From running day-to-day operations to creating new products and services, self-employed individuals and small business owners wear many hats. They can be a salesperson, publicist, accountant, entrepreneur and more. As a self-employed business owner, you’ll likely also have to consider retirement account options for yourself and your employees—wearing yet another hat. So how do you decide which self-employed retirement plan option to participate in?
To help inform this important decision, we’ve weighed various self-employed retirement plan types. For investors whose employers don’t provide retirement benefits, these plans can also provide insight about potential retirement plan options.
Simplified Employee Pension Individual Retirement Accounts (SEP IRAs)
Small business owners with one or more employees and self-employed individuals can benefit from SEP IRA plans that can pack quite a savings punch. They are similar to Roth and traditional IRAs, but come with a few alterations. The employer (or self-employed individual) sets up the Simplified Employee Pension (SEP) plan, and plan participants receive a SEP IRA account for contributions. However, the employer—not the employee—contributes to the accounts of his or her eligible employees equally. Self-employed individuals, who act as both employer and employee, contribute to their own SEP IRA.
Here are a few key features of this self-employed retirement plan type:
- Minimal Set-up: SEP IRAs have minimal setup and management costs.
- Contribution Limits: The employer (or self-employed person) can set aside up to 25% of an employee’s compensation, or $57,0001—whichever is less. Traditional and Roth IRAs generally limit contributions to $6,0002—a sizable difference!
- Contribution Flexibility: SEP IRAs do not have an annual funding requirement. So, for businesses and self-employed people with cyclical or volatile revenues, this allows for larger contributions throughout a peak season and smaller contributions during the off-season. The deadline for SEP IRA contributions in a given tax year is usually the deadline for filing tax returns.
- Vesting: Unlike many other retirement plan vesting schedules, eligible employees are automatically 100%3 vested once SEP IRA contributions are made on their behalf. That means once the self-employed business owner (or self-employed individual) contributes to an employee’s account, the funds belong to the employee.
- Tax Considerations: A portion of SEP-IRA contributions are generally tax-deductible for the business4.
- Withdrawals: Similar to a traditional IRA, the money in a SEP IRA generally is not taxable until withdrawn. However, if you’re under 59½, you may face an additional 10% tax on your withdrawals.
- Required Distributions: Generally, SEP IRA participants must begin taking required minimum distributions (RMDs) at age 72. Note: If you turned 70 ½ in 2019 or before you are required to begin taking required minimum distributions at age 70 ½.
Savings Incentive Matches Plan for Employees IRA (SIMPLE IRA)
Hooray for the acronym that makes this mouthful simpler to say! SIMPLE IRAs are available to self-employed individuals and employers with no more than 100 employees. Generally, SIMPLE IRAs are simpler to manage than their 401(k) counterparts.
These self-employed retirement plans also have nuanced features:
- SIMPLE Set-up: As the name implies, SIMPLE IRAs are generally easy to set up and are usually established between January 1 and October 1 of a given tax year. The employer (or self-employed person) must execute a written agreement with a financial institution to provide benefits to employees. Then they must provide employees with information about the agreement and set up an IRA for each employee.
- Contribution Limits: SIMPLE IRAs allow employees to contribute up to $13,0005 a year. If you are age 50 or older you can make additional catch-up contributions of $3,000 per year. In 2020, employers are generally required to match their employee’s individual contributions by matching up to 3% of an employee’s contribution. Or, employers can choose to match 2% of each employee’s salary.
- Vesting: Eligible employees are automatically 100% vested once contributions are made on their behalf. That means once the self-employed business owner contributes, the funds belong to the employee.
- Tax Considerations: Contributions made by an employer (or self-employed individual) to a SIMPLE IRA are tax deductible and employee contributions are made on a pre-tax basis.
- Withdrawals: Generally, SIMPLE IRA contributions are not taxed until withdrawn. But, if you’re under 59½, you may face an additional 10% tax penalty on your withdrawal. Importantly, that 10% penalty increases to a 25% penalty if you withdraw within two years of having first participated in the SIMPLE IRA6.
- Required Distributions: Generally, SIMPLE IRA participants must begin taking required minimum distributions (RMDs) at age 72. Note: If you turned 70 ½ in 2019 or before you are required to begin taking required minimum distributions at age 70 ½.
Traditional and Roth IRAs
You may decide to go the straightforward route and open a traditional or Roth IRA. These potential self-employed retirement plans offer straightforward savings options. However, they also offer more limited scope for savings than other self-employed retirement plans.
- Contribution Limits: Traditional and Roth IRA contribution limits are substantially lower than those for SEP or SIMPLE—$6,0007 in 2020.
- Contribution Flexibility: The deadline for traditional and Roth IRAs contributions in a given year is usually the tax return filing deadline.
