Retirement Plans for Small Business Owners and the Self-Employed

A recent study conducted by The Pew Charitable Trusts, an independent nonprofit organization, revealed that just over 1 in 10 self-employed individuals in a single-person business currently participate in a retirement plan. By comparison, 72% of employees in larger companies utilize a 401(k) at work.

Even more concerning is that Paychex—a leading payroll, HR, and benefits company—identified that only 30% of small business owners feel even “somewhat confident” they’ll be able to retire at some point in the future.

If you’re a small business owner or self-employed, saving for your golden years is even more critical since you don’t have the luxury of employer-provided retirement benefits. Fortunately, these six options can boost your retirement savings and possibly allow you to stash away significantly more than you ever could with an employer plan.

Defined benefit versus defined contribution plans

Before we explore your options, know that retirement plans fall into one of two classifications: defined benefit plans—which promise a specified monthly benefit at retirement (think Social Security or a pension)—and defined contribution plans that don’t and are generally tax-deferred (think a 401(k) or IRA). Your first five options fall under the umbrella of “defined contribution” plans.

Traditional IRA

A traditional IRA is a tax-deferred savings account, meaning you’ll pay taxes on a future date. Any contributions you make are therefore typically funded with pre-tax dollars, and earnings grow tax-deferred until you withdraw them in retirement. 

Ideal beneficiaries
A traditional IRA makes the most sense if you’re just starting out and/or looking for simplicity, as it’s the easiest to set up and includes no special filing requirements.

2023 IRA contribution limits
If you are under 50 years of age, the maximum annual contribution limit is $6,500 (limits do change annually). If you’re age 50 or older, you can contribute up to $7,500.

Other stuff to know
Anyone can open and fund a traditional IRA account. However, if you want to ensure your contributions are tax-deductible, the IRS does have income restrictions. These limits are based on how much you earn and whether you or your spouse currently participate in other qualified retirement plans—such as a 401k.

Traditional IRAs are individual plans: meaning that your employees (if applicable) can set up and contribute to their own IRAs.

Although there are exceptions, an early withdrawal penalty is generally assessed on those who withdraw money from their IRA before the age of 59½. The tax penalty is 10% of what you withdraw; with this amount also taxed as income.

As a traditional IRA is a tax-deferred account, Uncle Sam requires you to eventually pay taxes on your asset. This is where required minimum distributions (RMDs) come into play, reflecting the minimum amount of money you must withdraw from an IRA beginning at age 73.

Roth IRA

Unlike with a traditional IRA wherein tax breaks are immediate, these come later with a Roth IRA: as the latter is funded with after-tax dollars and you can enjoy tax-free withdrawals on qualified distributions in retirement.

Ideal beneficiaries
Generally speaking, a Roth IRA makes the most sense if you want more flexibility to withdraw funds (contributions) without penalty, no need to worry about RMDs during retirement, and/or the ability to diversify your retirement savings with both tax-free and taxable accounts.

2023 Roth IRA contribution limits
If you are under 50 years of age, the maximum annual contribution limit is $6,500 (limits do change annually). If you’re age 50 or older, you can contribute up to $7,500.

Other stuff to know
Roth IRAs do feature stricter income limits. For example, for 2023, you need to make less than $153,000 if you file taxes as a single (or $228,000 for joint filers). An IRS-approved method called a backdoor IRA provides the ability to sidestep these limits, requiring that you possess and convert a portion (or all) traditional IRA funds to a Roth IRA.

Unlike traditional IRAs, there are no RMDs and you don’t need to make any withdrawals during your lifetime. There are also fewer restrictions if you plan on leaving the account for your inheritance.

You can withdraw sums equivalent to your contributions penalty and tax-free—anytime, for any reason—even before the age of 59½! However, if you want to withdraw earnings from your Roth IRA (before the age of 59½), you’ll incur a 10% early withdrawal penalty. However, as with any rule, exceptions do exist.

SEP IRA

Simplified employee pensions (SEP) IRAs are tax-deferred accounts: meaning you fund the account with pre-tax dollars and pay taxes when you withdraw money used to provide retirement benefits for business owners and their employees.

Ideal beneficiaries
SEP IRAs are often most beneficial for those with no or few employees and who want the flexibility to choose when and how much to contribute (especially with respect to a seasonal business or fluctuating income).

2023 SEP IRA contribution limits
You can contribute up to either 25% of employee/owner compensation or $66,000: whichever is less.

