Retirement planning for a business owner is often an afterthought. There is always an emergency to deal with, a problem to solve, or a tax bill to pay — and all of them take priority over planning for an eventual retirement.
That can lead to missed opportunities and lost momentum in saving for retirement. After all, retirement planning for a business owner looks different from retirement planning for a traditional employee. While employees often enjoy having access to a 401(k) account through their employer, business owners have to establish their own retirement plans.
And so, business owners have to answer an important question: What retirement plan savings vehicle is best for them?
Two popular retirement plan options for small business owners are the solo 401(k) and the SEP-IRA. Each has its pros and cons. Here is a list of plan features and rules to consider before making the final choice.
Like all retirement plans, there are maximum annual total contribution limits that apply to both the solo 401(k) and the SEP-IRA every year. For 2021, the maximum limit for each is $58,000.
With a solo 401(k), the maximum allowable contribution limit comes from two sources. As the business owner, you are allowed to contribute as both the employer and as an employee.
Limits for the SEP-IRA are a bit more straightforward. You can contribute up to 25% of your compensation or net self-employment income, or $58,000 — whichever is less.
You can set up a solo 401(k) in one of two ways. The first is through a traditional plan. Just like an employer-sponsored plan, your contributions are made pre-tax. Any distributions taken after you turn 59.5 years old are taxed at your ordinary income tax rate.
You can also choose a Roth option for a solo 401(k). In this instance, you’ll make after-tax contributions now, and you won’t be taxed on your distributions when you take them. You may want to choose the Roth option if you project that your income (as well as your tax rate) at the time of contribution is lower than it will be in retirement.
With a SEP-IRA, you have the ability to deduct whichever is less — 25% of the net self-employment earnings or your compensation. Your distributions will be taxed when you retire, just like a traditional 401(k). There is no Roth version of a SEP-IRA available.
The deadline to open a solo 401(k) is December 31 each year. However, you have until you file your taxes to fund the account, which gives you extra time to make your contributions.
A SEP-IRA can be opened and funded up to the date you file your taxes. If you’re running behind, you may also file for an extension. This would give you more time to open and fund the account.
If you have employees or are planning to hire employees, you’ll need to consider how plan requirements may change.
You cannot contribute to a solo 401(k) if your company has employees. You can, however, hire your spouse as an employee. Your spouse would then be able to contribute to the plan up to the standard employee limits, plus your employer contribution rate — for a grand total of $58,000. This could be a way to potentially double the maximum amount that you as a couple could save toward retirement each year.
A SEP-IRA allows you to add employees to the plan. However, you are required to contribute as an employer to each of your employees’ accounts. You must contribute the same contribution percentage for each employee. Keep in mind that for the purposes of the SEP IRA, you are considered one of the employees. So, if you contribute 10% of your compensation to your SEP-IRA plan, then you must also contribute 10% to each of your employees’ plans as the employer.
Establishing a retirement plan for your small business can get complicated. A financial advisor can help you identify the best retirement plan option for you and your business based on your organization, details, and goals.
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