According to Business Insider, there were 14.9 million self-employed Americans in 2021, up from 12.7 million in 2020. If you’re among the growing number of individuals who are self-employed or own a small business, you may already know that you have several options when choosing your retirement plan. Two of the most common are the SEP-IRA and the individual 401(k), also known as the solo 401(k).
As we head into tax season, now is a great time for new and seasoned entrepreneurs to dive deeper into learning about the retirement plan options available to them. After reading this blog, you’ll be well-equipped to understand how to set up a small business retirement plan, increase your retirement contributions, reduce your tax liability, and grow your small business retirement plan.
The Simplified Employee Pension (SEP-IRA)
Let’s start with the Simplified Employee Pension (SEP), which offers generous tax breaks and can be adopted by companies with no employees or multiple employees. The SEP-IRA is a “simplified” profit-sharing plan, meaning as a small-business owner, you can make contributions to your own and your employees’ retirement savings based on your company’s profitability.
The SEP-IRA is inexpensive to set up, has a low level of compliance requirements, and is easy to manage. You can make employer contributions to an account that’s set up for each participant, including yourself. The SEP-IRA follows the same investment, distribution, and rollover rules as traditional IRAs.
If you have full-time employees (those receiving a Form W-2) enrolled in a SEP Plan, you’re required to make equal percentage profit-sharing contributions for all eligible employees. You have some flexibility as the business owner to decide how restrictive or nonrestrictive the participation rules are in your plan to determine employee eligibility.
One downside to a SEP-IRA is that W-2 employees are typically not allowed to make their own contributions, limiting their capacity to save for their own retirement. However, if you are a solo-entrepreneur or self-employed person, you can contribute to your own plan even if you outsource work or hire independent contractors (those filing Form 1099-MISC or 1099-NEC).
In 2022, you can contribute 25% of your adjusted net earnings up to $61,000—which has increased from the maximum of $58,000 in 2021—to a SEP-IRA. So, if you make $100,000 in net earnings as a small-business owner, you are allowed to contribute up to $25,000 to your SEP-IRA in 2022. Contributions to the SEP-IRA are fully tax-deductible up to IRS limits, giving you or your business a dollar-for-dollar reduction to your adjusted gross income.
The Individual 401(k)
If your overhead is low or you have plenty of room to save what you make from your business for retirement, you might look to the individual 401(k) for your small business retirement plan, especially if your goal is to maximize your retirement contributions. The individual 401(k) covers business owners without full-time employees, or the business owner and their spouse as long as they’re both working at least part-time in the business.
Since you can make contributions as both an employer and employee of your small business, you gain an additional layer of savings with the individual 401(k). Individual 401(k) plans also allow you to make post-tax Roth contributions, so you can pay income tax now in exchange for tax-free withdrawals in retirement.
As an employee of your own business, you can contribute up to 100% of compensation capped at $20,500 in 2022, up from $19,500 in 2021. As the employer, you are also allowed to put in a 25% match in profit-sharing on top of the annual contribution limit, which is calculated similarly to the SEP-IRA. In some cases, your total savings will exceed what you can do with the SEP-IRA plan.
Again, if you have $100,000 in net earnings in 2022, the individual 401(k) would allow you to save $25,000 plus the $20,500 employee contribution, for a total retirement savings of $44,500.
And unlike the SEP-IRA, individuals aged 50 and older can make catch-up contributions up to $6,500 a year to a solo 401(k).
SEP-IRA vs. Individual 401(k): Which Plan Is Right for You?
Both a SEP-IRA and an individual 401(k) offer a simple way for self-employed individuals—even those who are just starting to grow their businesses—to save for their retirement seriously and strategically. To determine which option is right for you, consider the following elements of your situation:
- Desired contribution rates
- Capacity for growth and hiring
- Roth options
Desired Contribution Rates
Your desired contributions rates may have a large impact on which retirement plan option you choose. Ultimately, an individual 401(k) will allow you to contribute more money at a faster rate. While, the SEP-IRA allows you to contribute up to 25% of your income to the account, the employer-employee benefits of the 401(k) allow you to save more.
As an “employee” of your business, you can save up to 100% of your earnings in the solo 401(k) up to the annual threshold. From there, you can also make employer contributions up to 25% of your earnings. So for example, an individual with $100,000 in net income could only contribute $25,000 to a SEP-IRA. The same individual could contribute up to $44,500 to a solo 401(k).
Capacity for Growth and Hiring
If your business already has W-2 employees, a solo 401(k) is not an option. In this case, a SEP-IRA might be the better choice. However, businesses with employees should also consider the merits of a SEP-IRA against a SIMPLE IRA if they want employees to be able to make their own contributions to their retirement accounts.
Roth Options
A SEP-IRA does not offer the option for the owner of the account to make Roth contributions—all contributions must be made on a pre-tax basis. If you’re interested in maximizing Roth contributions to your retirement fund, an individual 401(k) may be the best option. Alternatively, anyone under a certain income threshold can open a Roth IRA, but the annual contribution limits are much, much lower.
How to Set Up Your Small Business Retirement Plan
Once you’ve chosen the small business retirement plan that best suits your situation, all you need to do is open an account so you can begin making contributions. At Caviness Wealth Management, we help our clients set up their small business retirement plan and choose an appropriate investment strategy for funds within the plan.
We understand that every financial situation is unique and managing your wealth can be complex and time-consuming, especially for self-employed individuals and small business owners. With all the retirement plan options available, you may be feeling overwhelmed about how to choose the right plan and investments for your situation.
We endeavor to help you reach your financial goals by maximizing your tax savings and identifying the right retirement plan option for you and your small business. To see if we can help you set up and manage your small business retirement plan, click here to schedule a conversation today.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.
