How Much Money Can a Small Business Owner Put In a Retirement Account
Retirement Account Options for Small Business Owners
Involved in the busy lifestyle of a business owner, it is easy to forget to properly prepare for retirement. Sometimes, entrepreneurs need to step back and prioritize their personal finances over their business. Investing in your retirement savings account is not only a smart long term decision, but it provides peace of mind knowing that you have a backup plan in the fluctuating economy.
This article will cover popular retirement plan options for small business owners, the tax advantages of each plan, and what type of businesses are good fits for these plans.
1. Traditional IRA
Let’s start off with a traditional IRA, a tax-deferred savings account. This means that by investing in a traditional IRA the interest, capital gains, and dividends can be compounded tax-free until withdrawal. Traditional IRA owners just hold off the tax payment of their account until they take the money amount.
There are two varieties of this IRA: deductible and nondeductible.
A deductible IRA lowers your taxable income by allowing you to deduct your contributions from your income on your tax return.
A less preferred option, a nondeductible IRA, is funded with after-tax dollars. You cannot deduct contributions on your tax return.
Thus, the primary tax advantage of a traditional IRA is that it allows an individual to make annual tax-deductible contributions to their retirement fund, however, the withdrawal will still be taxed.
A traditional IRA option is typically best for individuals that do not have a retirement plan with their current employer, or who have already maxed out their 401(k) plan with a previous employer. A 401(k) is a company-sponsored pension plan that deducts money from an employee’s payroll and places it into their 401(k).
In 2020, the IRA contribution limit for a traditional IRA is the same as a Roth IRA:
- $6,000 ($7,000 if you’re age 50 or older)
- Your taxable compensation for the year, if less than $6,000.
2. Roth IRA
Alternatively to a traditional IRA’s tax advantage, a Roth IRA allows individuals to grow their tax deducted contributions without being taxed upon withdrawal. The money you contribute to this account has already been taxed by your employer. This means your employer already deducted from your compensation to pay for your FICA, Medicare, and Social Security taxes. Thus, allowing you to fund your Roth IRA through tax deducted contributions.
Additionally, since a Roth IRA is an individual retirement account, it is not necessary to have an employer deducting taxes from your annual compensation. Any paycheck provider, such as Paychex, can automatically collect tax deductions from you or the business owner. Then you can contribute to the retirement account once you receive your paycheck.
As referenced earlier, the contribution limit is $6,000 and $7,000 if you’re age 50 or older.
An advantage of holding a Roth IRA is that you have the opportunity to withdraw anytime after holding money in the account for at least five years, known as the Five Year Roth Rule. After you have held the plan for at least 5 years or reached the age of 59 1/2, you can only withdraw contributions tax-free with no penalties.
Since Roth IRAs have compounded interest, meaning the initial investment keeps growing, it is a great option for younger individuals that can see their money grow throughout the years.
Basically, the tax advantage of a traditional IRA is that your contributions are tax-deductible in the year they are made. The tax advantage of a Roth IRA is that your withdrawals are not taxed.
A SEP-IRA, also known as a simplified employee pension, is common amongst sole proprietors or small businesses with 1-4 employees. If the business owner plans to open a SEP IRA then only they are able to contribute to the retirement account, but the amount their employees want to contribute must be matched by the business owner’s amount. Business owners can also choose to opt-out of contributing into the SEP-IRA if business expenses are too high.
In 2020, the contribution limits for employees is 25% of their annual compensation or $56,000, whichever is less. There is no catch-up contribution. Catch-up contributions are contributions made to the retirement account after the age of 50 to ensure these individuals have enough in their savings account. Compared to the SIMPLE-IRA, which will be mentioned later, a SEP-IRA has a larger contribution limit since there are fewer employees.
Since retirement planning for employees can be a hassle, SEP IRAs are allowed to exclude workers who are part-time, those under age 21, and those who have not worked for the employer in at least two of the last five years.
A tax advantage is those deductible contributions reduce your tax bite. You may take a federal deduction equal to the number of their employer contributions or 20% of net earnings after expenses if you are self-employed. Additionally, all the money contributed to the SEP-IRA can grow tax-deferred in the account.
If you are a self-employed business owner or have a few employees, this is a great option for you as your contribution limit is higher than a traditional or Roth IRA and the profit-sharing aspect of it is beneficial for your employees.
