Frequently Asked Questions: What Types of Employer-Sponsored Retirement Plans are Available for the Self-Employed Individual?
by Bill Gallagher, CFP®, MPAS®
Many small business owners are so engrossed with running their company on a day-to-day basis that they neglect to save for retirement. This is not because they don’t think saving for retirement is important, but rather, they have so much on their plate that they tend to put it on the back burner. While establishing a retirement plan for their company has the obvious benefit of saving for retirement, it can also provide for some tax savings (either at the personal level or company level). Below are three of the most popular retirement plans that small business owners utilize for their retirement savings:
Simplified Employee Pension Plan (SEP-IRA)
A SEP IRA is a Traditional IRA, but for self-employed individuals and small business owners. Contributions made to a SEP IRA are tax-deductible and the investments grow tax deferred. When distributions begin in retirement they will be taxed as ordinary income in the year distributed. Please note, any money distributed prior to age 59 ½ may be subject to the 10% IRS early withdrawal penalty. The major advantage of SEP IRAs over Traditional IRAs is the amount a self-employed individual can contribute. In 2022, individuals are limited to a $6,000 annual contribution ($7,000 if they are age 50 and over) to their Traditional IRA. However, establishing a SEP IRA will allow the business owner to contribute up to 25% of their net self-employment income, not to exceed $61,000.
SEP IRAs are flexible, easy to establish, and involve minimal disclosure and reporting requirements. Contributions can be made in different amounts from year to year and can be made up to the tax filing deadline for the previous year (or later if you file an extension). SEP IRAs are a great fit for a business owner who has no, or few, employees. If the business has employees, and the owner decides to contribute to his/her own SEP IRA, then the owner is required to contribute to the employee’s SEP IRA on their behalf if the employee is age 21 or older, has worked for the business for at least three of the past five years, and received a minimum of $650 in 2022. If an employee has met these requirements, then the owner must make the same contribution, as a percentage of salary, to the employee’s SEP IRA.
Savings Incentive Match Plan for Employees (SIMPLE IRA)
The SIMPLE IRA is a retirement savings plan that is tailored to the needs of small business owners who have less than 100 employees. One of the great features of this plan is the ability for the employees to make contributions to their own account so that they can save for their own retirement. This contrasts with the SEP IRA, where all the contributions are made by the employer. The maximum amount the employee can contribute to his/her SIMPLE IRA is $14,000 (in 2022). If the employee is age 50 and over, then they can contribute an additional $3,000 (in 2022). An eligible employee will also be able to receive a company contribution (via a match) into their SIMPLE IRA. This contribution will not only help encourage participation in the plan but can also help boost the employee’s retirement savings. There are two options the company has when it comes to making contributions to their employees’ accounts. The first formula is a dollar-for-dollar match, up to 3% of the employee’s compensation. The other option is for the company to make a non-elective contribution equal to 2% of each employee’s compensation, regardless of whether the employee elects to make contributions.
Like the SEP IRA, SIMPLE IRAs plans offer low start-up and annual costs. In addition, eligibility requirements for employees are low. An employee is eligible to participate in a SIMPLE IRA if they received at least $5,000 in compensation during any of the two preceding calendar years and expect to earn at least that much during the calendar year of participation.
The Solo 401(k) is designed for the business owner who does not have employees (or whose only employee is their spouse). One of the great features of a Solo 401(k) plan is the ability for the business owner to make contributions to his/her plan in addition to receiving a contribution from the company (in the form of a profit-sharing contribution). As an “employee” of the business, the owner can contribute up to $20,500 (in 2022). Those age 50 and over can contribute an additional $6,500 (in 2022) to their Solo 401(k). In addition, as the “employer,” you can make a profit-sharing contribution up to 25% of compensation. However, it is important to note that total contributions to the plan (employee plus employer) cannot exceed $61,000 (or $67,500 for those over age 50) in 2022.
While a Solo 401(k) is flexible in its design, it is not as easy to maintain as a SEP IRA or SIMPLE IRA. For example, the plan must be established by December 31, there are reporting requirements (IRS Form 5500 must be filed every year when the plan balance reaches $250,000), and the IRS requires that contributions be “recurring and substantial” in order for the plan to remain active. However, unlike a SEP IRA and SIMPLE IRA, the owner can add a Roth feature to his/her Solo 401(k). This would allow him/her to make post-tax “employee” contributions to the plan, providing for tax-free growth and income in retirement.
Installing a retirement plan for your company can be a great way to maximize your retirement savings on a tax-favored basis. However, since you are both the employee and the employer, and since contribution limits change on an annual basis, you should have a conversation with your financial advisor and tax professional so they can help choose the right plan for your particular company, based upon your personal goals and objectives.