Explained in Any Niches: Retirement Savings Plans for Small Business Owners

What Is a Retirement Savings Plan?

A retirement savings plan is a high-earning, long-term account designed to help you prepare for your later years. Even though you can open a retirement account at time, we suggest doing it today in order to maximize your earnings. Once opened, you can contribute a portion of your taxable salary up to the annual limit set by the IRS. With some plans, you can select to receive a tax break now or during retirement.

Popular retirement savings plans for small business owners include:

• Solo 410(k)
• SEP IRA
• SIMPLE IRA

There are several retirement savings plans for the self-employed, all of which allow a heftier contribution than a traditional IRA. For example, the contribution limit for a traditional IRA in 2022 is $6,000 versus up to $61,000 for a solo 401(k). Some accounts even allow a “catch-up” option for those who are age 50 or older. We’ll go into detail below, but feel free to reach out to a retirement advisor for extra assistance.

What Is a Solo 401(k) Account?

Small business owners and independent contractors without staff are the target demographic for this plan. This isn’t the right strategy for you if you have full-time employees. However, you might also include your spouse (details below). As long as you provide an employment identification number, this plan does not have any age or income restrictions.

How Does a Solo 401(k) Work?

With the solo 401(k), you’re treated as both an employer and an employee of your business. Here’s what this means:

Employee: You can contribute up to 100% of your compensation (referred to as “earned income” for self-employed individuals). The contribution limit is $20,500 in 2022, or $27,000 if you’re 50 or older.

Employer: In addition to the employee contribution above, you can make an additional 25% profit-sharing contribution based on your net self-employment income. To calculate this, you take your net profit then minus half the self-employment tax and the plan contributions you made as an “employee.” If your business is an S- or C-corporation, then simply calculate 25% of your W-2 earnings.

Your total contributions can’t exceed the limit set for any particular year ($61,000 for 2022, or $67,500 if 50+). Furthermore, the limit applies to each person, not the individual plan. So if you’re paying into another company’s 401(k) plan, you’ll need to adjust your solo 401(k)’s contributions accordingly.

Your spouse needs to earn money from your business in order to be included in this plan. If so, they can also contribute up to 100% of their earnings. Additionally, you can make a 25% profit-sharing contribution on their behalf.

Many online brokers will assist you with opening a solo 401(k). Once your account’s balance reaches $250,000, you’re required to submit annual paperwork to the IRS. However, you don’t need to make a contribution every year.

The Solo 401(k) and Tax Deductions

You have the choice to do a traditional solo 401(k) or a Roth solo 401(k). Here’s a quick look at the differences:

Traditional: Your total contributions will reduce your income in the year they are made. As a result, your retirement distributions will be taxed as income.

Roth: Your yearly contribution will offer no immediate tax break, but you’ll be able to enjoy tax-free distributions in retirement.

Not sure which to choose? Generally speaking, a Roth account is better if you anticipate high income in retirement. However, if you think your income will drop significantly in retirement, most recommend the traditional 401(k) to take advantage of the tax break now.

One thing to keep in mind is that the IRS imposes strict penalties to early distributions made before the age of 59.5, regardless of whether the solo 401(k) is traditional or Roth.

What Is a SEP IRA?

SEP IRA stands for Simplified Employee Pension and Individual Retirement Account. The SEP IRA takes the concept of the traditional IRA and stretches it to fit the needs of freelancers, small-business owners, and self-employed individuals. However, unlike the solo 401(k), this plan doesn’t offer a catch-up contribution for anyone age 50 or older.

This is an ideal choice for those who want a simple and easy plan that doesn’t require a yearly contribution. You can also have a SEP IRA in addition to your employer’s 401(k) plan, which is a great way to stash away extra self-employment income. However, this is not an ideal choice for those with more than a few employees since you’re required to offer the same contribution to everyone on your team.

How Does a SEP IRA Work?

You can contribute up to $61,000 or 25% of your compensation per year, whichever amount is less. If you’re self-employed, you calculate the 25% based on your net earnings.

The main downside is that the employer (you!) is required to contribute equally to every eligible employee in your company. And guess what? You’re considered an employee too! So if you want to contribute 10% of your salary to this plan, you also need to contribute 10% to everyone else.

