Retirement Plan Options for Self-Employed Business Owners

Owning your own business gives you a great deal of freedom to make your own choices. It also comes with a lot of responsibility as well, including estimating and paying your own quarterly taxes, hiring reliable employees, and most importantly, saving for a secure financial future. Sometimes the choices for retirement plans can be overwhelming. That’s why we’ve laid out the leading retirement plan options for self-employed owners, so you can decide which plan best fits your business needs.

There are five main choices to consider as you vet the right one for you, including:

• Traditional or Roth IRA
• Solo 401(k)
• SEP IRA
• SIMPLE IRA
• Defined benefit plan

Traditional or Roth IRA 

A traditional or Roth IRA are the most straight-forward options to start saving for retirement. If you don’t plan on contributing a large amount each year, then these individual retirement plans are an ideal choice. Both the traditional and Roth IRAs are tax-advantaged plans with a 2020 contribution limit capped at $6,000 ($1,000 catch-up contribution for ages 50+). These plans also allow you to roll over an existing 401(k) plan from a previous employer into a new individual plan.

The biggest difference between the traditional and Roth IRA is when the tax breaks kick in. For the traditional IRA, the tax break occurs in the year that your contributions are made, making them tax deductible when you file your return. For the Roth IRA, the tax advantage occurs when your withdrawals are made in retirement—tax free. Always consider your tax position at the time of withdrawals to ensure a lower tax burden.

Solo 401(k)

If you’re looking to make larger contributions and save much more in your retirement account, a Solo 401(k) (aka one-participant 401(k)) is another option that allows you to contribute up to $57,000 in 2020 ($6,000 catch-up contribution for ages 50+) or 100% of earned income, whichever is less.

The key differentiator for this plan is that it’s designed for self-employed individuals with no employees; however, the business owner can contribute to the plan in two different capacities—one as the employee, and one as the employer. The IRS provides the following breakdown to showcase how an owner can contribute to a Solo 401(k) plan:

• Elective deferrals:up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit:
  • $19,500 in 2020, or $26,000 in 2020 if age 50 or over ($19,000 in 2019, or $25,000 in 2019 if age 50 or over); plus
• Employer nonelective contributions up to:
  • 25% of compensation as defined by the plan, or
  • for self-employed individuals, see discussion below

The only exception to the no-employee rule is if your spouse is employed by your company. If this is the case, you have the potential to double the contribution amount to your family.

A business owner must formally elect to make an employee contribution by Dec. 31 of the current tax year, but employer contributions can be made up until the personal tax-filing deadline of April 15 or October 15 if a tax extension was filed. In essence, the solo 401(k) has to be set up in the prior year to make an employer contribution that is deductible.

It’s also important to note that 401(k) plan contribution limits are defined by person, not by plan. So, if you are employed by a second company and participate in an additional 401(k) plan, the contribution limits are calculated across the board. You do not have to contribute every year to a Solo 401(k), but be sure to consider total annual limits and calculate elective deferrals across all plans accordingly.

SEP IRA

Similar to a Solo 401(k), the contribution limits for a SEP IRA are higher than traditional or Roth IRAs. An employer can contribute up to $57,000 in 2020 (no catch-up contribution available in this plan) or up to 25% of compensation or net self-employment earnings ($285,000 compensation limit to use in contribution calculation).

In addition, there are minimal administrative regulations, making it a much simpler plan to maintain. SEP IRAs have limited paperwork and no annual reporting to the IRS, and they do not require annual contributions, which allow for a more flexible savings strategy depending on the cash flow of your business.

The only SEP requirement that may present a challenge to some business owners is the contribution amounts must be an equal percentage of pay for both you as the employer as well as for each eligible employee. For example, if you would like to contribute 25% of your net self-employment earnings to your family’s retirement account, you also have to contribute 25% of compensation to all eligible employees.

SEP IRA contributions are tax deductible on your tax return, and then distributions are taxed as income in retirement. Unfortunately, there is not a Roth option for this type of retirement plan.

SIMPLE IRA

The next retirement plan option is designed for larger companies with up to 100 employees. The SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees, allows both employer and employee contributions, requiring the employer to either match up to 3% of compensation (no annual limit) or provide each eligible employee with a 2% nonelective contribution of his or her compensation up to the annual limit of $285,000 for 2020.

This plan has the potential to get expensive if the business has a large number of employees, as the contribution requirements are not as flexible as the other abovementioned options. The contribution limit for 2020 is savings up to $13,500 (plus a $3,000 catch-up contribution for ages 50+), and if you also contribute to an employer plan, the total of all contributions cannot exceed $19,500. Employee contributions are tax deductible as a business expense.

Defined Benefit Plan

A defined benefit plan is created for high-income earners in mind and provides a fixed, guaranteed stream of income upon retirement. The guarantee comes with a cost, however, as the plan is paired with steep setup and annual fees as well as complex administrative requirements.

Each year, business owners are required to file Form 5500 with a Schedule B signed by an enrolled actuary. The actuary calculates your deduction limit based on your age, projected return on investments, and the benefits you’ll receive at retirement. Another catch is that business owners must commit to the contribution amount or pay hefty fees to make any changes once the plan has been established.

A defined benefit plan is most suited for those who are looking to consistently save a large amount of money ($50,000 and above) for retirement year after year and who are not bothered by the extra administrative steps. This strict plan has its pay offs in the end though, as one is often able to accrue considerable benefits in a short amount of time.

Next Steps

These five types of retirement plans are created specifically for self-employed business owners. Depending on your business model, the amount of savings you’d like to contribute, and the number of employees you have, we can help you determine the right one for your business.

If you would like to discuss these options in further, contact me at tgoodall@bpw.com or (805) 963-7811 to help you determine which plan is most suited for your financial goals.