy to use and administer. They allow a good deal of flexibility in when and how much you contribute. Traditional 401k plans, by contrast, have many testing and administrative requirements because of Department of Labor regulations.
These smaller plans avoid all of that because of their limited scope and size. Therefore, these plans offer a great benefit for small employers that already have to juggle several balls at one time. What retirement options are you using? Tweet, message or email me at the links below.