This is a guest post from Dan Wesley, who is the CEO of CreditLoan.com. If you like what you see here, please consider subscribing to their RSS feed.
Salaried employees generally have an employer-sponsored 401(k) retirement account administered by the company’s HR department. Failing that, many use Individual Retirement Accounts (IRAs) from local banks, credit unions, or brokerages. Some especially conscientious employees use both.
Small business owners tend to likewise be big fans of the IRA, either in Traditional or Roth form. And while these are certainly better than having no retirement plan at all, an IRA is rarely the ideal plan. The self-employed have several retirement options which are both exclusive to them and, often times, more lucrative than the more traditional plans above.
Simple IRAs are ideal for small business owners who wish to set up retirement accounts for their employees. As Bankrate explains, these accounts were established with businesses of “no more than 100 employees who earned $5, 000 or more on the payroll for the previous calendar year” in mind.
Over time, Simple IRAs have become most commonly used by employers with seven or fewer employees. Fortunately, the Simple IRA is extremely easy to set up, requiring just four pages of paperwork and about ten minutes of one’s time. Employers are limited to contributing 3% of an employees pay, up to an $11, 500 yearly contribution limit.
The Solo 401(k)
One rarely discussed advantage of self-employment is the existence of retirement accounts with much higher yearly contribution limits. The Solo 401(k) account is a prime example. SmartMoney explores how Solo 401(k) plans work, explaining that they’re essentially regular 401(k) accounts with much higher contribution limits: up to $49, 000 per year in 2010, depending on age, income and other circumstances.
Putting things in perspective, regular 401(k) and IRA contribution limits top out at $16, 500 and $5, 000 per year (not counting catchup contributions), respectively. It should be noted that Solo 401(k) plans are generally restricted to business owners, rather than employees of the business in question.
The Solo Roth 401(k)
Solo Roth 401(k) plans are similar to regular Solo 401(k) plans, but offer the tax advantages of a Roth IRA. As you may know, Roth IRAs are accounts for which contributions get taxed, but withdrawals (which contain the accumulated savings, interest and investment returns of decades) do not. Moreover, InvestorGuide reveals several key advantages the Solo Roth 401(k) holds over a regular Roth IRA:
- High income earners can contribute to Solo Roth 401(k) accounts even if they’re not eligible for a Roth IRA
- You can contribute much more per year to a Solo Roth 401(k) as compared to a Roth IRA
- You can borrow from your Solo Roth 401(k)
- You can avoid (if you wish) the required minimum distributions of a Roth 401(k) by rolling its funds over to a Roth IRA prior to age 70-1/2, so long as you set up the Roth IRA account five years prior
- You can also maintain a Roth IRA in conjunction with a Solo Roth 401(k), which expands your potential annual contributions even further
The Simplified Employee Pension (SEP) IRA
The Simplified Employee Pension IRA (SEP-IRA) is in many ways similar to a Solo 401(k). While both have the same maximum annual contribution limit, it takes a higher level of income to max out the SEP-IRA. In 2009 and 2010, self-employed individuals and business owners can contribute 20% of net self-employment income or 25% of W-2 wages up to $49, 000 per year. Contributions are tax deductible.
Withdrawals prior to turning 59-1/2 are subject to a 10% penalty (plus income taxes), while withdrawals after 59-1/2 are just taxed as ordinary income. Unlike defined contribution plans, there are no restrictions on whether or how much money you can contribute to a SEP-IRA in a given year. SEP-IRAs are also designed for one person businesses or business owners with employees, rather than for the company’s employees themselves.
Keogh plans are a type of defined contribution retirement plan. Established by Congressional legislation in 1962, Keoghs allow tax deductible contributions of up to 25% of annual income up to $49, 000. Keogh funds can be withdrawn by 59-1/2 and must begin by 70-1/2.
A Keogh (also known as an HR10 plan) can be invested into the same broad range of securities – stocks, bonds, CDs and annuities – as can traditional accounts like 401(k)s and IRAs. Investopedia cautions, however, that their high contribution limits are accompanied by greater paperwork burdens and upkeep costs.
Defined Benefit Plans
Described by Bankrate as “the most expensive and complicated retirement plan for the self-employed, ” defined benefit plans are nevertheless an option for self-employed individuals with “mountains of money” to put toward retirement. Employers can save an eye-popping maximum of $195, 000 per year, but there’s a catch: an actuary is needed to determine the exact amount that can be contributed (a rather costly expense).
