Being a business owner has its benefits. Many know that businesses (unlike people) pay expenses before being taxed. So if there are reasonable business expenses that you might incur without your business, you essentially get to pay those expenses with tax-free dollars.
Even bigger is the ability for business owners to design a retirement plan that can save them thousands a year. We have clients that are going far beyond the $17,500 401(k) contribution maximum and are putting away over $50,000 annually into a low-cost retirement plan. Here are the most common small business retirement plans to consider.
Solo or individual 401(k). This plan is perfect for those who work on their own, with a spouse, or don’t have employees working at least half-time. The plans can work if you have a sole proprietorship, S-corporation, C-corporation or an LLC that is taxed by those methods. These plans cost little to set up and allow you to put aside the standard employee contribution of $17,500 a year (up to $23,000 for those 50 and over).
Where things really get interesting with the solo 401(k) is that the employer can put up to an additional 25 percent of your pay with a total annual contribution limit of $57,500 in some cases. That means depending on your income you and your spouse could put over $100,000 combined into your retirement accounts pre-tax.
SEP-IRA. If your retirement contribution goals are more modest, consider the often free SEP-IRA. Setting up a SEP involves little more paperwork than a traditional IRA. Like the solo 401(k), this plan works out best if you don’t have long-tenured employees.
Any employee who has earned $550 or more in 3 of the last 5 years participates in the plan, which can get expensive for the employer. The SEP can only accept contributions by the business, and the limits are 20 to 25 percent of each qualifying employee’s pay. So if you have an S-corporation that employs your spouse and you who are each paid $100,000 annually, the SEP allows the corporation to put aside $25,000 a year for each of you. Of course if you have employees who have been with you more than 2 years, the business will have to contribute the same percentage of their pay for them.
SIMPLE-IRA. This is the most basic plan that works for companies with more than a few employees but no more than 100. Businesses must offer a matching contribution of up to 3 percent of each qualifying employee’s pay or a straight 2 percent regardless of employee contribution. Employees can choose to defer up to $12,000 of their income, with those 50 and over able to kick in an additional $2,500. Employees who have earned at least $5,000 a year with you in any two years before the current calendar year must be included in the plan. If you have employees, this is a nice low-cost option with the downside of not allowing as much pre-tax savings.
Other options. If you want to offer your employees the ability to defer the maximum 401(k) contribution limit, then you’re looking at setting up a standard 401(k) plan, which can involve a lot of cost and complexity if you’re not careful. If you’re a prodigious saver and the 401(k) limits are too low for you, a complex and expensive option called a defined benefit plan may allow to you to put aside an additional $100,000 or more a year pre-tax. This plan favors those who are older and more highly compensated.
Most brokerage firms and mutual fund companies including Vanguard can set up the solo 401(k), the SEP-IRA, or a SIMPLE-IRA for you. Just be mindful of total costs and investment options. Once you get into a standard 401(k) or defined benefit plan, you need some more background. A good start is consulting theonline401k.com, employeefiduciary.com, and www.bogleheads.org/wiki/Setting_up_a_401(k)_plan.