Retirement plans for small business owners
MARTIN A. SCOTT, CFP®, EA
Employees generally have access to a retirement plan with their employer, but as a small business owner (self-employed), this is not the case. Small business owners must be proactive in creating their own retirement savings (and not just rely on the potential sale of their business in the future). With so much financial capital going into running and growing a business, it can be difficult to allocate money to invest for retirement. However, not properly addressing retirement planning can lead to adverse consequences for a small business owner in the long-term. The good news is that there are retirement plan options available to a small business owner that provide tax advantages (i.e., tax-deferred savings) and flexibility. This list does not include every potential option, but I discuss three retirement plans that I think are most applicable: SEP-IRA, Solo 401(k), SIMPLE IRA.
SEP-IRA
A Simplified Employee Pension (SEP) IRA is a retirement plan option that is advantageous to small business owners with a few (or no) employees and/or fluctuating earnings. This type of plan allows small business owners to set up SEP-IRAs for themselves and each of their employees (if applicable). If the owner has employees, then they generally must contribute to each of their SEP-IRAs (in addition to the owner’s SEP-IRA) that have been setup (contributions are a uniform percentage of income for each plan participant), but contributions are not required every year. By not having an annual contribution requirement, this type of plan provides much flexibility as the owner can decide on how much to contribute based on the performance of the business in a specific year. Additionally, small business owners value their time and cash flow, so the low start-up/operating costs and simplicity of setup of SEPs are very attractive features as well.
Regarding the annual contribution limit for the 2024 tax year, it is up to the lesser of 25% of compensation (compensation limit of $345,000) or $69,000. Note that special rules do apply for those who are self-employed.
Solo 401(k)
A Solo 401(k) is a retirement plan option that is designed for small business owners who have no employees (other than a spouse). The most beneficial feature is that this type of plan has higher contribution limits compared to the other plans as the owner can contribute as both the employer and an employee, which can substantially bolster retirement savings going forward.
Regarding the annual contribution limit for the 2024 tax year, it is up to the lesser of 100% of earned income or $69,000 ($76,500 when including $7,500 age 50+ catch-up).
SIMPLE IRA
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a retirement plan designed for a small business owner who has fewer than 100 employees. Like a SEP-IRA, this type of plan is easy to set up and has lower administrative costs. To get started, an owner must complete a short form and once the plan is established, SIMPLE IRAs are set up for each employee. Also, owners must make contributions for their employees and employees can make their own contributions (percentage of salary) as well. Given the mandatory contributions from the owner, it does not have the same flexibility as a SEP-IRA and Solo 401(k). Note that if a small business owner is a sole proprietor and has a SIMPLE IRA, then he or she is treated as both the employer and an employee regarding calculation of the plan’s contributions and limits.
Regarding the annual contribution limit for the 2024 tax year, it is the sum of the two items below:
Contribution by owner: required to make 2% in nonelective contributions or 3% in matching deferrals
Maximum contribution by employee: the lesser of 100% of compensation or $16,000 ($19,500 when including $3,500 age 50+ catch up)
Evaluating Your Options
After a full review of their financial situation, I provide a recommendation to each one of my small business owner clients on which one of these retirement plan options is best suited for them. Some factors that are considered in my recommendation include cash flow of their business, long-term business goals, and number of employees.