Remember Retirement When You Run Your Small Business
By David J. Haas CFP® March 31, 2021
There’s an old saying about going into business for yourself: You only have to work half days; the first 12 hours or the second! When you own and run a small business, you work really hard. Once the business is off the ground and you can pay yourself something, it makes it all worthwhile. I know because I own a small business too! Small business owners like me often forget that we also need to save for retirement. You can’t just rely on selling the business someday because there are so many factors that go into its worth. You need to save all along your journey and the good news is that there are many tax-advantaged programs which can help.
IRA and ROTH IRA
These are the simplest tax-advantaged accounts and work whether you own a business or work as an employee. You can save $6000 per year in your own IRA or ROTH IRA every year if you have no other retirement plan. If you are married, you can put another $6000 in a spousal IRA or ROTH IRA. If you or your spouse are over age 50, then the number increases to $7000 per year. If you or your spouse have another retirement plan such as a 401(k) from a job, there are some income limits to be allowed to contribute to these accounts. There is still time to contribute for 2020, since the deadline is the same as the tax-filing deadline which is May 17, 2021 for this year.
Retirement Plans for your business
The rest of the retirement plans are really for your business and have to cover ALL eligible employees. They all have different rules and complexities when you have employees. I will discuss them from the simplest towards the most complex.
SEP stands for Simplified Employee Pension Plan. The plan is basically an IRA account per owner and employee which the employee creates and manages. The business owner is allowed to deposit up to 25% of an employee’s earnings into their SEP account. This type of account is very simple to administer and works best when there are no eligible employees other than the owner because the same percentage has to be used for all employees/owners. The owner can contribute approximately 20% of their net income (reduced from 25% because of self-employment taxes) up to $57,000 for 2020 ($58,000 for 2021). The amount is calculated on your tax return. The deadline for establishing a prior-year SEP or contributing is also the tax filing deadline, so you can make contributions up to May 17 for tax year 2020.
This is a slightly more complex type of retirement plan and is a good one when you have a few employees. Like a 401(k), with a SIMPLE IRA, the employer creates accounts for every employee and owner. In this case, the employee or owner can make their own contributions up to $13,500 (plus extra $3,000 for those over 50). In addition, the employer can make an optional contribution of a percentage of employee earnings and the same percentage has to be used for all employees. SIMPLE IRA plans have to be set up by October 1st of the tax year, although employer contributions may be made up to the tax filing deadline.
Unlike the IRA-based plans above, 401(k) plans are ERISA plans. ERISA is a body of law which strictly governs employer retirement plans and protects employees from abuses. Prior to ERISA, there were cases where employers just stole their employees’ retirement money or never actually deposited the money with the custodian. Because of ERISA, these plans can be complex and they do have costs associated with administration and recordkeeping. But 401(k) plans can be some of the best and most flexible plans for retirement savings for employees and owners. Participants can contribute up to $19,500 per year with an extra $6,500 for those 50 and over. Employers can match or just make employer contributions based on salary percentage. ERISA requires yearly testing to make sure the plan does not discriminate against lower-paid employees and enough of them participate. There are some Safe-harbor rules that exempt plans following certain rules from testing which simplifies administration. Administration costs for small plans can be $1000 to $2000 which is tax deductible or may be passed on to employees. There are some tax credits for the first few years of a plan to encourage companies to adopt these plans. 401(k) plans must be adopted by October 1. Employer matching and contributions can be delayed until just after the end of the plan year.
This is a 401(k) for a very small business with only one owner/employee. It works just like a normal 401(k), but the plan is much simpler to administrate and no complex testing is required. The contribution limits are the same as a normal 401(k). Administration costs may be free or minimal from many providers. A solo 401(k) is a great plan for a highly-profitable solo business because between employee and employer contributions, you can shelter $84,000 of income from taxes in a single year.
The defined-benefit pension is another retirement plan option. These plans use company contributions to define a retirement plan benefit paid to owners/employees when they retire. If your company only has a few employees, but there is a big difference in the earnings and/or age between the employees and the owners, this can be an excellent option. Plans can be designed to really maximize the benefit to the owners and lower the benefit to the employees. But the company requires consistent cash flow because contributions MUST be made every year. Law or medical practices sometimes use DB plans because they tend to have the cash flow and company structure that can make this plan a success.
Many of these plans are tax-deferred. That means contributions are not taxed today, but distributions are taxed later once you retire. Unfortunately, not all states treat these plans well. NJ, where I live, does not allow a tax deduction for IRA contributions. NJ does allow a 401(k) deduction for contributions, so in NJ, a 401(k) is far superior to any kind of IRA. Also, the entire idea of a tax-deferred retirement plan is based on the premise that your taxes will be lower in future years than today. That could be true if you plan to move to a low-tax state and you have significant earnings today. But if you think it won’t be true, you should consider using ROTH plans (either IRA or 401(k)) where contributions are post-tax, but earnings come out tax-free when you retire.
Help from Cereus Financial Advisors
I can help you with any of these types of accounts. We have set up solo as well as multi-employee 401(k) plans. These retirement plans can be used even if you are simply an independent contractor. If you drive for Uber or teach piano lessons, you can set up a small-business retirement plan. Even if your business has employees, you still need to make sure you are saving for retirement. Ask me which plan is best for you and your company. Our website is www.cereusfinancial.com.