Other stuff to know
Sole requirements to open a SEP IRA are that you must be a sole proprietor, business owner, in a partnership, or earn self-employment income by providing a service.

SEP IRAs are funded entirely by you, the employer, and you have the flexibility to determine when and how much to contribute.

While some exceptions do apply to SEP IRAs, eligibility typically extends to employees over the age of 20 who have worked three out of the last five years and have received at least $750 in annual income from your business.

All eligible employees must be included; in other words, there are no plan “opt ins.” As each employee must receive the same contribution as a percentage of salary, this may limit your ability to make large contributions for yourself. Employees are 100% vested immediately, with distributions required to begin at age 73.

SIMPLE IRA

Akin to a SEP IRA, a Savings Incentive Match Plan for Employees (SIMPLE) IRA is also a tax-deferred account used to provide retirement benefits for business owners and employees.

Ideal beneficiaries
SIMPLE IRAs are better geared towards larger businesses (up to 100 employees) as both owners and employees can bear the funding burden.

2023 SIMPLE IRA contribution limits
Employees can defer up to $15,500 or 100% of compensation: whichever is less. Those age 50 and older can defer an additional $3,500, otherwise referred to as the “catch-up limit.”

Other stuff to know
To open a SIMPLE IRA, business owners must have 100 or fewer employees and cannot maintain any other employer-sponsored retirement plan.

Contributions made to employee accounts are deductible as a business expense.

For employees to participate in these plans, they must have earned at least $5,000 in any two preceding years and expect to earn $5,000 or more in the year they are eligible. Employers also have the option to make these requirements less restrictive.

Employers are required to make contributions to employee accounts in one of two ways: either via dollar-for-dollar matching contributions (up to 3% of each employee’s compensation) or non-elective contributions for all employees—including those who do not make contributions—equaling 2% of each employee’s compensation.

Solo 401(k)

Also known as an “individual 401(k),” a solo 401(k) is another retirement plan option that features many of the same rules and requirements as an employer-sponsored 401(k). One large difference is that to open one, you cannot have any full-time employees and the only other person you can add to the plan is your spouse. You also enjoy a wider breadth of investment options than an employer-sponsored plan and can fund alternative investments such as real estate and cryptocurrencies.

Ideal beneficiaries
A solo 401(k) can best help those aiming to maximize their retirement savings and/or seeking the flexibility to save even more in years when their business is most profitable.

2023 solo 401(k) contribution limits
As a business owner, you can contribute both as an employer and employee. However, your total contributions cannot exceed $66,000—with an additional $7,500 in catch-up contributions (if eligible).

As an employee, you can contribute up to $22,500 with an additional $7,500 in catch-up contributions. Contributions are simply deducted from your paycheck.

As an employer, you can make an additional matching contribution equaling up to 25% of profits or 25% of your net self-employment income (for sole proprietors and single-member LLCs).

Other stuff to know
Spouses have the same contribution limits for employer-sponsored 401(k)s, which, for 2023, is $22,500—with an additional $7,500 for those age 50 and older.

Also note that RMDs are applicable to solo 401(k)s.

You can contribute to a Roth IRA, traditional IRA, and solo 401(k), provided you don’t exceed contribution limits: which, in this case, are aggregated.

You can also set up a traditional solo 401(k) or Roth solo 401(k), which mimics the tax treatment of a Roth IRA.

Defined benefit plan

A defined benefit plan works like an employee pension in that it provides a guaranteed stream of income during retirement. Contributions are generally tax-deductible, and distributions at retirement are taxed as income.

Ideal beneficiaries
This option is best suited for small business owners (or self-employed individuals) who have a robust income—typically at least $250,000 per year—and are looking to save a lot of money for retirement and shelter profit from taxes.

2023 contribution limits
Your contribution limit is a calculation based on your age, expected investment returns, and the benefit you’ll receive at retirement.

Other stuff to know
Plan contributions are mandatory and fluctuate based on the plan’s investment performance and demographics of eligible employees.

This retirement plan option is more expensive to set up and maintain than others, as you’re required to enroll all eligible employees (often those with at least one year of service who work at least 1,000 hours a year and are over the age of 20). Defined benefit plans are also more of an administrative burden given that an actuary must file forms and determine your funding levels and tax deduction limits.

In sum: retirement plan options for small business owners and the self-employed

You’re likely to encounter several challenges and headaches while running your own business. Now that you’re familiar with the options discussed in this article, saving for retirement need not rank among them.

———

Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.