Self-Employed business owners face unique challenges (and opportunities!) in areas throughout their business endeavors. Saving for their eventual retirement is no exception. Self-Employed business owners sometimes face challenges when determining when, how, and how much they could or should be saving or investing for retirement. At the same time, being a self-employed owner lends itself to unique opportunities to save in ways that others cannot. Below is an overview of some of the basic considerations and options available to those individuals that are self-employed and looking to save for retirement in a tax-deferred manner. This list is introductory and not all-inclusive. It does not address each and every consideration of the options listed below, but it is a good initial starting point for self-employed small-business owners when considering some available methods to save for retirement.
Individual Retirement Accounts (IRAs)
The most basic and straightforward retirement saving option for a self-employed individual is a Traditional (or Roth) Individual Retirement Account. In 2019, an individual who is under 70.5 and can contribute the lesser of $6,000 or earned income to a Traditional IRA. Those aged 50 and over can increase the $6,000 limit by $1,000 for a total limit of $7,000 if they have sufficient earned income. Depending on the availability and participation of a spouse in a qualified employer-sponsored retirement plan, the deductibility of Traditional IRA contributions can vary, however contributions are always permitted if age and income requirements are satisfied. Those who have no earned income, but whose spouse does, can potentially utilize the earning spouse’s income to make a contribution themselves - potentially doubling the amount available for contributions if both spouse’s can contribute to separate IRAs. In total, Traditional IRAs can be limited in the amount one is able to save but are easy to establish and often a better option than not saving and investing at all if no other alternative is available. Roth IRAs have slightly different rules that must be navigated, resulting in different benefits.
Individual (“Solo”) 401(k) Plans
Employers with no other common law employees can establish a Solo 401(k). This option is great for certain self-employed business owners that want flexibility, will plan to make contributions consistently over time and don’t mind a small amount of administrative work.
In this unique plan structure the self-employed individual is able to wear two hats: one as employer and one as employee. As employer, the self-employed business owner can contribute up to 25% of their eligible compensation based on the annual maximum compensation limits established by the IRS. It is important to note that contributions (employee or employer) may need to be coordinated with any other 401(k) or SIMPLE IRAs that the individual participates in to ensure not too much is contributed, otherwise severe penalties can exist and time and effort to correct mistakes is required. As an employee, the owner can contribute up to the lesser of $19,000 or 100% of compensation in 2019. The total maximum annual addition to a Solo 401(k) plan is $56,000 if sufficient compensation exists and without consideration for catch-up contributions (for those age 50 and older).
While the Solo 401(k) is an attractive option to many, it is important to recognize however that solo 401(k) plans do have unique rules that differ slightly from the 401(k) most employees come across when working for an established company. They are very similar but not the same. Solo 401(k)s do not enjoy the same exact creditor and other protections that an ERISA employer-sponsored 401(k) plan provides, though adequate protections do exist for many. Further, once surpassing a set amount of assets, typically $250,000 as of the last day of the plan’s year, a Form 5500 must be filed with the IRS. Solo 401(k) plans should be established by the end of the calendar year in which contributions are first intended to occur.
SEP IRA
SEP IRAs are a great option for self-employed individuals that are paid as consultants and want a simple solution to save efficiently for retirement. This plan is often used in lieu of a Solo 401(k) plan for many self-employed, independent contractors. SEP IRAs require slightly less work to establish than their Solo 401(k) counterparts, but in some ways offer less flexibility. Unlike the Solo 401(k), a SEP IRA only permits employer contributions. These contributions are limited to 25% of eligible compensation based on the annual maximum compensation limits established by the IRS. The overall maximum benefit for the year that can be obtained by an employer is the same as the solo 401(k), just achieved by a different path and income requirements. These plans can be established and funded up until the taxpayer’s filing deadline, including extensions and therefore provide more simplicity and flexibility in some ways than a solo 401(k).
SIMPLE IRA
SIMPLE IRAs are unique, in that they are only available to employers with 100 or fewer employees and require contributions be made not just for the self-employed individual, but also for certain qualifying employees. The self-employed owner is able to choose one of two methods to determine how they make required contributions for employees - either through matching contributions or a percentage of employee compensation.
SIMPLE IRA plans allow for up to $13,000 of contributions per year for employees, with an additional $3,000 for those eligible for catch-up contributions. This plan is flexible in the regard that it can be established as late as the tax return due date of the business, including extensions. Before establishing a SIMPLE IRA plan, it is also important to be comfortable with the early withdrawal rules and penalties. While all retirement plan options possess some form of early withdrawal penalty, the SIMPLE IRA's penalty rule can be more harsh than others if funds must be withdrawn prematurely in some cases.
A SIMPLE IRA is not always utilized by small employers and self-employed individuals, but it can be a quality option for those that want to offer a low-cost and easy to administer plan for themselves as well as their employees.
Defined Benefit Plans
Defined benefit plans are a traditional option for many business owners and self-employed persons. In many cases they have lost favor as the appeal of 401(k) and other defined contribution plans has risen. For some businesses however, a defined benefit plan can offer very unique and powerful retirement savings options that are not available in any other plan. Funding for a defined benefit plan is determined through actuarial formulas and calculations. Due to the calculations that are involved, businesses with certain high-earning owners and other modest earning employees can benefit tremendously though steps must be taken to ensure the plan is comply with required laws. Defined benefit plans often work best for more established small-to-mid-size businesses that have reliable cash flow to meet funding requirements. Defined benefit plans can be more difficult or costly to implement initially, but for the right type of employers the longer-term benefits can greatly outweigh the initial costs and may provide the best way to save the most for retirement - especially if savings were neglected earlier in the owner’s career. There are several different types of defined benefit plans, yet almost always businesses interested in this type of arrangement should be well-established and have a record of earnings and project sufficient reliable cash-flow for several years into the future.
Conclusion
Before implementing any retirement saving strategy we recommend consulting with a qualified financial professional to ensure a given strategy is consistent with your broader goals. Often times, business owners may have more than one entity or source of earnings. This can complicate matters and the need for properly designing and implementing an appropriate strategy becomes paramount. At Hudson Oak Wealth Advisory we are able to work with various types of business owners to ensure they properly coordinate the tax and retirement strategies available to them to maximize their overall wealth. We engage in this process as an independent expert while being thoughtful of our clients’ broader business goals and personal financial plan. For further information or for questions pertaining to the various benefit plans and retirement options for self-employed business owners, please reach out.
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