4. Solo 401(k)
Another popular option amongst business owners is a Solo 401(k). Compared to the SEP-IRA, a Solo 401(k) is a newer and refined option for sole proprietor business owners.
Unlike a SEP-IRA plan, Solo 401(k)s allow participants to make an employee contribution in addition to profit-sharing contribution. A sole proprietor can contribute up to $57,000 in employer contribution and $19,500 in employee contributions into the plan for 2020. Furthermore, unlike the SEP-IRA, Solo 401(k)s allow individuals who are 50 years or older to contribute an additional $6,500 for 2020 as catch-up contributions, in addition to their $57,000 contribution limit.
In addition to holding a Solo 401(k), these investors can also open a Roth IRA account, and accrue a substantial tax-free withdrawal after a couple of years. Some business owners choose to go with a solo Roth 401(k), which has the same tax treatment of a Roth IRA. If your income and tax rate are lower now than you expect them to be in retirement then this option could be worth looking into.
The tax advantage of a Solo 401(k) is that it allows pre-tax contributions like an employer offered 401(k), and distributions after the age of 59 1/2 years are taxed.
A Solo 401(k) is designed specifically for sole proprietors. Since these small business owners have no employees to contribute to the account, they can use their spouse as an “employee” in order to utilize the generous contribution limit and the catch-up contribution, if eligible. This doubles what you can save as a couple and business.
5. Defined Benefit Plan
This defined benefit plan guarantees income after retirement, which is calculated by how many years the employee has worked and their salary. Furthermore, the contribution limit is calculated based on your retirement benefits, your age, and expected investment returns.
This plan’s tax advantage allows for contributions to be tax-deductible, but distributions will be taxed based on income. Usually, that amount needs calculating from an actuary, especially if there are multiple employees working for you. Due to the complexities of calculating the amount you will expect in retirement, many employees prefer a defined contribution plan, also known as a 401(k).
Since the plan is typically based on a fixed formula that varies per person, it becomes expensive to cover actuary and administrative costs trying to set this plan up for every individual.
A defined benefit plan is the best option for individuals that have a stable source of high income that they want to be saved in large amounts as they are approaching retirement. This plan is not good for small businesses with more than one employee as it carries high administrative costs, annual fees, and a penalty if one were to adjust how much money they want to place in this account in a year.
6. SIMPLE IRA
A Savings Incentive Match Plan for Employees Individual Retirement Account, also known as a SIMPLE IRA, is a tax-deferred retirement plan that is mostly used by small businesses with a good amount of employees, typically in the 50-99 range.
In 2020, the contribution limit is $13,500 and there is a catch-up contribution option of $3,000 if an individual is 50 or older. As mentioned in the SEP-IRA section, there is a lower contribution limit for employees due to the large size of the business they work in. However, these contribution limits are still higher than traditional IRAs.
A SIMPLE IRA’s tax advantage is that contributions are tax-deductible and distributions in retirement are taxed. These contributions to employee accounts are deductible as a business expense. According to the IRS, employers are required to annually contribute money for each employee by either matching up to 3% of compensation or making a 2% nonelective contribution. In 2020, the compensation limit for factoring contributions is $285,000.
Comparatively to the defined benefit plan, a SIMPLE IRA has few administration costs and is an effective way for businesses with a substantial amount of employees to provide retirement options. Since employees are paid various salaries in these larger businesses, there is a nondiscrimination testing policy attached to this retirement plan. This means that no matter if an employee is paid significantly higher than their coworkers, they are still required to stay within the contribution rate defined by individuals with lower salaries.
A SIMPLE IRA is the best option for business owners of larger-sized companies, due to the perks it provides its employees and the low administrative cost that goes with it. However, it is important to note that business owners need to be aware that if many employees are on board with this retirement plan, that means the employer needs to make mandatory contributions to match their accounts.
As a business owner, it is important to not only care for your own future but to also genuinely think about the future of your employees. Being aware of your circumstances and what type of savings you are comfortable storing is essential for deciding which retirement plan is best for you.
Getting information through the Internet about “popular retirement options for business owners” is the right step towards securing a safe financial future. It is highly recommended that contacting and speaking with a financial advisor can be helpful to ease your mind from the stress that comes with organizing small business retirement plans.
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