Which Retirement Plan Is Best For Your Business?
Retirement planning is an important aspect of personal financial planning. This topic becomes even more important for business owners because they not only have to plan for their own retirement but also for the retirement of their staff (if they have any employees). In this article, I will cover discuss the five main types of retirement accounts/plans for business owners, including Traditional and Roth IRA, SIMPLE IRA, SEP IRA, Solo 401(k), and Defined Benefit Plans. I will also highlight the main differences between each plan, along with each one’s advantages and disadvantages, contribution limits, and examples of the kinds of businesses that each plan would be most suited for.
Traditional and Roth IRA
The simplest type of retirement savings vehicle is an Individual Retirement Account (IRA), which is available to just about anyone (some exclusions apply, which will be mentioned a little further down in this article). The main difference between a Traditional and Roth IRA lies in the timing of tax benefits they offer to the account holder and investor. Both Traditional and Roth IRAs are a great way to start saving towards retirement due to the fact that they are easy to set up and have minimal if any, fees.
Traditional IRA
Traditional IRA contributions are tax-deductible, and any gains within the account accumulated are tax-deferred until they are withdrawn in retirement (typically after age 59 1/2). Any funds withdrawn from the account during retirement are taxed as regular income.
Advantages of Traditional IRAs
Tax-deductible contributions (depending on income tax filing status and annual income amount)
Tax-deferred growth of earnings (no taxes on gains within the account until withdrawn in retirement)
Disadvantages of Traditional IRAs
Any contributions and growth within a Traditional IRA are taxed as ordinary income during retirement
Required Minimum Distributions (RMDs) must be taken from a Traditional IRA once the owner reaches the age of 73 (or age 75 in 2033).
Roth IRA
Roth IRAs are similar to Traditional IRAs, however contributions to a Roth IRA are made with after-tax dollars, and the growth within a Roth IRA accumulates tax-free. Withdrawals in retirement are tax-free as well.
Advantages of Roth IRAs
Tax-free withdrawals during retirement
No Required Minimum Distributions (RMDs)
Disadvantages of Roth IRAs
Contributions to Roth IRAs are not tax-deductible
Unavailable to individuals earning more than $153,000 (filing single) or $228,000 (filing jointly) for 2023
Contribution Limits For Traditional and Roth IRAs
The maximum contribution limit for 2023 for all IRAs is $6,500, with a $1,000 “catch-up” contribution allowed for individuals who are 50 years of age or older.
Note: Individuals earning more than $153,000, or couples filing jointly earning more than $228,000, are unable to contribute to a Roth IRA. There are strategies that can be implemented to get around this restriction, such as the “Back-door Roth Conversion”. If you are a high-income earner, contact one of our advisors to learn more about how you can contribute to a Roth IRA.
Simple IRA
The Savings Incentive Match Plan for Employees (SIMPLE) IRA is a retirement savings plan for small businesses with 100 or fewer employees. These plans may be a good option for midsize companies, as they are easy to set up and the accounts are owned by the employees. SIMPLE IRAs allow both the employer and employees to make contributions to the plan.
Advantages of SIMPLE IRA
Easy to set up and administer
Employers are required to make contributions, which can help attract and retain employees
Employer contributions are tax-deductible
Disadvantages of SIMPLE IRA
The contributions are lower compared to other plans
Employers must make contributions even during years when the business is not profitable
Contribution Limits for SIMPLE IRA
The maximum amount an employee is able to contribute to a SIMPLE IRA for 2023 is $15,500, with an additional $3,500 in “catch-up” contributions allowed for individuals over the age of 50.
The employer is generally required to match each employee’s salary contribution on a dollar-for-dollar basis up to 3% of the employee’s compensation, or 2% of each eligible employee’s compensation if the employer chooses to make Non-elective contributions.
SEP IRA
The Simplified Employee Pension (SEP) IRA is a retirement savings plan that is a great option for small-business owners with no or few employees. This type of plan allows small business owners to make contributions on behalf of themselves and their employees. SEP IRAs are popular amongst self-employed individuals or businesses with few employees because they are easier to set up and maintain than a Solo 401(k) - which we will discuss below.
Advantages of SEP IRA
Easy to set up and administer
Employers have the flexibility to choose the contribution amount each year
Tax-deductible contributions (deducted from the business level, Form 1040, Schedule 1)
Tax-deferred growth of earnings (no taxes on gains within the account until withdrawn in retirement)
Disadvantages of SEP IRA
Employer-only contribution means that employees do not make their own contributions and you must contribute the same percentages of employee compensation as you do to your own SEP account as a business owner.
No catch-up contributions after age 60, unlike other plan options
Contribution Limits for SEP IRA
The maximum amount an individual can contribute to a SEP IRA for 2023 cannot exceed 25% of compensation, up to $66,000. Unfortunately, SEP IRA plans do not offer any “catch-up” contributions after age 50 as other plans offer.
Solo 401(k)
This plan, which the IRS calls a “one-participant 401(k)” is a good option for business owners or self-employed individuals with no employees (except a spouse, if applicable). Although more complicated than other options listed within this article, Solo 401(k) plans offer flexibility and benefits to business owners who are looking to save for their retirement.
Advantages of Solo 401(k)
High contribution limits
Employer and employee contributions are tax-deductible
Tax-deferred growth of earnings
Disadvantages of Solo 401(k)
More complex than other plans
High costs for set up and administration
Contribution Limits for Solo 401(k)
The maximum amount an individual can contribute to a Solo 401(k) for 2023 is $66,000, plus a $7,500 catch-up contribution for individuals over the age of 50, or 100% of earned income. Since there are technically two parties typically contributing to a 401(k) plan, the employer and the employee, you, as the business owner and employee, could contribute to the Solo 401(k) as both parties. As an employee of your business, you would be able to contribute up to 100% of earned income, or $22,500 (plus that $7,500 catch-up contribution) to your plan. As the employer, you would be able to contribute up to 25% of compensation (up to the $66,000 total contribution limit for 2023).
Defined Benefit Plan
Define benefits plans are a type of retirement plan that guarantees a specific benefit payout to employees upon retirement. Unlike defined contribution plans, such as 401(k) plans, which have uncertain benefit payouts based on employee contributions and investment returns, defined benefit plans provide a predictable benefit to employees. While these plans can be attractive to employees, they also come with administrative and financial responsibilities for business owners who choose to offer them.
Advantages of Defined Benefit Plans
High contribution limits
Retirement income (benefit) is guaranteed
Tax-deductible contributions
Disadvantages of Define Benefit Plans
Higher costs and fees
Large mandatory contributions
Less control compared to other options
Contribution Limits for Solo 401(k)
The maximum amount an individual can contribute to a Defined Benefit Plan cannot exceed the lesser of 1) 100% of the participant’s average compensation for his or her highest 3 consecutive calendar years, or 2) $265,000 for 2023 ($245,000 for 2022; $230,000 for 2021 and 2020; $225,000 for 2019)
In conclusion, there are many retirement plan options available for business owners, each with their own unique benefits and considerations. Traditional and Roth IRAs, SEP IRA, SIMPLE IRA, Solo 401(k), and Defined Benefits Plans all offer different features to suit different needs. Choosing the right plan for your business can be a daunting task, but it is crucial to ensure that you are saving enough for retirement and maximizing tax benefits.
At any point, if you have any questions or would like a free consultation to discuss which plan may be best for your business, please do not hesitate to reach out to us. Our fiduciary investment advisors are here to help you navigate the retirement planning landscape and make informed decisions for your future!