Retirement Plans for the Self Employed and/or Small Business Owner

Tina D'Agata (Mar, 2021)

Are you self-employed and/or a small business owner that thinks they are paying too much in income tax? If so, do you have a retirement plan?  If the answer is no, now is the time to think about setting one up.  If the answer is yes, it is also a good time to review your plan to make sure what you are offering still fits your personal and professional retirement goals. 

There are tax advantages and incentives for both you as the business owner, as well as a plan participant (employee).  Following are a few:

  • Employer Contributions are deductible from the employer’s business income.  Therefore, you are reducing the overall profit that you pay taxes on.  It is not too late to establish a plan for 2020 if you have not filed your tax return yet!
  • If you create a plan that allows for Employee Contributions such as a 401(k) plan, these too are pre-tax and will reduce your personal income tax. (Roth contributions are not pre-tax but can be advantageous too.)
  • Contributions into the plan and their earnings grow tax-free until the year you opt to take your money out of the plan.
  • High allowable contribution limits, which allow you to save a large amount for retirement.
  • Tax credit for business owners establishing a new retirement plan that has a least one non-highly compensated employee.  The credit is 50% of your eligible startup costs up to the greater of $500, or the lesser of $250 multiplied by the number of non-highly compensated employees eligible to participate in the plan or $5,000.  This tax credit can be claimed in each of the first 3 years of the new plan’s existence.

Now that we see some of the benefits of establishing a retirement plan for both your business and personal income tax, it is time to think about the different types of retirement plans.  Understanding the differences between the plans, what they offer, as well as how they affect your business and personal income tax return is very important.  In order to decide what plan is right, you need to think about how much you want to save for retirement, how many employees you have and how much, if anything, you want or need to contribute on their behalf.  

You can choose between the following:

  • A SEP (Simplified Employee Pension) only allows for employer contributions.  Any employee who has worked for you in the last 3 of the past 5 years needs to be included.  The annual contribution is discretionary up to 25% of compensation, with a maximum compensation of $290,000 per person for 2021 and a maximum contribution of $58,000 per person.  Generally, whatever percent of compensation you choose to contribute for yourself also needs to be contributed on behalf of your eligible employees. All contributions are made into IRA accounts set up on behalf of each eligible person.
  • A SIMPLE-IRA, which allows for both employee and employer contributions.  Any employee who has earned at least $5,000 during any 2 preceding years and expected to earn the same in the current year needs to be included.  Employee contributions are limited to $13,500 and are deducted directly from their paycheck, with an additional $3,000 allowed if you are 50 or older.  Employer level contributions are mandatory for most years and are limited to either: 2% of pay to all eligible employees or up to a 3% of pay “matching” contribution to those employees who elect to defer some of their salary into the plan.
  • A 401(k) Plan allows for both employee and employer contributions.  This can be more expensive to set-up and maintain. It gives you the most flexibility in your choice of who is eligible, as well as how much and to whom you want to contribute.  A 401(k) Plan also offers the highest contribution limits, allowing an employee to elect to contribute up to $19,500 from their pay, with an additional $6,500 allowed if they are 50 or older.  The employer contribution limit is discretionary up to 25% of total eligible compensation, with a maximum compensation of $290,000 per person for 2021 and a maximum contribution of $58,000 per person.  In a 401(k) Plan, employer contributions can be more flexible and any employer contributions can be subjected to a vesting schedule, so employees may not be able to keep all of the contributions you have made on their behalf if they do not stay with your company long enough.

To discuss the different options, and how one may fit your business, please contact our Retirement Plan Design and Administration Group at Dermody, Burke & Brown, CPAs.

 

The information reflected in this article was current at the time of publication.  This article will not be modified or updated for any subsequent tax law changes, if any.

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