By Trent Derrick, CMT®
As a small business owner, it can be hard to save for retirement when there are so many other aspects of your business to worry about. Running the day-to-day operations tends to take top priority, meaning retirement planning can end up at the bottom of the to-do list.
And when you do finally commit to starting a retirement plan, it can be difficult to sort through all the information out there and truly know what’s best for you and your business. That’s where a trusted financial advisor can help. There are many retirement plan options available to self-employed professionals, including individual 401(k) accounts and SEP IRAs. Here’s how to decide which option is right for you.
Also known as a solo 401(k), an individual 401(k) is designed for business forms with only one employee, the business owner. The IRS calls it a one-participant 401(k) and only businesses without employees are eligible.
- Roth accounts: As with other 401(k) plans, the individual 401(k) offers both traditional and Roth accounts. With a traditional account, contributions are made pre-tax and taxes are paid upon withdrawal. Roth 401(k)s, on the other hand, are funded with after-tax dollars, but they grow tax-free. This gives you the flexibility to actively choose the contribution style that works best for your specific tax situation.
- Employee deferrals: Individual 401(k) plans also allow employee deferrals in addition to the employer contribution. This option is not available with SEP IRAs.
- Loan provisions: Another benefit of this plan is the ability to take loans against the account balance up to the lesser of 50% of the balance or $50,000.
- Higher contribution limits: Individual 401(k) plans have two types of contribution limits. First is the profit-sharing limit for employer contributions, which is the lesser of 25% of business revenue or $61,000 for 2022 and $66,000 for 2023. The next limit is the annual employee elective deferral limit, which is up to $20,500 to the plan for 2022 and $22,500 for 2023, even if the business loses money in those years.
- Strict reporting requirements: If your account balance exceeds $250,000, you will be required to file an annual return with the IRS. The return consists of Form 5500 and it can be quite extensive. Even if you don’t have $250,000 in your account, you may be required to file.
- Only available for businesses with no employees: Individual 401(k)s are only available for businesses with no employees except the owner’s spouse. If you have plans to expand your business and hire additional employees, opening an individual 401(k) is probably not for you. You may be required to convert your plan to a qualified 401(k) and contribute on behalf of your employees if you were to hire any.
A Simplified Employee Pension (SEP) IRA functions similarly to a traditional IRA, except as the owner, you set up and contribute to accounts for both yourself and your employees.
- Tax-deductible contributions: Your contributions are tax-deductible up to 25% of all participants’ compensation, or up to 25% of net earnings if you’re self-employed.
- Higher contribution limit: For 2023, the contribution limit for a SEP IRA is the lesser of 25% of an employee’s compensation or $66,000. This limit is higher than the limit for tax-advantaged accounts like traditional and Roth IRAs, but as mentioned above, it’s not as high as the limits for individual 401(k) plans.
- Easy setup & maintenance: SEP IRAs do not require the extensive reporting requirements required by other qualified retirement plans. You are also not responsible for the underlying investments in your employees’ accounts. As the employer, you simply choose the financial institution you want to work with and you open the accounts. Beyond that, it is the employees’ responsibility to choose and manage their own investments. Additionally, many financial institutions offer SEP plans with little to no management fees, making this a very inexpensive and attractive option for small business owners.
- Contributions are discretionary: Contributions to these plans are flexible and discretionary, meaning you can adjust your contributions as your cash flow changes. This ensures you’re never contributing more than you’re bringing in.
- Strict eligibility requirements: According to the IRS, all employees must be allowed to participate in the SEP plan if they are age 21 or older, earned at least $650 in 2022, and worked for you for at least 3 of the last 5 years. This can make SEP IRAs an inflexible option for small businesses that want to limit the number of employees in the plan.
- When you do contribute, you must contribute to everyone: In the years that you contribute to a SEP IRA, you are required to make equal contributions as a percentage of compensation to all eligible employees. For instance, if you contribute 20% of your income to your own SEP IRA, you must then contribute 20% of every employee’s income to their respective accounts. Because of this, SEP IRAs are generally recommended for self-employed individuals or small businesses with very few employees.
- No loan provisions, Roth accounts, catch-up contributions, or employee deferrals: Many of the benefits offered by individual 401(k)s are not available for SEP IRAs.
Which Plan Is Right for You?
If you’re a solo attorney or member in a small firm, don’t wait to start saving for retirement. At Legacy Wealth Management, we can help you decide which retirement plan is right for you and your business. To learn more, book a consultation with me here or email me at firstname.lastname@example.org.
Trent Derrick is a financial advisor and Chief Market Technician at Legacy Wealth Management. Trent is passionate about the value small businesses bring to their communities and specializes in serving small business owners by providing seamless financial advisory services tailored to their financial needs, including tax planning, cash flow management, retirement planning, and bookkeeping. Trent has a bachelor’s degree from the College of Charleston and studied economics at the University of South Carolina, Columbia. He is a Chartered Market Technician® (CMT®) professional. Trent serves as a guest lecturer for the College of Charleston’s MBA program and acts as chairman of the Market Technician Association’s Charleston chapter. When he’s not working, Trent, a proud Eagle Scout, enjoys volunteering with the Charleston Animal Shelter’s outreach program. Trent and his wife love to cook international cuisines and host dinner parties with their friends. To learn more about Trent, connect with him on LinkedIn.