Self-employed business owners and entrepreneurs working for themselves part-time have a lot of flexibility when it comes to saving for retirement and managing their taxes. Though self-employed retirement plans are quite easy to set up and fund, there are some deadlines to be aware of. Particularly for individuals with significant cash flow, opening a retirement account for your business can be a great opportunity to lower your tax bill and save for retirement...assuming you ever want to.
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- One participant retirement plans
- Retirement plans for your part-time business
- Small business retirement plans
How self-employed entrepreneurs can use a retirement plan as a tax-saving strategy
The two most common types of retirement plans for self-employed business owners are the SEP IRA and Solo 401(k). If you don't have a plan in place yet, it may not be too late. These self-employed retirement plans offer a lot of flexibility for established and new business owners alike.
- A SEP IRA is the most flexible type of plan to set up and fund. You can open and contribute to a SEP IRA as late as the company's tax filing deadline (usually April 15th, but longer if filing on an extension) for the funds to count towards the current calendar year.
- An Individual 401(k) plan must be set up by the company's fiscal year end, although individual salary deferrals and employer profit sharing contributions can be made as late as the tax filing deadline (usually April 15th, but longer if filing on an extension). Under the Secure Act, employers can establish a new qualified retirement plan, such as a 401(k), as late as the corporate tax filing deadline. While the extension won't impact individual contributions, which must be made before the end of the year, it would permit self-employed employers to make a profit-sharing contribution to their employee account for the previous tax year.
- The total annual contribution limit for both SEP IRAs and Solo 401(k)s is $56,000 in 2019 and $57,000 in 2020. For Individual 401(k) plans, owners 50 and older can make a $6,000 additional catch-up contribution in 2019, which increases to $6,500 in 2020. Your actual permitted contributions may be less than that though.
- SEP contributions are limited to the lesser of 25% of W-2 earnings, or 20% of net income if self-employed, or $56,000 in 2019 and $57,000 in 2020. Your CPA can calculate this amount. Contributions are made by the business, versus the entrepreneur personally. More on that later.
- Solo 401(k) plans can be funded in two ways: an elective contribution (by the business owner personally) and a profit-sharing contribution (by the company):
- In 2019: the maximum elective deferral in 2019 is the lesser of $19,000 ($25,000 if over age 50 due to the $6,000 catch up contribution) or 100% of W-2 compensation or net self-employment income. In 2020: the maximum elective deferral in 2020 is the lesser of $19,500 ($26,000 if over age 50 due to the $6,500 catch up contribution) or 100% of W-2 compensation or net self-employment income.
- An optional profit-sharing contribution can also be made of up to 25% of W-2 wages or 20% of net self-employment income for a partnership, sole proprietorship, or single-member LLC that has not elected to be taxed as a C-corporation or S-corporation. The combined total annual contribution (personal + profit-sharing) cannot exceed $56,000 in 2019 ($62,000 if over age 50) or $57,000 in 2020 ($63,500 if 50+).
Eligibility and funding:
- A SEP IRA is funded solely by employer contributions. A SEP IRA can be established by business owners with employees. Contributions are optional, but if SEP contributions are made, they must be done equally across all eligible participant accounts. This can either be a flat dollar amount or equal percentage of compensation. A SEP IRA must also cover all eligible employees. An employee is considered eligible if they are over the age of 21, have worked at the company for at least three of the last five years, and received compensation of at least $600 (2019 and 2020) in the year.
- Individual 401(k) plans can be funded by an entrepreneur in two ways: as the employee and the employer, subject to the maximum annual additions limit. A Solo 401(k) can only be used if the only employees of the company are the business owner and a spouse.
- SEP IRA: For sole proprietors, the SEP contribution will represent an above-the-line deduction on your personal tax return. If your business is taxed as a C corporation, S corporation, multi-member LLC, or partnership, the SEP contributions will be deducted as a business expense. This reduces the company’s net taxable income, which then reduces the taxable income that will be passed through to an owner on their K-1.
- Individual 401(k): For sole proprietors, the employee and employer contribution will be combined as an above-the-line deduction on your tax return. If your business is taxed as a C-corporation, S-corporation, multi-member LLC or partnership, the tax benefits will be split in two parts:
- Your employee contribution will reduce your W-2 taxable income as an above-the-line deduction.
- The profit-sharing contribution from the business will be deducted as an expense by the business, reducing the company’s net taxable income, which then reduces the taxable income that will be passed through to an owner on their K-1.
Starting a retirement plan for your part-time business
Can you still start your own retirement plan for your business even if you're covered by a plan at work? Likely, yes.
Limits on your contributions as an individual:
The annual elective deferral limits apply to the individual, not the plan. So if you’re covered by a 401(k), 403(b), SIMPLE 401(k), or SIMPLE IRA, your individual contributions will be aggregated and cannot exceed the lesser of deferral limits set by the plan, 100% of your eligible compensation under the plan, or the maximum contribution limit as set annually by the IRS.
