In this article:
- Traditional & Roth IRAs
- SEP IRA
- Simple IRA
- 401K & Self-employed 401K
- Keogh Plans
Running your own business or being self-employed definitely has its perks—choosing your hours, choosing who you want to work with and where you want to work, and being responsible only to you. But this also means that you’re responsible for your own benefits packages, such as retirement plans.
When it comes to planning ahead, you need to decide whether or not a retirement plan is a good option for you and what options are available. Throughout this article, we’ll go over several types of retirement plans for business owners and self-employed individuals so you can make an informed decision about which is best for you.
Please note: This article is for informational purposes only. Solo does not assume any liability for the accuracy of this information. Consult a licensed, qualified retirement investment broker and/or financial advisor.
What’s the best retirement plan option for small business owners or self-employed individuals?
As you are looking into retirement plans for yourself, you should become familiar with the different options that are available in order to make the best decision for your situation. First, it’s good to have an idea of how much money you’ll need to retire comfortably. Use this retirement calculator to determine that amount.
Once you’ve determined how much retirement income you’ll need, let’s go over several types of retirement plans that can help you reach that goal.
Traditional or Roth IRA
An individual retirement account, or IRA, is a retirement savings account offered by financial institutions, and it is generally tax-free. IRA’s are an investment that grows over time. You can choose how involved you want to be in these investments and based on that, pick a provider through which to invest your money and start your IRA.
The main difference between a traditional IRA and Roth IRA is when you want to take advantage of the tax deduction.
With a traditional IRA you can deduct contributions to your IRA from your business taxes and you won’t owe any income taxes on your IRA contributions or earned interest until you withdraw the funds. If you are in a lower tax bracket when you retire, this could be a great advantage of this type of IRA.
Roth IRAs are the other way around: you don’t pay taxes on the money when you withdraw it in retirement, but you can’t deduct contributions to a Roth IRA from your annual business taxes. In other words, you are contributing Roth funds “after taxes.” Additionally, any earnings your Roth account makes grow tax-free, subject to certain limitations, while traditional IRAs’ earnings are tax-deferred until you start withdrawing your funds at retirement.
There are also contribution limits for traditional and Roth IRAs, so it’s important to be aware of what that limit is each year. If you are wanting to put away more than the annual contribution limit for these types of plans, then you may want to look at other options.
The contribution limit for 2020 and 2019 for traditional and Roth IRAs is $6,000 ($7,000 if you are over age 50).
With a traditional or Roth IRA, you must wait until you are a certain age (or meet specific exceptions) before you can withdraw your retirement funds. The current age is 59½, so if you are planning on retiring before then, you may want some additional funds to get you through to that time.
One more thing to keep in mind when deciding between traditional and Roth IRAs: anyone with earned income can contribute to a traditional IRA, up to age 70.5. However, Roth IRAs have a limit on modified adjusted gross income if you want to contribute. In 2019 you couldn’t choose a Roth IRA if you earned more than $122,000 if single, or $193,000 if married filing jointly.
A “simplified employee pension,” or SEP IRA, is a good choice for a retirement account for business owners and self-employed individuals. You can deduct your annual contributions from your business taxes and your taxes are deferred on your retirement savings until you withdraw it as income.
Important note: If you have employees that are eligible for the SEP IRA (they are at least 21 years of age, have worked for you for at least 3 of the last 5 years, and have been compensated more than $600 each year), then you must contribute to their IRA accounts at the same rate that you contribute to your own. For example, if you are contributing 10% of your income to your SEP account, then you must contribute 10% of your employees’ income into their SEP account. Because of this, a SEP IRA is best suited for self-employed individuals or those who have few or zero employees.
One reason that SEP IRAs are appealing is that they allow a significantly larger contribution limit than traditional and Roth IRAs. The contribution limit for 2020 is $57,000. However, one thing to be aware of is that that you cannot contribute more than 25% of your compensation. So if you earn a more modest salary, you may not be able to max out that $57,000 annual contribution limit.
SIMPLE IRAs are generally offered by companies with 100 or fewer employees. This allows you to offer your employees the same retirement plan that you have for yourself. If you don’t have many employees, this option probably isn’t the one for you.
SIMPLE is an acronym for “Savings Incentive Match Plan for Employees.” With a Simple IRA, employers must contribute to their employees’ accounts based on set requirements from the IRS. A Simple IRA also allows employees (and you, as an employee of your own company) to choose the amount that they want to contribute, up to $13,500 in 2020.
The contributions to each employee’s (and your own) account will reduce the taxable income for the year and income taxes on this account won’t apply until it is withdrawn.
401K & Self-employed 401K
A 401(k) is similar to IRAs in that you set aside money into a retirement plan for investments. The major differences between 401Ks and IRAs are the contribution limits and when you can pull out your retirement funds.
The 2020 annual contribution limit for a 401K is $19,500 for employees. If you have a self-employed 401K, you can contribute as the employer and as an employee of your own company, meaning that you can contribute $19,500 as an employee and then as an employer contribute 25% of your earnings, up to $57,000.
The second major difference between 401Ks and IRAs is the conditions surrounding when you can withdraw your retirement funds. Under an IRA, you can pull your retirement savings at any time, with the caveat that you’ll face a 10% tax penalty if you pull them before age 59½.
With many 401K and self-employed 401K plans, you must meet one of the following requirements if you need to access your retirement funds before age 59½:
- Retire from or leave your job
- Die or become disabled
- Experience certain hardships (outlined by the plan)
- The plan gets terminated
If your plan allows early withdrawal under the above or other circumstances prior to age 59½ you will be subject to the 10% tax penalty, in addition to paying your standard income tax rate on the funds. This can be a healthy chunk, so think very carefully before you try to withdraw 401K funds.
Note: Some 401(k) plans allow for “hardship distributions” where you can use a portion of your savings for medical or funeral expenses (among others) under certain conditions, without facing an early withdrawal penalty. So be sure to discuss these options with your investment counselor.
Keogh plans were created for self-employed business owners and unincorporated businesses to offer their employees and owners retirement benefits. Independent contractors do not qualify for a Keogh plan.
Keogh plans fall into two categories: defined benefits plans and defined contribution plans.
A defined benefits plan uses a formula to calculate a predetermined amount for the employee’s contributions. Generally, this will take into account the employee’s time with the company and their annual earnings. Due to the formula and variations between employees, this method can become more complicated than other retirement options.
Defined contribution plans are basically 401Ks. They specify an exact amount of funds that can be placed into an employee’s account and have the same allowances and tax requirements as a 401K.
As you can see, you have several options for starting a retirement plan. You just need to decide which option is best for you as a business owner and your employees (if you have any). Once you’ve come to that decision, find a local provider that can help you get your retirement accounts set up.
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