The SEP IRA and Tax Deductions

There is no Roth option with this plan. This means that every year’s contribution is deducted from your tax return, which is great for right now. But come retirement time, you’ll be taxed on your distribution. It’s not a big deal if you envision a lower income in retirement. However, if you expect your income to increase significantly in retirement, we suggest considering another plan.

What Is a SIMPLE IRA?

The name SIMPLE makes you think this plan is super basic and easy. Well, it is, but the name actually stands for Savings Incentive Match Plan for Employees. This plan is geared toward small businesses with up to 100 employees. So if you’re a one-person band, this option isn’t for you! The contribution limit is much lower than the other plans we’ve discussed—$14,000 in 2022, $17,000 if 50 or older—but it comes with a smaller burden as the employer.

How Does a SIMPLE IRA Work?

This plan differs from the SEP IRA in the fact that the employee determines how much they want to contribute. Your responsibility as the employer is to establish a mandatory employer contribution. You have two methods to consider:

Matching: Provide a matching contribution of up to 3% of the employee’s pay. There is no annual salary limit with this option.

Fixed: Provide a fixed contribution of 2% to every eligible employee’s compensation, regardless of how much they contribute individually. The maximum salary cap is $305,000 in 2022.

The individual contribution limit is set at $14,000 for 2022, with an additional catch-up contribution of $3,000 for age 50 and older. If you also contribute to another employer’s 401(k) plan, your total contributions can’t exceed $20,500 for 2022.

You can open a SIMPLE IRA plan with most online brokers. The paperwork is more involved than a standard IRA, but your broker will help guide you.

The SIMPLE IRA and Tax Deductions

Every individual’s contribution is deductible for the year they made the contribution. As a result, the distributions in retirement are taxed. There is no Roth version for this account.

As an employer, you can deduct all matched or fixed contributions as a business expense. This will help reduce your overall tax liability.

Comparing a 401(k) vs. SEP IRA vs. Simple IRA: Which is right for you?

Picking the right plan all comes down to the size of your business, your long-term savings goals, and your anticipated income during retirement. Let’s break it down.

Solo 401(k) — Best for reaching your maximum savings goals

Even though the solo 401(k) looks similar to the SEP IRA, you have the catch-up option with the former to save an additional $6,500 per year if you’re 50 or older. The SEP IRA only allows 25% of your net earnings, whereas the solo allows 100% plus an additional 25% profit-sharing contribution. Basically, the solo 401(k) allows you to reach the maximum limit faster. The solo plan also offers a Roth option, which is a plus if you want to enjoy tax-free distributions later in life.

The downside is that the solo 401(k) doesn’t allow any employees (except for your spouse), which ultimately limits your business’s potential for growth and expansion.

SEP IRA — Best for a regular job and self-employment

This is an ideal choice if you have a 401(k) plan through another employer and a freelance business on the side. Yes, you can have a traditional 401(k) and a SEP IRA and hit the max of both.

The downside is that you have to offer identical contributions to all employees in your company. This can become costly if you decide to grow your business.

SIMPLE IRA — Best for having multiple employees

The other two plans aren’t suited for accommodating employees, especially if you have more than a few on deck. The SIMPLE IRA is basically a scaled-down version of a traditional 401(k) plan. In the end, it won’t break your bank by matching employees’ contributions.

The downside is that it’s not equipped to reach your maximum savings goals, with a significantly lower contribution limit than the other two plans.

Retirement Savings Plans for Small Businesses: Think About the Big Picture

Picking a retirement plan is no easy feat. The options can be overwhelming, and it’s hard to know where to get started. However, it’s important to pick something so you’re well-prepared for retirement.

Write down your goals.

• Do you want to max out the savings limits for yourself and enjoy a tax-free retirement? Then go with the solo 401(k) Roth.
• Do you want to entice future employees with a robust matching plan? Then go with the SIMPLE IRA plan.
• Do you want to stash away your freelancer cash while also building up your 401(k) account? Then the SEP IRA is just for you.

In order to better understand your unique goals, we ultimately advise speaking with a financial expert. Although no plan is perfect, we’re sure you can locate the best retirement savings plan for your small business with enough time and research.