In contrast to the flexibility offered by Solo 401(k) accounts and Simple IRAs, a defined benefit plan is an extremely structured arrangement that must be operated in accordance with strict rules. Largely because of these expenses and complications, Bankrate finds that there are roughly 38, 000 defined benefit plans today, down from 114, 000 in 1985. Nevertheless, they remain a worthwhile tax-deferral possibility for wealthy business owners.
13 Responses to “Best Retirement Plan for Small Business Owners?”
I’ve lived this situation; Max out working spouse 401k option; As long as sahs remains married; quarterly tax, ss, medicare are covered by working spouse thru weekly deductions. The key here, stay married, (tax hell will break loose otherwise). I would then max out both Roth IRA. But, I’m thinking SAHS, is not eligible for traditional Roth as income is pre-tax. The biggest value will be the 401k(not my favorite if choices are poor) as it reduces taxable income. Use caution,if SAHS,increases income and changes status, incorporates or hires employees, much of this retirement planning will need to be undone.
I highly recommend using a professional firm, with lots of experience to handle your retirement plan. I tried to set up my own DB plan years ago and had so many issues with it. Long story, short….I did not have enough knowledge and experience to do it myself.
A colleague suggested that I contact Steidle Pension. Steidle has handled my plan ever since. We did some major restructuring and it has been running smoothly ever since. The time and frustration that I have saved by using Steidle is worth so much more than their annual fee!
I changed administrators of my company’s retirement plan five years ago to Steidle Pension Solutions and wish I had done it much sooner. No hidden fees, friendly and knowledgeable staff, and quick/clear responses to my questions. http://www.sps401k.com.
I am interested (similarly) in knowing how starting a new marriage will change my 401(k). I’m 27 and I started my 401(k) about four years ago. When I get married next year will my husband contribute to the same 401(k) or will he have to start his own? Another monkey wrench: He’s Canadian and he’ll be moving to the US. Figure this one out!
Thanks for responses. I agree with you CFP gal – I would never consider a DB in this situation.
I did more research – there is no schedule C deduction for solo 401K contributions. So whether husband contributes to a solo 401K, or wife contributes to her 401K at work, retirement contributions will go on the same line on their 1040 (MFJ) – so net tax effect..6 one way, half dozen the other. smeh.
It appears the only advantage of the solo 401K over the wife’s 401K with her employer (other than the fact that he’ll reach retirement age 3 years before she will) is the number of investment options available for the solo 401K (401K at her work has rather limited investment options, but only charges $20/year – same as the solo at Vanguard that jim mentioned). The only drawback is increased reporting when assets reach $250K (or if they close account)…but with as much diversifying as this couple does, I don’t think they’ll have to worry about reaching $250K in the one account anytime soon, or ever if he plans to quit his home “business” several years from now like he says he’s going to (he enjoys tutoring kids, but his own kids are going to require a lot more time, attention, & taxiing around once they reach middle school!!). But on the same note, given that he plans to have zero income in about 5 years (and would no longer be able to contribute to the solo), I think they need something more than better investment options to choose a solo over a regular. They’ve got plenty of investment options in the ROTH IRAs.
and based on my reasearch, I think the author definitely needs to change the line :”The self-employed have several retirement options which are both exclusive to them and, often times, MORE LUCRATIVE than the more traditional plans above.” I didn’t find any of these more lucrative in this case!!
thanks for getting the brain going today and challenging me to learn something new 😉
I always cringe when I see articles like this from non-experts in retirement planning. It’s a very complex topic and you can quickly go astray with unclear or misleading statements. The author also used a link that touts solo DB’s as the “next big thing.” Actually they are the next hot (!)product(!) that wall street is hoping will catch on. DB plans are rarely used by anyone except high earners nearing retirement that are willing and able to sock away large amounts of cash. Administration costs are one issue that can be mitigated with some DIY as Bodark says, but the bigger issue is the annual funding requirement. It can mean heavy fines and legal issues if your revenues fall and you can’t make the required contributions. As you can imagine, this has happened to people with some frequency over the last two years.
@Interested: A small business, in your 30’s, with a young family? You have a long way to go before a DB plan should even be considered. And as a young person, the math for potential asset growth is resoundingly in favor of a DC plan like 401k’s.
