Tax Tip Tuesday: Retirement Plans for Businesses

Tax Tip Tuesday

Experts estimate that Americans will need 70 to 90 percent of their preretirement income to maintain their current standard of living when they stop working. Now is the time for business owners and employees to start planning for retirement.

Retirement choices

There are five main choices for the self-employed or small-business owners: an IRA (traditional or Roth), a Solo 401(k), a SIMPLE IRA, a SEP IRA, or a defined benefit plan.

1. Traditional or Roth IRA – An IRA is probably the easiest way for self-employed people to start saving for retirement. There are no special filing requirements, and you can use it whether or not you have employees.  The upside to a Traditional IRA is that your contribution qualifies for a tax deduction.  There is no immediate deduction, however, for a Roth IRA.  But Roth IRA withdrawals in retirement are tax-free.  Please note that the Roth IRA has income limits for eligibility; those who earn too much are not able to contribute.

2. Solo 401(k) – This is the most common account and is ideal for a business owner or self-employed person with no employees (except a spouse, if applicable).  This plan works just like a standard, employer-offered 401(k): The business owner makes contributions pretax, and distributions after age 59½ are taxed.  Keep in mind that the contribution limits apply per person, not per plan — so if you also have outside employment that offers a 401(k), or your spouse does, the contribution limits cover both plans.

One other thing to know: You can also choose a solo Roth 401(k), which mimics the tax treatment of a Roth IRA. Again, you might go with this option if your income and tax rate are lower now than you expect them to be in retirement.

3.  SIMPLE IRA – This is similar to a 401K but has an even simpler plan.  Essentially it has less bells and whistles and slightly lower limits. If you are the owner of a midsize company with fewer than 100 employees, the SIMPLE IRA is a fairly good option, as it is easy to set up and the accounts are owned by the employees. SIMPLE IRA contribution limits are significantly lower than a SEP IRA or Solo 401(k).  Contributions are tax deductible, but distributions in retirement are taxed. Contributions made by the employer to employee accounts are deductible as a business expense.

4. SEP IRA – It works great for a sole-proprietor or small business.  The contribution to this plan if made before the tax deadline can help the business owner save on their 2021 taxes.  SEP stands for Simplified Employee Pension. 

When establishing a SEP IRA, the business owner will determine a percentage of compensation to contribute to the SEP IRA for each employee and for himself.  This works best for when there is just the owner in the business.  The compensation determinant for a sole proprietor is the profit of the business.  The owner can put in up to 25% of the company profit or a maximum of $58,000 for 2021.  The contribution must be made by the due date of the tax return, including extensions.

For example, if a sole proprietor had $40,000 profit for 2021, $10,000 could be put in a SEP IRA AND deduct it as an adjustment to income on their 2021 tax return.  The contribution must be made by April 18.  If filing an extension, the contribution must be made by October 15.   This is a great deduction if a business owner has no employees.  However, if a business owner also has employees, the same percentage amount would need to be contributed for each employee as well.   

5. Defined Benefit Plan – This plan is ideal for a self-employed person with no employees who has a high income and wants to save a lot for retirement on an ongoing basis.  It is essentially a pension for the self-employed — a guaranteed stream of income — in retirement by using a defined benefit plan.  The downside to these plans is that they are expensive, with high setup and annual fees.  And if there are employees, that fee will likely go up, plus you will need to make contributions on their behalf. They carry a heavy administrative burden each year, and they require a commitment to fund the plan with a certain amount per year. If you need to change that amount, there are additional fees.

The upside is that you can stash a lot of cash in these, so if you are fairly close to retirement, earning a high income that you know you will maintain and that allows you to save a significant amount per year — we’re talking $50,000 to $80,000 or more — you might consider using this plan to supercharge your savings efforts.

It is necessary to note that all retirement plans have important tax, business and other implications for employers and employees.  Additional considerations include income level, number of employees, entity structure, and overall long-term goals for the business or family.  Therefore, you should discuss any retirement savings plan that you consider implementing with your accountant or financial advisor.

If you find yourself with more questions than answers, let us help!  Contact us at  Saunders Tax & Accounting, where our clients experience a Less Taxing Life and More Prosperous Solutions.