Employer contributions are not aggregated:
The annual profit sharing contribution limits by an employer apply to each unrelated company’s specific plan. For 2020, the annual additions limit for employee and employer contributions to defined contribution plans (like a 401(k), 403(b), or SEP IRA) is $57,000 for those under the age of 50. SEP IRAs are funded only by employer contributions. So while your individual contributions may be limited to $19,500 (in 2020, under age 50) across all your retirement plans, each of your employers (which includes your business) may still be able to contribute up to $57,000 per plan. Keep in mind the actual amount you (or your employer) can contribute will still be subject to your earnings, plan limitations, and other factors.
If you're covered by a plan at work, a SEP IRA may be a great option because your SEP funding won't be reduced by contributions you make at your full-time job.
Retirement plans for small business owners with employees
For companies with full-time employees, a traditional 401(k) plan, SIMPLE 401(k) or SIMPLE IRA may be more appropriate. Keep in mind that the decision does get more complex when employees are involved. There are various regulations you'll need to be aware of including: eligibility, notifications, timing of investments, recordkeeping, and so on.
The following is an overview of some of the considerations involved with a 401(k), SIMPLE 401(k) or SIMPLE IRA. Due to the complexity of retirement plan requirements, consult a professional to discuss your specific situation.
Comparing employee eligibility:
- Traditional 401(k) plan - generally 1 year of service* and age 21+
- SIMPLE IRA - employees who have earned at least $5,000 during any of the 2 preceding years or expect to earn at least $5,000 in the current year. For employers, must have under 100 employees
- SIMPLE 401(k) - generally 1 year of service* and age 21+. For employers, must have under 100 employees
*The Secure Act has expanded employee eligibility requirements favorably for part-time employees. In 2019, employers could prevent part-time workers from becoming eligible to participate in the 401(k) plan if the individual worked less than 1,000 hours during the year. Effective for plan years starting in 2021, employers must expand eligibility requirements to include part-time employees who have worked at least 500 hours per year for the last 3 years (consecutively). The three-year lookback period will only apply to hours worked after January 1st 2021, meaning long-term part-time workers who meet this eligibility criteria could contribute starting in 2024.
Deferral limits (individual or employee-participant):
All limits below assume participants only participate in the one retirement plan indicated below.
- Traditional 401(k) plan - maximum elective deferral in 2020 is the lesser of $19,500 ($26,000 if over age 50 due to the $6,500 catch up contribution)
- SIMPLE IRA - maximum elective deferral in 2020 is $13,500. The catch-up contribution for those over age 50 is $3,000 (Note: employer contributions are required - see below)
- SIMPLE 401(k) - same as the SIMPLE IRA
SIMPLE plans have minimum employer funding requirements:
- SIMPLE IRA - Employers must make either mandatory contributions of 2% of compensation up to salary of $285,000 (in 2020) or make dollar-for-dollar matching contributions calculated as the lesser of: 100% of employee salary deferral or 3% of salary without an income limitation. With a SIMPLE IRA, businesses have the option to reduce their matching contribution to as low as 1% in up to 2 of the last 5 years (rolling).
- SIMPLE 401(k) - Employers must make either mandatory contributions of 2% of compensation up to salary of $285,000 (in 2020) or make dollar-for-dollar matching contributions calculated as the lesser of: 100% of employee salary deferral or 3% of salary. Note that the $285,000 limit on covered compensation applies to either type of employer contribution in the SIMPLE 401(k), but there is no option to reduce the matching contribution for a period of time. For employers who have newly-eligible part-time employees under the three-year rule, current legislation suggests that employers won't be required to make matching, or nonelective contributions to the accounts of long-term, part-time part employees.
Traditional 401(k) testing requirements:
A 401(k) plan doesn't have any automatic minimum employer funding requirements, though employers can choose to elect matching, nonelective, and/or profit-sharing contributions. However, there are layers of compliance testing and administration which could make using a traditional 401(k) plan infeasible.
A 401(k) plan offers higher annual deferral limits (similar to a Solo 401(k)) but there are annual testing requirements to prevent the plan from skewing benefits towards "highly compensated employees" or HCEs. If the plan fails testing, the employer may be required to disallow or refund excess contributions made by HCEs (even if under the IRS limit) and make extra additions to non-highly compensated workers accounts. The testing process is complicated and you'll need to rely on a 401(k) plan administrator to help.
For employers who have newly-eligible employees under the three-year rule, they will not be required to include those individuals in annual nondiscrimination and top-heavy tests. Current legislation also suggests that employers won't be required to make matching, profit-sharing, or Safe Harbor contributions to the accounts of long-term, part-time part employees.
Most employers will have 2 options to avoid annual testing:
- Safe Harbor 401(k) plan. With a safe harbor 401(k), the employer must make either mandatory contributions of 3% of pay to each eligible participant's account (whether they are contributing or not) or matching contributions. There are a couple of ways to structure matching contributions but employees who max out the match can get up to 4%. The maximum compensation that can be considered in 2020 for safe harbor or matching contributions is $285,000.
- SIMPLE IRA or SIMPLE 401(k). Like the safe harbor plan, SIMPLE plans also impose minimum funding requirements. Refer to the section above for details.
The best plan for a company will depend on a number of factors, but business owners can and should run the numbers to determine which arrangement will be most advantageous for their retirement goals while making sure funding requirements for employees will remain affordable.
Retirement plans are a great way to save for retirement and reduce your taxable income. Business owners especially need to make sure they're minding their future finances because if they don't - who will?