If you are a small business owner, you’ve probably wondered how to maximize your retirement planning in the most tax efficient way for you (and your employees). This is one of the most common topics we run across with our business owner clients. We get questions like: What are the options? How much can I contribute? Is there a tax advantage?
The truth is there is no one-size-fits-all solution for small businesses. However, there are multiple options that may work differently for each business owner. In this article, I want to explore some of the options I discuss with our clients, including SEP IRA’s, Solo 401(k), SIMPLE IRAs, and Traditional/Safe Harbor 401(k) plans.
SEP IRAs are the most common of the options for Sole Proprietors and single member LLCs.
The SEP IRA allows the business owner to contribute up to 25% of revenue (in most cases) or up to $61,000 in 2022, whichever is less. These contributions are tax deductible to the business owner. The biggest advantage to the SEP is that the plan is not subject to some of the reporting requirements of other qualified retirement plans, making it the simplest option for most individual business owners. However, these contributions are made simply as employer contributions. This means that once the business hires any full time employees beyond the business owner they are required to contribute for the employee at the same percentage of compensation as the owner.
Solo 401k plans are designed exclusively for Sole Proprietors with no additional employees.
Solo 401(k)s can offer some advantages over a SEP IRA to an individual business owner. The Solo 401(k) allows for the owner and a spouse that is also employed in the business to make employee contributions up to the annual 401(k) maximum ($20,500 in 2022) regardless of the revenue of the business in that year. It also allows for people over 50 to catch up on contributions ($6,500 in 2022). In addition to the catch up contribution, the business owner is able to make a profit sharing contribution of up to 25% of compensation (for themselves and a participating spouse) to a maximum of $61,000 in 2022. These contributions are a tax deferral on income for the business owner and participating spouse.
The SIMPLE IRA can be beneficial for small businesses with more than one employee.
Once a business owner hires one or more employees, the most cost effective of the plans ends up being the SIMPLE IRA in most cases. The SIMPLE IRA allows each employee earning at least $5,000 per year to contribute to the plan, with a maximum of $14,000 in employee deferral. The employer is then required to match up to 3% of the employee’s compensation dollar for dollar. While this option may be cost effective in terms of plan administration it comes at the cost of having a lower contribution limit compared to a traditional 401(k) Plan.
The 401(k) is the most commonly known retirement plan used by most businesses with 10 or more employees looking to maximize employee deferral contributions.
There are two types of plan in this category, Traditional and Safe Harbor. The Traditional 401(k) is subject to testing requirements to determine if there is a compensation gap within the company (top heavy testing) which will limit the amount of contribution highly compensated employees (typically the owner and other management level members) are able to make.
The Safe Harbor 401(k) is the plan used by most businesses because it allows all employees to maximize contributions. The plan allows each employee to contribute up to the annual maximum contribution ($20,500 in 2022), plus catch up contribution ($6,500 in 2022). The company is then required to match employer contributions. The most common way the employer satisfies the match requirement is with a dollar for dollar match on the first 4% of employee contribution, or dollar for dollar on the first 3% and 50% on the next 2% (meaning an employee must contribute 5% in order to get 4%).
The 401(k) options typically come with additional administrative cost from a third party provider due to the governing requirements of ERISA, which is federal law of the standards for retirement and pension plans in private industry.
There is a lot of thought and consideration to be taken into account when selecting which plan is best for each business owner, company, and their employees. At Marshall Financial Group, we provide a thorough analysis of all aspects of your business structure to help you build the best retirement plan options for you. As always, if you have additional questions and would like to know more about your options please let us know and we will set up a time for a consultation.
Contribution amounts and limit information provided by IRS.gov.
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