How Business Owners Can Maximize Their Retirement Plan Savings
Business owners spend a tremendous amount of their time, energy, and money building their business, often putting off investing for their retirement until a later stage in life. That is why it is not surprising that many business owners are behind the savings curve as they approach retirement. However, the tax code provides business owners with several opportunities to save for retirement while taking advantage of tax deductions to their company.
Choosing from among the different plan options can be perplexing. But you can narrow down the choices based on several factors, including your age, amount of compensation, number of employees both full- and part-time, retirement date, and your personal financial objectives.
Understanding all the various rules, eligibility, contribution limits, and administration requirements of the different options can be daunting. But this breakdown of the different plan options is the right place to start.
SEP (Simplified Employee Pension) IRA
If you do not plan on hiring more than a few full-time employees, your best option may be a SEP IRA. It is easy to set up and administer, and it has a high contribution limit. Employees set up their own IRAs and are responsible for directing their funds. However, the employer makes 100 percent of the contributions on behalf of its employees. Of course, employer contributions are tax-deductible to the business.
Also, contributions are not mandatory and can be made at the employer’s discretion based on profitability. You can contribute up to 25% of your employee’s eligible compensation up to the contribution limit of $58,000 in 2021. For your own contribution, you can contribute up to 20% of your net earnings. Whatever percent of profits you contribute for yourself must be the same for all eligible employees.
If you have more than a few employees but less than 100, your best option may be a SIMPLE IRA. It is considered the most straightforward and lowest cost option, but it has the lowest contribution limit for the business owner. Employees establish their own IRAs and direct their own funds. All employees, including the business owner, may contribute up to 100 percent of their salary up to the contribution limit, which is $13,500 for 2021, with a $3,000 catch-up contribution for employees age 50 or older.
The employer has the option to match up to 3 percent of employees’ compensation or provide a 2% fixed contribution for all employees regardless of whether they have chosen to make salary reduction contributions.
Solo (Individual) 401(k)
If you have no employees other than your spouse, a solo-401(k) plan offers the best opportunity to maximize your tax-deductible contribution. For 2021, you may contribute up to $19,500 through salary deferrals ($26,000 if you are 50 or older) plus up to 20 percent of your net self-employment income for a maximum combined contribution of $58,000 or $64,500 with catch up contributions.
Additionally, you can contribute 25 percent of your net profit up to $58,000 based on a maximum salary of $290,000. You are not required to make any contributions in years in which you have no profits. This additional contribution is not allowed if you are operating as an S-Corporation.
Safe Harbor 401(k)
If you are highly compensated relative to your other employees, a safe harbor 401(k) may be your best option. A safe harbor plan allows key employees, business owners, and highly compensated individuals to maximize salary deferrals ($19,500/$26,000) without being limited by poor participation of the non-highly compensated employees. A Safe Harbor 401(k) plan eliminates the need for some of the annual compliance testing by having an Employer either; 1) make a 4% matching contribution (100% up to 4% of compensation), or 2) provide a 3% non-elective contribution to all employees regardless of participation.
If you are significantly older than your other employees, you could consider combining your safe harbor 401(k) plan with an age-based profit-sharing plan. Your profit-sharing contributions can be weighted more heavily toward older employees. Between salary deferral and profit-sharing, the maximum contribution is $58,000. Age-based profit-sharing plans require a custom design and third-party administration.
Comparing the Retirement Plan Options
Contribution limits for plan year 2021
The tax code affords business owners many opportunities to minimize their taxes while maximizing their retirement plan contributions. While each of these retirement plan options can offer significant tax benefits, they each have both pros and cons that need to be considered in light of your personal and business circumstances with the help of a financial and tax advisor.
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