Many small business owners are too focused on simply keeping their enterprise afloat to worry about their eventual retirement. But retirement planning is as much an imperative for the self-employed as it is for every cubicle jockey with an automatic 401(k).
The recently passed tax reform bill provided several benefits for sole proprietors and other small business owners. But paradoxically, the law made it less advantageous for some to save for retirement, by reducing the tax incentives to put money away. Cutting the tax rates for pass-through businesses means the tax deductions for funding retirement plans aren’t quite as beneficial as they used to be.
That shouldn’t keep small business owners or sole proprietors from taking the long view. Here are some steps these clients can take right now to help ensure their long-term health:
SEP stands for Simplified Employee Pension, and they are indeed simple, able to be set up on a single-page form. They allow the self-employed to contribute a tax-deductible amount of up to 25 percent of their net earnings from self-employment to a limit of $55,000, into a traditional IRA.
The biggest advantage of a SEP IRA is that increased contribution limit, which blows past the traditional IRA limit of $6,500 for those age 60 and older. Another benefit: They can be set up as late as the due date for your income tax return for that year.
The SIMPLE IRA (for Savings Incentive Match Plan for Employees of Small Employers) is a bit more complicated. It’s generally only available to small businesses with no more than 100 employees earning at least $5000 a year. There is no percentage limit on the contributions, although it’s capped at $12,500 for 2018, plus an additional $3,000 if you're 50 or older.
While the SEP-IRA is funded solely by the employee’s contributions, with a SIMPLE, the employer is required to contribute. It can be either a matching contribution up to 3 percent of the employee’s compensation, or a 2 percent nonelective contribution for each eligible employee. But all employer contributions are tax-deductible.
The 100-employee limit means that if your business is poised to grow beyond that, you’ll need to switch retirement plans at that point. Unlike a defined benefit plan, employers cannot offer another type of retirement plan at the same time they’re offering a SIMPLE IRA.
A solo 401(k) is an option available to sole proprietors and the self-employed. Because you’re both employer and employee, you can make double contributions: The employee can contribute up to $18,000 for the year (plus up to $6,000 in catch-up contributions if you’re over 50), and the employer can contribute up to 25 percent of the business’s total earnings. The employer contributions are also deductible as a business expense.
As with a traditional 401(k), your contributions are pre-tax, and you pay tax on withdrawals. You can put in as much, up to the limit, or as little as you want from year to year.
Defined Benefit Plans
Small businesses still have access to traditional pension plans, which offer a set annual benefit at retirement, usually based on salary and years of service. The annual contribution is calculated by an actuary based on the benefit you set and other factors, such as the employee’s age. The maximum annual benefit can be as much as $220,000.
In part because of those factors, though, defined benefit plans can be expensive and cumbersome to administer. The business is legally required have an actuary handle the funding levels and fill out the paperwork for the IRS.
Traditional and Roth IRAs
Traditional and Roth IRAs are available to anyone, self-employed or not. The basic difference between the two: With traditional IRAs, you put away money tax-free and pay taxes on it when you withdraw it in retirement. With a Roth, the contributions aren’t tax-free, but the withdrawals are. But funding a full retirement with one can be tough. Contributions are limited to $6,500 per year for those 50 or older ($5,500 of you are younger), and those married couples with combined incomes over $199,000 can’t contribute to a Roth at all.
It’s worth noting that these plans have lost some flexibility recently. While you used to be able to switch from a Roth to a traditional and back again, the new tax law took that option away. From now on, there’s only one switch permitted.
Each of these plans has its own nuances and benefits. Transamerica has a dedicated team of experts that can help you determine which plan is best for your clients. Please give us a call at 888-401-5826 for more information.
Neither Transamerica nor its agents or representatives may provide tax, investment or legal advice. Anyone to whom this material is promoted, marketed, or recommended should consult with and rely on their own independent tax and legal advisors and financial professional regarding their particular situation and the concepts presented herein.
Things to Consider
- Find the retirement plan that’s right for your small business.
- Learn about the retirement options you have as a self-employed person.
- Learn how the recent tax law affected retirement options for the self-employed.