Learn about the different accounts designed to help self-employed individuals and their employees save for retirement.
Many small business retirement plans provide the same tax advantages as 401(k) plans and traditional IRAs.
Consider your age, income level, number of employees, and account administration preferences when making your decision.
Learn and explore the main differences between SIMPLE IRA, SEP-IRA, QRP (Keogh) and Individual 401(k) plans.
Small business retirement plans are big business. 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 and create on average 65% of net new jobs.1
As any successful small-business owner will attest, such accomplishments don't come without risk and hard work—but the rewards can be well worth it.
And though income taxes and retirement plans aren't high on the list of what small business owners love most about self-employment, the Internal Revenue Code offers 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:
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 required to make a small matching contribution of 1% to 3% of each employee's compensation, including your own.2 For 2014, eligible employees may contribute 100% of their income up to $12,000. Participants who are 50 or older can make an additional $2,500 "catch-up" contribution for 2014. A SIMPLE IRA 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 or QRP (Keogh)
With both of these types of plans, the employer makes the contributions, not the employee. SEP stands for simplified employee pension; with this arrangement, employers contribute to traditional IRAs (SEP-IRAs) set up for employees. A QRP is a qualified retirement plan for the self-employed, sometimes referred to as a Keogh plan. The tax-deductible contribution limits with SEPs and QRPs are potentially much higher than a SIMPLE IRA: 25% of employee compensation (20% of net self-employment income for the owner3) with a $52,000 limit for 2014. 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 information on each of these plans, check out IRS Publication 560: Retirement Plans for Small Business.
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 $17,500 salary deferral for 2014, to the maximum limit of $52,000 ($57,500 for those 50 or older, including a catch-up contribution of $5,500). 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, if you're eligible, you can contribute to your own traditional IRA or Roth IRA in addition to these employer plans.
Which small business retirement plan is right for you?
A number of variables will factor into your choice of small business retirement plan.
1. Ease of implementation and administration. 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.
2. Number of employees. 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.
3. Age and self-employment income. SIMPLE IRAs and Individual 401(k)s allow catch-up contributions for those 50 or older; SEP-IRAs and QRPs do not. In addition, at a certain income level, the maximum contribution to a SIMPLE IRA, a SEP-IRA and a QRP is the same. In 2014, if you're under age 50, this "break-even" income level is $75,871, which allows a contribution of $14,102.4 Different retirement plans allow you to contribute more or less, depending on whether your business income is more or less than the break-even level. Income exceeding $75,871 would favor a SEP-IRA or QRP, but income less than that would favor a SIMPLE IRA because contributions to a SEP IRA or QRP are based on a percentage of income only (25% of earnings, or 20% of net self-employment income). For those 50 or older who can make the SIMPLE catch-up contribution of $2,500 for 2014, the break-even income level is $91,676. An Individual 401(k) could be an even better deal because it not only allows for the same contribution as a SEP or QRP but also lets you make an elective deferral of $17,500. So a self-employed person under age 50 with business income of $75,871 could contribute $31,602 ($14,102 + $17,500) to an Individual 401(k)—and those 50 and older could contribute $37,102. Keep in mind, Individual 401(k)s are currently subject to the same $52,000 cap as a SEP or QRP. So with any of the three plans, if you're under age 50, the contribution advantage is lost when business income exceeds $270,881 ($260,000 net self-employment income). If you're 50 or older, in 2014, you can contribute an additional $5,500 to the Individual 401(k) for a total cap of $57,500.
What about defined benefit plans?
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 (DB) pension plan (also known as a Personal Defined Benefit Plan). If your business is generating high levels of income, this type of QRP could allow you to exceed the regular contribution limits. With a DB plan, those limits are based on actuarial factors as well as business income. Although there's a bit more complexity involved, Schwab provides 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, March 2014.
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 $75,871.
SIMPLE IRA contribution
• $75,871 x 0.9235 = $70,067 "compensation"
• $70,067 x 0.03 = $2,102 match
• $2,102 match + $12,000 contribution = $14,102 contribution
SEP-IRA or QRP contribution (and base Individual 401(k) contribution)
• $75,871 x 0.9235 = $70,067 compensation
• $70,067 x 0.153 = $10,720 SE tax
• $75,871 - ($10,720 x 0.5) = $70,511 "net self-employment income"
• 70,511 x 0.20 = $14,102 contribution
Individual 401(k) additional contribution
• $14,102 + 17,500 = $31,602
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