If you work for a mid-sized or large company you likely have retirement account options available through your employer, and if so, you should definitely take advantage of this option. But, even if you are self-employed or run a small business there are some options you should consider, to both reduce your current taxable income and to save for retirement.
The Simplified Employee Pension (SEP) Plan is open to businesses of any size, but are generally used by small businesses, especially in businesses in industries that tend to have more boom/bust types of financial performance. The biggest advantage is that firms can change their contribution from year to year, so in good years they contribute more to their employees accounts while in bad they can reduce it. The largest disadvantage is an employer must contribute the same percentage of each employee’s pay to the plan (this money comes from the employer on top of salary/wages, employees don’t contribute to a SEP Plan), so this type of plan is most typically used by small firms where most or all of the employees are family, especially single individual firms (anyone considered an independent contractor). Here’s a few other key facts:
- The total amount that can be contributed is $61,000 per employee
- All contributions are from the employer, not the employee
- The employer must contribute the same percentage (up to 25%) to all eligible employees’ accounts, up to the compensation maximum of $305,000
The Simple Incentive Match PLan for Employees (SIMPLE) plan can be setup by an employer for its employees as either a 401(k) plan or IRA. There are some small differences in how the plan will work whether it is a 401(k) or an IRA, but the key features are the same in both cases:
- Employers must either contribute 2% of each eligible employee’s salary, regardless of the employee contribution status, or a matching contribution of 3%.
- Employees can contribute up to $14,000 of their salary per year (this is up from $13,500 in 2020 and 2021).
- Employees age 50 and older can contribute an additional $3,000 as a catchup contribution.
- SIMPLE Plans are available to employers with 100 or fewer employees, but there’s a two year grace period available for transition if the firm outgrows this limitation.
Some of the differences include process and notice period if the employer desires to terminate the program, whether employees can take loans against their account, and employer filing requirements, among others. The biggest advantage for employers is that these types of programs enable employees to contribute substantially to their retirement account but while being substantially easier and cheaper to manage than a 401(k) intended for larger companies.
401(k) SE / Solo 401(k)
The Solo 401(k) / 401(k) Self-Employed (SE) is an excellent plan type for those who qualify for it, but it is very limited in terms of who can qualify. As you can probably tell from the name, this type of plan is limited to the self-employed, or single person firms where the sole employee is the business owner. The one exception is that this extends to the business owner’s spouse, who can also be a participating employee in the plan.
- This is a 401(k) plan, so the employee can contribute up to $20,500 (up from $19,500 in 2020 and 2021).
- The employer can contribute up to 25% of the employee’s compensation.
- The total contribution to an individual’s account cannot exceed $61,000 (up from $57,000 in 2020 and $58,000 in 2021).
As mentioned, this plan type only works for self-employed business owners (extended to married couples where both spouses are employed by the business), and there are no other eligible employees or business owners. So it may be confusing to refer to the employer and employee, as this is the same individual wearing two hats: employer and employee. An example may make this more clear, so let’s assume this:
- John owns 100% of John’s Plumbing Company LLC
- John is the sole employee, and based on prior years he pays himself $6,000 per month / $72,000 annually, and that still leaves himself sufficient additional revenue to pay for other expenses.
- John starts a Solo 401(k) and contributes the full $20,500 to the 401(k) as an employee.
- John’s Plumbing Company LLC then contributes 25% of John’s salary to the plan. This is 0.25 * $72,000 = $18,000.
- Overall, John has $38,500 go into his Solo 401(k) for the year, between the employee and employer contributions.
This is great, and John cannot do much better with the other plans presented, but it is limited. He cannot hire anyone else, unless it’s his spouse. But, this type of plan may make sense if you are an independent contractor, and the nature of your business will always be something where you own and operate the business solo.
If you’re the owner/manager of a small business, between 2-100 people you’ll want to look closer at the SIMPLE and SEP plans and figure out if this may be a good option for you, especially if your firm doesn’t offer anything today. If you’re self-employed all three options will provide the basic benefit of reducing your taxable income now and saving money for retirement. The main difference in which one fits your needs will be how much your income varies year to year, and also whether you see your firm growing beyond just you.