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Anybody with earned income* can contribute to a traditional IRA or depending on income level, to a Roth IRA. However, a small business owner has several other (Better) options when it comes to a retirement plan.
The decision on which plan to set up is usually based on cost, complexity and desired amount of contributions. Other factors to consider are whether the business has any employees (That are not owners of the business) and whether the employees will be allowed to contribute their own monies as well.
The most well-known retirement plan, the 401 (K) plan is not suitable for small businesses given the initial and ongoing expenses, required administration, fiduciary responsibility etc. The following are better options for small businesses:
1) Simplified Employee Pension Plan (SEP IRA plan)
2) Self‑Employed 401(k) plan
3) Savings Incentive Match Plan for Employees (SIMPLE IRA plan)**
The benefits of having any kind of retirement plan are:
- It allows the owner and the employees to set aside funds for retirement in a tax efficient manner.
- It makes the business competitive by attracting and retaining talent.
- There are tax benefits for the business owner as contributions to employees are deductible as a business expense. In addition, businesses can get a tax credit of up to $500 for certain expenses in setting up a retirement plan for the first time.
The key differences between the three plans listed above are:
- A SEP IRA is for self‑employed people and small‑business owners with any number of employees. Contributions are made by the employer only and are tax deductible as a business expense. This is a good option to maximize contributions with minimum paperwork whether the business has employees or not. It also offers flexibility to vary contributions- or skip it altogether- according to the business needs. The caveat is that contributions must be made for all eligible employees which could turn out to be a large amount if there are several employees.
Employer can contribute up to 25% of employee compensation or up to a maximum of $54,000 in 2017.
This is the easiest plan to set up and maintain and a great option for sole proprietors.
- A Self‑Employed 401(k) plan is a tax‑deferred retirement plan for self‑employed individuals with no employees who are also owners. It offers the most generous contribution limits of the three plans. This plan requires more paperwork than the SEP IRA but the business owner can contribute even more.
The business owner can contribute both as an employee (Elective deferral) and as a business owner (Employee non-elective contribution). Elective deferrals for 2017 is up to $ 18,000 or up to $24,000 if over 50 years old. Total contributions cannot exceed $54,000 or $60,000 including the catch up for people over 50 years of age. If spouse is employed by the company then similar contributions can be made for the spouse as well.
This is a good option for self-employed individuals with no employees who want to maximize contributions for themselves and their spouse.
- A SIMPLE IRA is for businesses with 100 or fewer employees. Just like a 401 (K) plan, it is funded by tax‑deductible employer contributions and pretax employee contributions. Under this plan the obligation of the employer is less but so is the amount the business owner can contribute for herself. This is because the business owner is subject to the same contribution limit as the employees.
Mandatory business contribution is either: 1) 100% match on the first 3% deferred (match may be reduced to 1% in two out of five years) or 2) a 2% nonelective contribution on behalf of all eligible employees regardless of how much they contribute. No additional business contribution may be made.
Employee can contribute up to 100% of their compensation through salary deferral, not to exceed $12,500 for 2017. Catch‑up contributions of up to $3,000 (2017) available for those who are 50 years or older
This is a good option for a business with fewer than 100 employees and where employees are also given the opportunity to contribute.
*Earned Income is income for work done for your employer or your own business; different from for example, capital gains which is not earned income.
**Businesses can also adopt a SIMPLE plan as part of a 401 (K) plan.