Owning a business is tough. Long hours, lean early years and high anxiety are all too common for many business owners. But, for many, the long-term returns are worth the struggle. Having a greater sense of control over your future and achieving more income are a few of the goals that many business owners seek. Unfortunately, business owners often miss out on another opportunity to improve their financial well-being—business retirement plans.
I frequently find that many people are familiar with individual retirements plans, such as traditional and Roth IRAs, but know less about the retirement plan options for businesses. Some people may have experienced a “pension” or 401k account set up by a prior employer, but very few small to medium-sized business owners take the time to set these up for their own businesses. Those that fail to do so are missing out on a huge benefit and are leaving money on the table.
Two of the best options for small to medium-sized businesses are “SEP” and “SIMPLE” IRAs. Both of these options are easy to establish and maintain while providing an opportunity to achieve better overall financial results through tax savings. In a nutshell, these tools provide an easy way to yield more money for every dollar of revenue and should be considered by all business owners.
SEP stands for “Simplified Employee Pension” and was created to provide small businesses and self-employed individuals the opportunity to create retirement savings accounts. SEPs can generally be easily established through brokers (e.g., Charles Schwab) in a manner that is very similar to setting up an IRA. In fact, they have many of the same benefits as IRAs including tax-deferred growth and tax savings in the contribution year. However, SEPs can be far more advantageous than using IRAs given that they have much higher contribution limits. For example, in 2018 the contribution limit for IRAs was $5,500 per person versus a whopping $55,000 per person for a SEP. SEP contributions are based on a chosen percentage of income (up to 25%) and employers must contribute to employee accounts at the same level as business owners. So, SEPs are great tools for small closely-held businesses and self-employed “1099 contractors” who have a desire to convert some income into retirement savings in a tax-efficient way. SEPs also have flexibility in that the contributions can be “turned on/off” from year to year based on cash availability. One of the best features of a SEP is that contributions are not required until the due date of the business return so businesses can generally assess their full-year performance after the year is over before making a final determination on contribution amounts.
A SIMPLE plan, which stands for “Savings Incentive Match Plan for Employees,” generally has the same tax benefits as a SEP IRA (i.e., tax deferred growth and tax savings at the time of contribution). However, SIMPLE plans are much better for medium-sized businesses with up to 100 employees that are looking to establish a plan mainly as an employee benefit. SIMPLE plans can be established through brokers (e.g., Charles Schwab) and are generally much easier and cheaper to administer than 401k plans. Generally, employers must either agree to “match” an employee’s contribution, up to 3% of income, or pay in 2% of income to each employee annually.
For highly compensated individuals who have excess earnings and are looking to maximize retirement savings, there are more optimal, but also more complicated, options available. For example, a “Defined Benefit” pension plan uses one’s current salary and desired salary in retirement to determine the current year contribution. These contributions can well exceed $100,000 per person per year under certain circumstances. Administration of this plan type is much more expensive and employers can generally expect to pay between $5,000-15,000/year for administration and tax preparation.
It’s worth noting that SEP and SIMPLE IRAs can be easily managed by professional advisors when established through brokers. So, while many 401k plans have limited investment options and are exclusively self-directed by the account owner, these types of plans can be invested in anything available on the brokerage platform and, if desired, directed by a professional wealth advisor.
It’s worth reviewing the tax benefits of business retirement plans as they are substantial. Tax-deferred growth means that these plans pay no taxes on year-to-year gains. This fact is true regardless of the tax-characterization of the gains (e.g., income, dividends or shot-term/long-term capital gains). Rather, they are taxed as income upon withdrawal in retirement – a benefit that can be enormous when compounded over decades of growth. Moreover, the contribution is generally tax-deductible in the year that it is made. So, as a proxy for that benefit, you can multiply your estimated tax rate by the contribution amount to compute an estimated savings (e.g., a 30% marginal tax rate with a contribution amount of $25,000 may yield an approximate savings of $7,500). That’s an easy way to increase your business return on investment that requires minimal incremental work and expenditure. So, go out and give yourself a much deserved bonus today!