Sanford Stolar, CPA and Carol Gomez, CPA
12.14.2017 | Berdon Industry Insights
If you have worked for a corporation, you already know the drill for new hires. Go through employee training and, after a few weeks on the job, sign up for the company retirement plan, usually a 401(k). However small business owners and the self-employed need to shop for a retirement plan that meets their objectives.
Whether you are planning for yourself or your employees, finding the right retirement option can be daunting. From various types of Individual Retirement Accounts (IRAs) to defined benefit plans, what individuals choose today shapes their financial security tomorrow.
This choice is especially important for the 15 million self-employed workers in America, of which more than 15% are 65 and older according to the Bureau of Labor Statistics.
Before researching plan pros and cons, reflect on your current finances, retirement goals, and stage of life. Age, income, target retirement age, and performance of existing retirement investments are crucial factors in identifying the best retirement strategy.
For an employer, things are a bit more complicated. Employers have to consider the size of their business, number of employees they have, cost of administering and funding the plan, and unique incentive structures to attract and retain talent. Subsequent to that, employers should consider the fine print.
Fees associated with retirement plans are often overlooked but will, over time, impede progress toward your goals. However, self-employed workers do have unique retirement options that can help avoid the confusing and often bloated fees associated with mutual funds and actively managed 401(k) plans.
The Solo 401(k) Plan
A solo 401(k) is a plan utilized by self-employed individuals with no employees other than the business owner(s) and their spouse(s). It is essentially the same as the traditional 401(k) plan offered by many corporations. These plans can be set up through traditional brokerage firms such as Fidelity, Vanguard, and Charles Schwab. Under this type of plan, the self-employed individual is afforded the opportunity to contribute to the plan in both an employer and employee capacity. For the employee contribution, an elective deferral is allowed of 100% of compensation but is capped at $18,000 in 2017 (or $24,000, if over age 50). For the employer portion of the annual contribution, a non-elective contribution of up to 25% of the self-employed individual’s earned income is allowed. To calculate earned income, an individual would deduct from his or her net earnings half of self-employment tax and the contributions. The total contributions allowed for the 2017 tax year is $54,000. For individuals age 50 or older the contribution may be up to $59,000.
The solo 401(k) plan is often an alternative for an individual who has the resources to contribute a significant amount to their defined benefit plan but does not have earned income of at least $270,000, the maximum earned income one can take into account in 2017 for making retirement plan contributions. It is important to note that there are annual filings for a solo 401(k) plan with assets in excess of $250,000. The solo 401(k) is a basic option for sole proprietors and single-member LLCs, and its strengths (and weaknesses) resemble those of a traditional 401(k) plan. High net worth individuals, or those who need to save more than the limit, may want to consider other options more suited to their circumstances.
SIMPLE IRAs (Savings Incentive Match Plan for Employees) are ideal for business owners who are looking to readily establish and manage a group retirement plan for fewer than 100 employees. Under this plan, the IRS requires employers to either match up to 3% of an employee’s elective deferral (not to exceed $12,500 per year), or to set it up similar to a pension, making a 2% non-elective contribution up to $270,000 of an employee’s income in 2017.
SIMPLE IRAs can become expensive for self-employed business owners with larger staffs. However, due to relative ease in setting up this type of IRA through most major investment firms, SIMPLE IRAs are a popular option.
Also known as the Simplified Employee Pension, the SEP IRAs are best for self-employed business owners with fewer employees who have earned income of at least $270,000 a year. Offered by most major investment firms, a SEP does not have the start-up and operating costs of a conventional retirement plan and allows for a contribution of up to 25% of your earned income and your employees’ pay. Beware, if you choose a SEP IRA for your business, because you must contribute the same percentage amount to your employees’ plans as you do to your own, which can become expensive.
Like a solo 401(k) plan, SEP IRAs are tax-deferred and have a maximum contribution of $54,000 in 2017. However, unlike the solo 401(k) there are no annual filings for this plan.
Defined Benefit Plans
A defined benefit plan is a pension plan that allows the self-employed and small business owners to aggressively contribute to their retirement savings. It is the most costly and complex option to set up and administer—though easily the most lucrative. In 2017, the annual benefit for an individual could be up to $215,000, which makes it a unique and powerful investment tool for self-employed individuals who are high net worth or highly compensated.
There is also access to unique tax incentives, such as the ability to write off your contributions as a business expense and still contribute to other retirement plans, such as a solo 401(k). One of the downsides of a defined benefit plan is the administrative overhead, which requires that an actuary determine the plan’s structure. For an employer, the cost of making contributions on behalf of the employees can also grow, similar to an SEP IRA.
Making the Right Choice
There are a range of factors to consider when picking a plan. What looks good on paper might not be the right plan for you in practice. It is essential to know your financial situation, consider the operating costs, and arm yourself with the basics. From there, self-employed individuals should have all the information they need to work with their tax advisor and planning specialist to pick the best option.
Berdon LLP, New York Accountants