The solo 401k employee deferral limits are the same as for a regular 401k. The higher limits are only available in the form of profit sharing which means you have to be incorporated. However, even with the normal 401k limits you can stash more than with a Roth-IRA. IRS reporting is simplified and as the others said, the fees are minimal. Make sure you specifically ask about any set-up fees, ongoing plan and participant costs, and how costs increase if you add employees.
Some owners hire their spouses part-time in order to make plan contributions for them. It sounds like your wife doesn’t have a Roth 401k option so this might be attractive as your revenues grow. Her aggregate deferrals to both plans would be subject to the IRS limit.
Looks like Vanguard solo 401k is as cheap as $20 a year per fund or if you have >$50k in the account its free. What are the fees for your employers 401k? Many if not most 401k’s offered by employers do not even document the fees which can be very high in many cases. The employer 401k may be costing you more in fees that you aren’t even aware of.
Also, as for fees, you can open a Solo 401(k) with Fidelity or Vanguard for very (very!) little cost. The only possible catch is that there might be a minimum to open. This is exactly a great topic for a future post – thanks!
Hah. I originally wrote my comment as gender neutral, but then changed it because I thought I remembered seeing a “she” in the original comment. Guess not. My bad! 🙂
I love how you assume SHE is the stay at home spouse 😉 In this example, she is actually the working spouse. It’s DAD who stays home and brings in $9K 😉 (and even though this is a real couple, I would never suggest they structure their retirement based off of opinions on a message board over what a CPA says – so no worries there).
Thanks for your response, except, if they contribute $9,000 for his solo 401K, the annual fees would eat up any tax advantages a Solo 401K would have over the 401K with wife’s employer, wouldn’t they? Currently, the couple’s only tax liability is basically equal to the self-employment tax on the home business (and he does not expect business income to grow…so we are assuming income will stay at/around $9K each year). Isn’t there a cutoff to make a solo 401K feasible – like contributions of AT LEAST $10K – $15K? or something like that?
I try to stay current on tax law, but I am not a tax professional. and of course, I completely understand that opinions posted here are just that – opnions, and not advice. 🙂 I’m just trying to get the gears going and get people thinking of the unusual cases…To find cases where the self employment options are actually NOT the best retirement options for a small business owner 😉
@ Interested: Solo K for the spouse until/if income increases, then move to a DB plan.
The comments about DB plan being expensive are slightly true, but like all things in context – it’s Liabilitites versus Assets at plan year end. Usually 12/31/20xx. The EA (enrolled actuary) has to sign the Schedule B. However, you can do all the math, put in a spreadsheet and “buy” 1 hour of an EA’s time at plan year end. So to say it is complicated and or expensive… all realtive.
But then I think a new car is a waste of money, and a few thousand dollars on a gun is a rational investment.
Hmmm. A Solo 401(k) would allow the self-employed spouse to defer her entire income (up to $16,500). If income grows in the future, she could do additional “employer” contributions (based on a % of income similar to SEP) up to $49k total, or whatever the limit is at that time. If you prefer, you could do the same thing with the Solo Roth 401(k).
Note that this shouldn’t preclude regular IRA (Roth or traditional) contributions, so it really ramps up what you can do — as long as you have enough money to support all the contributions.
Of course, you should check with a tax advisor, etc., etc. as I’m not in a position to offer specific advice. Just listing some possibilities.
OK financial wizards – I want to know – what would you do with these facts:
One spouse makes $60K. employer contributes an amount equal to 9% of that salary to a 401K (with no required contribution from employee, but employee is fully vested in $50K+ balance)
Other spouse stays at home, but has a home business (schedule C) with taxable income of 9K per year (yes, just 9,000).
Couple contributes $10K to Roth IRAs each year ($5K to hers, $5K to his). They are both in their early 30s (translation: they still have many years until retirement!) and have 3 kids (translation: they have 3 little “deductions & credits” to wipe out a large portion of their tax liability each year).
So what you would you do if you were this couple? Stick with the Roth IRA for stay at home spouse? or look into one of these alternatives? Would the answer change if they have about $2,000 – $4,000 extra (on top of the 10K) to contribute to retirement accounts each year? Should working spouse contribute the extra to 401K at work, or should stay at home spouse open one of these plans available for the self-employed?
-Interested in seeing how others respond to this scenario.