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. Additionally, there
are frequent updates and changes made by the IRS, such as the CARES Act in 2020
and SECURE Act in 2019, that change the landscape. 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. These plans
also can be simple to establish and maintain.
Your Business Needs a Succession Plan: Here Are the
Basics
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withdrawal penalties if funds are withdrawn before age 59.5 and can trigger tax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
401(k) 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 and Roth IRA Rules for 2021
Max contribution: $6,000 (or $7,000 if 50 years old
or older)
Best for: Individuals looking to save a modest amount
- IRAs have lower contribution limits than other
retirement savings plans, but contributions to them 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 depending on your adjusted gross income (at
$76,000 for singles and $125,000 for joint filers), and the ability to make a
Roth contribution becomes restricted as taxable income for a married couple
hits $198,000 (or $125,000 for singles).
- However, if you don’t have a retirement plan
offered through your work, these phase-out restrictions do not apply to
traditional IRAs. There are still income restrictions for a Roth.
- 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 it 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 for
the prior year are due by the income tax filing deadline for that year.
- No loans are permitted from either traditional
or Roth IRAs, and RMDs for traditional IRAs follow IRS regulations — except
where amended by specific regulations, such the CARES Act, which suspended the
requirement for RMDs in 2020.
- As amended in the 2019 SECURE Act, there are no
longer any age limits on who can make contributions. Previously, they had been
capped at age 70.5.
SIMPLE IRA (Savings Investment Match Plan for Employees)
Max Contribution: $13,500 ($16,500 if 50 years old or
older)
Best for: Midsize businesses with up to 100 employees
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- 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 made on a pre-tax
basis.
- Employer is required to make either
dollar-for-dollar matching contributions of up to 3% of a worker’s pay 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 IRS regulations, and no loans
permitted. Cannot be a Roth.
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 $650 a
year may be excluded in 2021 (up from $600 in 2020).
- Limited paperwork and costs.
- Contributions must be made by Oct. 15 of the
following year.
- RMDs follow IRS regulations, and no loans
permitted.
- No age-based catch-up contributions are
allowed. As amended in the 2019 SECURE
Act, there are no age limits on who can make contributions.
- 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 50 and older) up to 100% of your
compensation.
- Additionally, the self-employed person 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 50 or older.
- Employee deferral elections must be made by Dec.
31, but employer contributions may be made by the tax-filing deadline (April
15, or Oct. 15 if an extension was filed).
- Plan must be opened by Dec. 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: Unique to the Roth version of Solo 401(k)s, there are RMDs — unlike a
regular Roth. There are no age limits on
who can make contributions.
- Loans are permitted.
- 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). The combined total contributions to
the employer retirement plan and the individual 401(k) can’t exceed the maximum
of $58,000/$64,000.
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: This sum represents the IRS maximum for a
defined benefit plan of $230,000 plus the $64,500 for a 401(k).
- Typically the costliest and most complex type of
retirement plan 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 the plan is established, the employer’s
contribution amount is not discretionary. That means that the employer is
required to make the annual minimum contribution that was established in the
plan documents. The plan must be fully funded if it is ever frozen or
terminated.
- There are excise taxes if annual minimum
contributions are not met. So if you have a bad year and can’t afford to
contribute what you had planned, the IRS can impose excise taxes. Interest is
accrued at a rate established in the original plan set-up.
- Loans may be permitted.
- The plans are subject to RMDs, but there are no
age limits on contributions.
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