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Choosing the right retirement plan can be confusing and overwhelming. Multiple options are available, which is a good thing, but understanding their attributes and intricacies takes time. The good news is that these plans allow self-employed individuals (including small business owners) to put away far more money than they can with a traditional corporate 401(k) plan. They also can be simple to establish and maintain.
Ultimately, the goal of any qualified plan is to save for retirement in a tax-efficient manner. Plans can facilitate tax-free investment earnings (Roth) or tax-deferred savings and investment growth (traditional pre-tax); in either case, a tax benefit is enjoyed on the growth throughout. Bear in mind, however, that these are retirement plans, so they impose early withdrawal penalties if funds are withdrawn before age 59.5 and trigger tax consequences upon withdrawal. Also, many have required minimum distributions (RMDs).
The following outlines the five most common retirement plans for self-employed individuals: traditional IRA, SIMPLE IRA, SEP IRA, individual 401k and defined-benefit plan. These plans permit pre-tax savings of $6,000 to nearly $300,000 per year. They are listed in increasing order of complexity and the maximum amount that may be contributed for 2021:
Traditional or Roth IRA
Max contribution: $6,000 ($7,000 if over 50 years old)
Best for: Individuals looking to save a modest amount
- IRAs have lower contribution limits, but contributions qualify for tax benefits.
- You can contribute $6,000 tax deferred to a traditional IRA plus $1,000 catch-up if age 50 or older. The same amount after-tax can be contributed to a Roth IRA. You can save in a traditional and Roth IRA in the same year, but the combined total cannot exceed the IRS maximum ($6,000/$7,000.)
- The tax deductibility of the initial IRA contribution phases out quickly and the ability to make a Roth contribution becomes restricted as taxable income for a married couple approaches $200,000.
- However, if this is your only retirement savings vehicle, these phase-out restrictions do not apply.
- An IRS-sanctioned method is available to contribute to a Roth even when your income exceeds the maximum limits. It is known as the “backdoor Roth.” This involves contributing to a traditional IRA and then converting to a Roth. A conversion is permitted once per year.
- IRAs are not associated with an employer so you can continue to use the same IRA no matter where you work.
- Contributions are due at income tax filing deadline.
- RMDs follow IRA regulations and no loans permitted.
SIMPLE IRA (Savings Investment Match Plan for Employees)
Max Contribution: $13,500 ($16,500 if over 50 years old)
Best for: Mid-size businesses with up to 100 employees
- The appeal of SIMPLE IRAs is that they have minimal required paperwork – just an initial plan document and annual disclosures to employees.
- Low startup and maintenance costs.
- Funded by employer contributions and elective employee salary deferrals.
- Employer is required to make either a 3% matching contribution or a non-elective contribution of 2% of compensation. Max contribution is $13,500 with a $3,000 catch up if age 50 or older.
- Employee must have earned $5,000 from the employer in any two preceding years and be expected to earn at least $5,000 in the current year.
- RMDs follow IRA regulations and no loans permitted.
SEP IRA (Simplified Employee Pension Plan)
Max Contribution: $58,000
Best for: Business owners with few or no employees
- Maximum contribution of $58,000 per year or 25% of employee pay, whichever is less. For self-employed individuals specifically, contributions are limited to 25% of your net earnings from self-employment up to the $58,000 limit.
- It is an employer contribution. The contributions must be made for everyone; only employees making less than $600 a year may be excluded.
- Limited paperwork and costs.
- Contributions must be made by October 15 of the following year.
- RMDs follow IRA regulations and no loans permitted.
- No age-based catch-up contributions but contributions can still be made past age 72.
- SEP IRAs can be converted to a Roth.
Individual or Solo 401(k)
Max Contribution: $58,000 ($64,500 if over 50 years old)
Best for: A self-employed business owner with no employees other than a spouse
- Employee may make an elective deferral contribution of up to $19,500 ($26,000 for those over 50 years old) 500 up to 100% of your compensation.
- Additionally, the employer can make non-elective contributions of 25% of net income up to a maximum of $58,000 or $64,500 (including employee deferral amount) if over 50 years old.
- Employee deferral elections must be made by December 15, but employer contributions may be made by the tax filing deadline (April 15, or October 15 if an extension was filed).
- Plan must be opened by December 31 of the current year, and depending on the program, there may be start-up and annual fees.
- Once the plan is greater than $250,000 it requires filing an annual IRS Form 5500.
- Can be a Roth but one stipulation is RMDs. Can contribute past age 72.
- Individuals who have full-time jobs with an employer retirement plan and have their own businesses may utilize the individual 401(K). However, the maximum limit amounts are cumulative (i.e., max between the two plans combined is $19,500/26,000.
Defined-benefit plan
Max Contribution: $100,000 - 230,000 depending on age and compensation history plus the 401(k) Max
Best for: A self-employed individual whose business has very solid cash flow and who would like to contribute more than $60,000 per year to a retirement account
- Contributions may be up to a maximum of $294,500 when combined with a 401(k) profit sharing plan.
- Typically the costliest and most complex to administer. It should be set up with a CPA and an actuary. The contribution amount is a formula based on age and compensation history.
- Once established, the employer’s contribution amount is not discretionary. The Plan must be fully funded if ever frozen or terminated.
- There are excise taxes if annual minimum contributions are not met.
- Interest is accrued at a rate established in the original Plan set-up.
- RMDs but contributions may also be made after age 72.
Andy Leung is a vice president with Procyon Partners, a registered investment advisor based in Shelton, CT.
Procyon Private Wealth Partners, LLC and Procyon Institutional Partners, LLC (collectively "Procyon Partners") are registered investment advisors with the U.S. Securities and Exchange Commission (“SEC”). The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. Procyon Partners does not provide tax or legal advice.
The views expressed in this commentary are subject to change based on market and other conditions. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
For additional information, please visit our website at https://www.procyonpartners.net/disclosures/.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.