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Retirement Plan Options for Small Business Owners

I have been working with a number of small business owners who are looking to save for retirement.  Many times, they are working so hard and are so busy with life, that they do not set up a retirement plan for themselves or their employees.  There are a few options out there to consider, and it is important to understand the choices, since it is not a "one size fits all" solution.

The individual 401K is only available to self employed or small business owners with no employees, or only a spouse that is also an employee.  This is a great plan for someone who wants to save a great deal of money in some years, but does not want to have to contribute to  the 401K plan every year.  Sometimes there are fluctuations in business income that would not allow for contributions to be made in certain years.  This plan is pretty easy to administer, but does require that you file a Form 5500 when your assets reach or exceed $250,000.  It is important to note that the individual 401K must be established by December 31 or your fiscal year end, whichever occurs first.  Salary deferrals must be made by the end of the business year.  Profit sharing contributions are due by the business's tax filing date, plus any extensions.  The contribution limit is $57,000 for 2020, and $58,000 for 2021.  Profit sharing contributions can be made up to 25% of net self employment income up to a maximum of the above limits, but the limit on compensation to be used in the calculation is $285,000.  Salary deferrals are limited to $19,500 for years 2020 and 2021.  

Another retirement plan available for small business owners is known as the SEP plan.  Self employed or small business owners with no or few employees can utilize this option. This plan differs from the individual 401K in that it is only funded by employer contributions. There is no employee salary deferral, contributions do not have to be funded annually and full vesting is immediate. If you have employees and and contribute for yourself, you must contribute for all eligible employees including those who have terminated throughout the year. Maximum contribution limits are the lower of $57,000 in 2020 or $58,000 in 2021 or up to to 25% of net self employment earnings or compensation limited to a cap of $285,000 per employee in 2020. This plan must be established by the tax filing deadline of the business in order to contribute for that tax year.  Contributions can be made until the employer's actual tax filing deadline including any extensions.  SEP plans are easy to set up and maintain.  You can make sizable contributions for yourself and eligible employees.  Tax filing is not required, and you can vary contributions from year to year or even skip a year. This type of plan is good for business owners that do not mind contributing for all employees and who desire a low administrative burden since they require limited paperwork and no annual reporting to the IRS.

SIMPLE IRA's are an option for businesses that have 100 or fewer employees and that have this as the only retirement plan that they fund. One requirement is that the plan must include all employees age 21 and up if they received at least $5,000 in compensation during any prior two years and if you reasonably expect that they will receive at least $5,000 this year. Early withdrawals from this plan cause negative tax consequences. If you withdraw funds within the first two years of being enrolled in this plan, you are subject to a 25% early withdrawal penalty as opposed to a 10% penalty for withdrawals in any of the other plans.  SIMPLE IRA's are funded with contributions deducted from employee's salaries, as well as annual employer contributions.  Each eligible employee decides whether or not to participate and how much to contribute, but employer contributions are mandatory. The non-elective contribution option requires that you contribute 2% of each employee's eligible compensation up to a maximum of $5,700 for tax year 2020 and $5,800 for tax year 2021.  Employees can contribute up to 100% of compensation, or a maximum of $13,500 for 2020 and 2021.  If you also contribute to another plan, the total of all contributions cannot exceed $19,500.  The compensation limit for factoring contributions is $285,000. New plans must be established by October 1.  Employer contributions must be made annually by the employer's tax filing deadline, including extensions. Employee contributions are deducted from employee wages, and must be deposited at least monthly.  SIMPLE IRA's are best for larger businesses with up to 100 employees.  They have low administrative burden on the employer, but can be expensive due to the required matching or 2% non-elective contributions that are required to by made each year. The SIMPLE contribution limits for the employee are significantly lower than the other plans, and the employer cannot maintain any other type of retirement plan if they also offer the SIMPLE IRA.

Each of these plans has different advantages and disadvantages, and it is important to choose the right plan for your business.  The most important thing is to start saving early for retirement, and if you own your own business, establishing the right retirement plan is so important.  For some, the most important factor is the ease of administration, and other clients want to be able to contribute the largest amount to their retirement account.  It is best to consult with a financial advisor that understands your financial goals and your business to help you make the right choices when establishing your retirement plan. 

About the Author

Patti Hughes is a Chicago Fee-Only Financial Planner.  Lake Life Wealth Advisory Group provides comprehensive and objective financial planning, retirement planning, and investment management to help clients organize, grow and protect their assets through life’s transitions.  She is a fiduciary, and does not sell products or earn commissions, so she truly acts in the best interests of her clients.