Small Business Retirement Plans

September 14, 2012

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

According to the Small Business Administration, there are more than 28 million small businesses in the United States. Amazingly, small businesses employ half the nation's private workforce, account for nearly half of private sector output and are consistently responsible for creating around 65% of net new jobs.¹

As any successful small-business owner will attest, such accomplishments don't come without taking on a good amount of risk and putting in a lot of hard work—but the rewards can be well worth it.

And though income taxes aren't high on the list of what small business owners love most about self-employment, The Internal Revenue Code offers an additional reward: some very favorable tax rules designed to help self-employed individuals and their employees save for retirement.

Retirement accounts for small businesses

Most of us are familiar with 401(k) plans and traditional IRAs. These accounts provide an up-front tax break and the ongoing benefit of tax-deferred compounding as we save for retirement. Here are some additional retirement accounts that provide the same tax advantages, available to smaller companies with fewer (if any) employees:

• SIMPLE IRA. A savings incentive match plan for employees—better known as a SIMPLE IRA—is easy to set up and might be a good choice if you have employees and want to let them make their own contributions. As the employer, you're still required to make a small matching contribution of 1% to 3% of each employee's compensation, including your own.²
  
  For 2012, eligible employees may contribute 100% of their income up to a limit of $11,500. Participants who are 50 or older can make an additional $2,500 "catch-up" contribution for 2012.
  
  A SIMPLE plan must be in existence by October 1 of the year for which contributions are claimed. You have until the due date of the tax return plus extensions to deposit employer contributions. For more, see the IRS' SIMPLE IRA Plan Checklist.
  
  
• SEP-IRA or QRP (Keogh). SEP stands for simplified employee pension, and a QRP is a qualified retirement plan for the self-employed, sometimes referred to as a Keogh plan. With a SEP-IRA or QRP, the employer makes the contributions (employees can't contribute). Importantly, the tax-deductible contribution limits are potentially much higher than a SIMPLE IRA: 25% of employee compensation (which works out to 20% of net self-employment income for the owner³) up to a $50,000 limit for 2012.
  
  You can set up a SEP-IRA as late as the date the tax return is due (including extensions) for the year in which you claim the tax-deductible employer contribution. However, a QRP has to be in existence by December 31 of the year for which contributions are claimed, even though employer contributions themselves can be deposited as late as the due date (plus extensions) for that year's tax return.
  
  The IRS has a SEP Checklist you may find useful. And for more detailed information on each of these plans, check out IRS Publication 560: Retirement Plans for Small Business.
  
  
• Individual 401(k). An Individual 401(k) offers benefits similar to a traditional 401(k), but requires less administration. These plans allow for contributions up to 25% of compensation (20% of net self-employment income for the owner) and an additional $17,000 salary deferral (for 2012), to the maximum limit of $50,000 (maximum of $55,500, including the 2012 catch-up contribution of $5,500 for those 50 or older).
  
  An employer has to establish an Individual 401(k) before the end of the year, but can make contributions by the tax-filing deadline, including extensions.

Remember, you can contribute to your own traditional IRA or Roth IRA (if you're eligible) in addition to these employer plans.

Which plan is best?

There are a number of variables to consider. SEP-IRAs and SIMPLE IRAs are both relatively easy to establish and maintain, and can provide greater control over the size and frequency of contributions. An Individual 401(k) or QRP plan takes a little more paperwork and maintenance.

If you have employees and want them to fund the bulk of their own retirement, a SIMPLE IRA would probably be the best choice.

On the other hand, if you have very few or no employees and the ability to save for yourself is most important, you might want to look at a SEP-IRA, Individual 401(k) or QRP, which could allow for larger contributions.

Your age and self-employment income may play a role in your decision. For instance, there's a certain income level at which the maximum contribution you can make to a SIMPLE IRA versus a SEP-IRA or QRP is the same. Income above or below this level determines which account will allow you to contribute more. If you're 50 or older, you need to factor in catch-up contributions as well, which are allowed for SIMPLE IRAs and Individual 401(k)s, but not for SEP-IRAs and QRPs.

In 2012, for example, if you're under age 50 (no catch-up contribution allowed), the SIMPLE IRA versus SEP IRA/QRP break-even income level is $72,709.⁴ At this level, a SIMPLE IRA allows a contribution of $13,514—the same as a SEP-IRA or QRP.

Business income above $72,709 would favor a SEP-IRA or QRP because of the lower contribution limit on SIMPLE plans, but income below that level would favor a SIMPLE IRA because contributions to a SEP IRA or QRP are based on a percentage of income only (SIMPLE IRAs allow a $11,500 contribution on top of the percentage calculation—see the calculation below). For those 50 or older who can make the SIMPLE catch-up contribution of $2,500 for 2012, the break-even income level is $88,515.

Of course, an Individual 401(k) could be an even better deal. It allows for the same 25%-of-earnings limit (20% of net self-employment income) as a SEP or QRP, plus lets you make an elective deferral of $17,000. In the example above, a self-employed person under age 50 with business income of $72,709 could contribute $30,514 ($13,514 + $17,000) to an Individual 401(k) —$36,014 for those 50 and older!

Keep in mind, Individual 401(k)s are currently subject to the same $50,000 cap as a SEP or QRP. So, if you're under age 50 the contribution advantage is lost as business income exceeds $260,312 ($250,000 net self-employment income). At that point, you reach the maximum total contribution of $50,000 with any of the three plans, and other considerations—ease of implementation and administration, number of employees (Individual 401(k)s are ideal if you have no employees) and so on—should drive your decision. Of course, if you're 50 or older you can contribute an additional $5,500 to the Individual 401(k) in 2012 for a total cap of $55,000 (no catch-up contributions are allowed for the SEP or QRP accounts).

Finally, older small business owners who need to catch up on their retirement savings may want to consider another option—setting up their own defined benefit pension plan (DB plan). If your business is generating high levels of income, this type of QRP could allow you to exceed the regular contribution limits, because with a DB plan those limits are based on actuarial factors as well as business income. There's a bit more complexity involved, but some providers offer convenient turnkey solutions. For example, Schwab provides both actuarial services and assistance with required IRS forms for its Personal Defined Benefit Plan clients.

1. "Frequently Asked Questions about Small Business," U.S. Small Business Administration, September 2012.
2. SIMPLE plans define a self-employed owner's "compensation" as self-employment income before deductions—the amount shown on line 4 of Short Schedule SE (Form 1040)—which is net income from your business multiplied by 92.35%, as described in IRS Publication 560.
3. SEP-IRA and QRP contributions are based on net self-employment income, which is defined as the net income from your business minus half your self-employment tax (which you get to deduct "above the line" on your income tax return) and minus the amount of your contribution. This results in something of a circular calculation that translates as 20% of income after subtracting self-employment tax. See Form 1040 Schedule SE for step-by-step instructions on how to calculate self-employment tax.
4. Here's how we calculated the break-even income level, assuming net profit from Schedule C of $66,386.

SIMPLE IRA contribution

SEP-IRA or QRP contribution (and base Individual 401(k) contribution)

Individual 401(k) additional contribution