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Retirement Plan Options for Small Business Owners: Defined Contribution or IRA-Based Plans

By Timothy Lee on December 13, 2021
Categories: EXECUTIVE COMPENSATION, RETIREMENT

Small business owners have a few options to choose from when it comes to preparing their retirement plan. It can be an overwhelming amount of information, but it’s important for small business owners to understand which retirement plan is the best fit for them and their situation. Some of the key considerations include the number of employees in the business, the plan’s maximum annual contribution limits, and the plan’s ease of administration.

There are two main types of retirement plans: defined contribution or IRA-based plans and defined benefit plans. This article will focus on defined contribution or IRA-based plans.

What are defined contribution or IRA-based plans and how do they work?

Generally speaking, defined contribution / IRA-based plans are tax-deferred retirement plans, in which employees can contribute to fund their retirement and may also receive matching contributions from the employer. With defined contribution / IRA-based plans, retirement benefits are not guaranteed. The benefit in retirement is based on the investment performance of the plan, which is determined by the investments that the employee chooses. In contrast, a defined benefit plan provides retirement benefits that are guaranteed by the employer. As the business owner, it’s important to remember that you act as both an employee and the employer for whichever retirement plan you participate in.

For small business owners, there are three main options for defined contribution / IRA-based plans: Individual 401(k)s, SEP IRAs, and SIMPLE IRAs.

Individual 401(k)

Individual 401(k)s, also known as Solo 401(k)s, are typically well-suited for small business owners with no employees (other than a spouse). In 2021, the maximum annual contribution limit for Individual 401(k)s is $58,000 (which includes both employee and employer contributions), plus an additional $6,500 of catch-up contributions for those age 50 and older. For a business owner who employs their spouse (assuming no other employees), this could potentially equate to a total maximum annual contribution of $129,000 for the couple in 2021 (assuming they are both at least age 50). Once the plan has $250,000 or more in assets, the employer will be required to file an annual report to the IRS. Overall, Individual 401(k)s can be attractive to small business owners who want to save significant amounts of money each year and are also willing to be responsible for some annual administrative requirements once the plan exceeds $250,000.

SEP IRA

SEP IRAs are typically well-suited for small business owners with no or few employees. In 2021, the maximum annual contribution limit for SEP IRAs is the lesser of $58,000 (which only includes employer contributions) or 25% of net self-employment earnings, with no catch-up contributions. In contrast to Individual 401(k)s, the employer must contribute an equal percentage of salary for each eligible employee, including themself. For example, if a small business owner contributes 10% of their net self-employment earnings for themself, they must also contribute 10% of each eligible employee’s compensation. The upside is that SEP IRAs have a low administrative responsibility, because they do not require annual reporting to the IRS. Overall, SEP IRAs can be attractive to small business owners who want to save significant amounts of money each year and benefit from low administrative duties and are also willing to contribute to the plan for their employees.

Simple IRA

SIMPLE IRAs are typically well-suited for small business owners with larger businesses of up to 100 employees. In 2021, the maximum annual contribution limit for SIMPLE IRAs is $13,500 (which includes both employee and employer contributions), plus an additional $3,000 of catch-up contributions for those age 50 and older. The employer must contribute either matching contributions to employee accounts of up to 3% of employee compensation, or fixed contributions of 2% to every eligible employee. Choosing the latter means that the employer will have to contribute 2% of each employee’s compensation, regardless of whether or not the employee contributes. Similar to SEP IRAs, SIMPLE IRAs also have a low administrative responsibility, because they do not require annual reporting to the IRS. Overall, SIMPLE IRAs can be attractive to small business owners who want to provide a larger number of employees with the flexibility to contribute to the plan and benefit from low administrative duties and are also willing to accept a lower maximum annual contribution limit.

The Bottom Line

As a small business owner, choosing the retirement plan that best fits you can be a tough decision. That is why it is important to work with a certified financial advisor to guide you through your unique situation. No matter what type of plan you are considering, your financial advisor can help you choose a retirement plan that is best suited for you and your situation. If you are looking for assistance as you navigate this decision, contact us at Dowling & Yahnke Wealth Advisors, and our team would be happy to help.

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