Retirement Planning for Small Business Owners
August 30, 2021 | BY Our Partners at Equinum Wealth Management
For many Americans, saving for retirement means participating in the 401(k) or 403(b) retirement plans offered by their companies. This leaves the self-employed and small business owners out in the cold when it comes to saving for retirement. Luckily for them, there are several options they can utilize.
Every American not covered by a company plan, can contribute to an IRA to save for retirement. The $6,000 contribution limit for these plans however, just won’t cut it for many. SEP IRAs were established as a way to help small-business owners establish retirement accounts for their businesses without the headaches that come with ERISA-sponsored plans. Later legislation introduced the solo 401(k), which also offers a simplified way for business owners to save for retirement and enjoy some of the benefits of a 401(k) plan that are not available with SEPs.
Here are the highlights of these two plans, and their key differences:
A Simplified Employee Pension (SEP) IRA is a plan that can be established by employers, including the self-employed. SEP plans benefit both employers and their employees. Employers may make tax-deductible contributions on behalf of eligible employees to their SEP IRAs. SEPs are advantageous because they have low administrative costs, are easy to set up and allow an employer to determine how much to contribute each year, without annual requirements. The contribution limit for 2021 is the lesser of $58,000 per person and 25% of adjusted net earnings. (For self-employed income, the percentage is a little lower.)
One major benefit of a SEP IRA from the employee’s perspective is that an employer’s contributions are vested immediately. No loans are permitted from a SEP IRA. The deadline for SEP IRAs is the filing date, including extensions, which make it a good option if any discussion arises after year’s end. A drawback from the employer’s perspective is that the employer must contribute on behalf of all employees who earn a total annual compensation of more than $600 if they reach the age of eligibility, even if they are only part-time workers.
Solo 401(k) plans are for sole proprietors, small business owners without employees (though spouses can contribute if they work for the business), independent contractors and freelancers.
With these plans, both the employer and the employee can make contributions. Like a regular 401(k), there is a Roth option to have after-tax funds contributed to these accounts. The contribution limit for 401(k)s for 2021, as an employee, is $19,500. If you are 50 or older, you can make an additional catch-up contribution of $6,500.
Wearing the employer hat, you can contribute up to 25% of your compensation. The total contribution limit (employee and employer contributions) for a solo 401(k) is $58,000 for 2021. This does not include the employee’s $6,500 catch-up amount for those over the age of 50. The calculation usually breaks down to the sum of $19,500 as an employee and $38,500 as an employer.
So, which one is a better option – a SEP IRA or a Solo 401(k)? The answer depends on your situation.
If you’re unsure which plan may work for you, please reach out to us at firstname.lastname@example.org. We’ll help you review your options and come to a decision tailor-made for your needs.