- Vesting: Unlike SIMPLE and SEP IRAs, traditional and Roth IRAs do not have a vesting schedule since employers do not open, manage or contribute to these accounts.
- Tax Considerations: Qualified contributions to traditional IRAs may be tax-deductible, while contributions to Roth IRAs are not. With the traditional version, assets are allowed to grow tax-deferred until you begin taking distributions. With a Roth, because you paid taxes on initial contributions, distributions are free from federal capital gains taxation.
- Withdrawals: Traditional IRA withdrawals and distributions are taxable. And, like the other self-employed retirement plans listed here, if you are under 59½ you may have to pay an additional 10% tax penalty for early withdrawals. Qualified Roth IRA withdrawals and distributions are not taxable.
- Required Distributions: Generally, traditional IRA participants must begin taking RMDs at age 72. Roth IRA participants usually do not require withdrawals until after the death of the account owner.
However, there are a few management issues with these IRAs. You can’t deduct contributions from business taxes. Plus, Roth IRA contribution eligibility phases out as your income rises—high income earners generally aren’t allowed to contribute to a Roth IRA.
SIMPLE 401(k) Plans
SIMPLE 401(k) plans are yet another option for self-employed small business owners and self-employed individuals. SIMPLE 401(k) plans are basically a cross between a SIMPLE IRA plan and a traditional 401(k) plan—featuring aspects of both self-employed retirement plan options:
- Set-up: A SIMPLE 401(k) takes a bit more effort to manage than a SIMPLE IRA. First, the IRS requires an annual filing for a SIMPLE 401(k). Plus, the potential for more investment options and flexibility could mean more administrative costs.
- Contribution Limits: Unlike a regular 401(k) plan, the employer must either match each employee’s contribution dollar-for-dollar up to 3% of pay, or a non-elective contribution of 2% of each eligible employee’s pay. Employees can contribute up to $13,500 in 2020, with an additional $3,000 catch-up contribution amount allowed for employees over age 50.10
- Contribution Flexibility: SIMPLE 401(k)s have the same contribution limits as SIMPLE IRAs and are required to be set up during the same part of the year.
- Vesting: Employees are immediately vested in 100% of contributions.
- Tax Considerations: The business is able to deduct all employer contributions.
- Withdrawals: Optional participant loans and hardship withdrawals are available to participants. However, if you take one, you need to either pay yourself back with interest, or face the stiff early withdrawal penalty—10% above your federal tax rate.
- Required Distributions: SIMPLE 401(k) participants generally must begin taking required minimum distributions (RMDs) at age 72. Note: If you turned 70 ½ in 2019 or before you are required to begin taking required minimum distributions at age 70 ½.
However, the increased withdrawal and loan flexibility associated with SIMPLE 401(k) plans may be an additional administrative burden for the employer. Further, you cannot maintain any other retirement plans if you participate in a SIMPLE 401(k) plan which can limit your saving options.
Self-Employed Retirement Plans: What Comes Next
If you are self-employed, you probably won’t be surprised to learn there is even more work to do. After choosing a plan, you will need to manage the plan’s investment strategy. An effective investment strategy aims to grow the money in the self-employed retirement plan over time—so your assets meet your retirement goals. Asset allocation—the mix of stocks, bonds and other securities—is a key factor in the likelihood you’ll achieve your long-term goals.
That is where Fisher Investments comes in. We can help you by designing a customized portfolio based on the unique goals of your business. To learn more about this process, download a free guide or contact Fisher for a complimentary portfolio evaluation.
The contents of this document should not be construed as tax advice. Please contact your tax professional.
Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations. The foregoing constitutes the general views of Fisher Investments and should not be regarded as personalized investment advice or a reflection of the performance of Fisher Investments or its clients. Nothing herein is intended to be a recommendation or a forecast of market conditions. Rather it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated here. Not all past forecasts were, nor future forecasts may be, as accurate as those predicted herein.
1$57,000 for 2020 and $56,000 for 2019. https://www.irs.gov/retirement-plans/plan-participant-employee/sep-contribution-limits-including-grandfathered-sarseps.
2$7,000 for folks age 50 or older. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits.
4 The most you can deduct on your business’s tax return for contributions to your employees’ SEP-IRAs is the lesser of your contributions or 25% of compensation. If you are self-employed and contribute to your own SEP-IRA, there is a special computation to figure the maximum deduction. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps-contributions.
5 For more on contribution limits see: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-simple-ira-contribution-limits
7 Or $7,000 if you are 50 or older. See https://www.irs.gov/retirement-plans/traditional-and-roth-iras for more information.
8 Unless you qualify for an exception.
10 For more information: https://www.irs.gov/retirement-plans/choosing-a-retirement-plan-simple-401k-plan and https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits