Running a small business or being self-employed can offer flexibility, freedom and control over your earning potential. While the perks are plentiful, there’s one thing that’s usually missing when you own a small business: an employer-sponsored retirement plan.
Self-employed people don’t have 401Ks, and small business owners tend not offer them, citing the time and cost to set up and administer them. The good news is there are several other retirement plan options available to small business owners. If you have yet to begin saving for retirement as an entrepreneur, here’s how you can change that.
The Simplified Employee Pension (SEP) IRA is an excellent choice for the sole proprietor who wants to save for retirement with a minimum of administrative headache. Unlike the Solo 401K, a SEP IRA can cover employees, thus allowing greater scope for business growth. The plan is easy to setup and maintain, and there are no setup fees or annual charges.
These plans are completely employer funded, and employees make no contributions. For 2020, the employer can contribute up to 25% of compensation to a maximum of $56,000. Note though, that a SEP can become expensive if you want to save aggressively. While you as an employer are not required to make a contribution every year, you must contribute the same percentage for employees that you contribute for yourself.
The Savings Incentive Match Plan (SIMPLE) IRA allows businesses with fewer than 100 employees to establish an IRA for each employee. Employees are allowed to make salary deferral contributions of up to 100% of compensation, or no more than $13,000 in 2020. Employees over the age of 50 may also make a $3,000 catch-up contribution for a total of $16,000.
The employer also contributes to the account, either matching employee contributions dollar-for-dollar up to 3% of compensation, or contributing 2% of each employee’s compensation. Advantages to this option include easy setup and few administrative burdens.
The contribution limits for a SIMPLE IRA plan are also more generous than those allowed for the traditional or Roth IRA. However, contributions to this account are considered “elective deferrals” that count toward an individual’s overall annual limit on elective deferrals.
For a sole proprietor, a Roth IRA can be used to supplement retirement savings, provided that income falls under the ceiling of eligibility. It’s possible, for example, to fund a SEP or SIMPLE IRA and a Roth IRA.
Contributions to the Roth IRA are made from after-tax income, and therefore assets held within the account grow tax free. Distributions are tax-free as well. The big drawback to the Roth IRA is that it’s limited on the basis of income and thus not accessible to high earners. Contributions to the Roth IRA phase out completely for single filers at an annual income of $133,000, and for joint filers at an annual income of $196,000. Annual contributions are capped at $5,500, or $6,500 for individuals over 50.