There are several retirement plan alternatives available to today’s small company owner. Each kind of IRA, such as a regular IRA, a Roth IRA, a SEP IRA, a SIMPLE IRA, or a 401(k), has its own set of benefits. You may set up these retirement plans for workers and yourself as a self-employed person or small company owner. Let’s go through these plans and see how they vary.
A retirement plan is a technique to produce income for yourself when you stop working by saving and investing. It’s critical to have a plan in place since many of us may anticipate to live far beyond our working lifetimes. Recognizing this, the government offers tax breaks to encourage individuals to save.
Contributions to an IRA made as a self-employed individual or single proprietor are often deductible. Employee contributions are also tax deductible for them. Only when monies from a retirement plan are withdrawn is income tax due. Such withdrawals are referred to as distributions.
IRA (Traditional IRA)
A classic IRA (individual retirement arrangement) is a tax-advantaged savings and investment plan intended to provide a person with cash in retirement. Because it is intended for individuals, self-employed people and single proprietors may put one up. An individual retirement arrangement (IRA) may be backed by either an IRA for investment or an annuity.
A typical IRA may help you save money on taxes in two ways. Contributions to it are tax deductible, lowering your taxable income. Furthermore, the monies in the IRA, including earnings and profits, are not taxed. Contributions to an IRA are invested, and the income generated by those assets is reinvested in the IRA, allowing your profits to compound tax-free. Only the distributions are taxed.
The amount you may contribute to a regular IRA is limited; for 2020 and 2021, the cap is $6,000, and if you are 50 or older, the limit is $7,000. Contributions, however, must not exceed your taxable salary, which is normally the profits from trade or company contributions made on your own behalf to the plan as well as the deductible portion of your self-employment taxes. Contributions for 2020 and following years may be made at any age. The previous age restrictions for making donations have been lifted.
Traditional IRAs have no income limits, and with the adoption of the SECURE Act in 2019, the age barrier for contributing to a traditional IRA was lifted. Anyone, regardless of age, who works and/or has earned money may now contribute to a conventional IRA.
Recently, adjustments have been made to distributions. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of December 2019 raised the age at which Required Minimum Distributions (RMDs) must begin from 7012 to 72. A required minimum distribution (RMD) is a yearly sum that must be withdrawn. Furthermore, RMDs have been eliminated for IRAs and retirement plans until 2020 following the Coronavirus Aid, Relief, and Economic Security (CARES) Act.
A conventional IRA is beneficial if you anticipate having a lower tax rate in the future than you do today.
A Roth IRA is an individual retirement plan that is similar to but not identical to a standard IRA in certain ways. Contributions to a Roth IRA, unlike standard IRAs, are made after-tax income. As a result, since the tax has already been paid, eligible payouts are tax-free. A qualifying payout is one made at least five years after the first payment and after you reach the age of 5912 or become handicapped.
A Roth IRA used to offer the benefit of allowing donations even after reaching the age of 7012. With a regular IRA, this was not conceivable. The SECURE Act, on the other hand, altered that. After the age of 7012, you may now contribute to a standard IRA.
Roth IRAs, unlike standard IRAs, have income limitations. For the 2020 tax year, for example, if you file married jointly or as a qualified widow(er), your modified AGI must be less than $206,000. Contributions of up to $6,000 are allowed if your combined income is less than $196,000 (up to $7,000 if you are 50 or older). If your salary is between $196,000 and $206,000, you may donate a lower amount.
Roth IRAs have contribution limitations identical to standard IRAs. If you exclusively contribute to Roth IRAs, the maximum is the lesser of $6,000 ($7,000 if you are 50 or older) or your taxable earnings.
There are no mandatory minimum distributions with Roths throughout the owner’s lifetime. A beneficiary, on the other hand, must either accept the whole amount in distributions within five years after the owner’s death or during their lifetime beginning no later than one year after the owner’s death.
Because contributions are taxed, a Roth IRA makes sense if you plan to be in a higher tax band in retirement than you are today.
Plans for SEPs
A Simplified Employee Pension (SEP) plan allows a self-employed individual or small company owner to save for retirement on behalf of themselves and their workers. Employee contributions are not permitted in a SEP. The employer makes all contributions. A SEP-IRA can only be a regular IRA; it cannot be a Roth IRA.
A SEP IRA provides benefits over a normal or conventional IRA. However, in order to reap the benefits, you must first construct a formal written agreement outlining the plan by completing IRS Form 5305-SEP.
Contributions may be made on behalf of both your workers and yourself. The maximum is much greater than that of a standard or Roth IRA. It is the lesser of 25% of the employee’s yearly salary or $57,000 for the 2020 tax year. It is $6,000 for standard IRAs. Contributions may also be made beyond the age of 7012.
Contributions to the SEP-IRA, whether for yourself or your workers, are tax deductible. All contributions to a SEP IRA are instantly fully vested, and members have complete control over how their assets are invested.
Even if you participate in an employer-sponsored retirement plan at your normal day job, you may open a SEP for your company. A SEP-IRA must be established for each qualifying employee, and contributions, which do not have to be paid every year, must be done in accordance with a documented mechanism that does not benefit “highly compensated workers.”
SIMPLE IRA Strategy
A Savings Incentive Match Plan for Workers (SIMPLE) plan allows small company owners and employees to contribute to a retirement savings plan. However, it is only eligible to enterprises with 100 or fewer workers that earned $5,000 or more the previous year.
Employees contribute to a SIMPLE plan via pre-tax salary deductions, and the employer contributes matching or nonelective payments. When the employee does not contribute, the employer makes a nonelective contribution.
All qualified workers must be registered in a SIMPLE plan; the employee has no choice. They do not, however, have to contribute if they do not like to, even if they will continue to receive the employer’s contribution.
Employer contributions to a SIMPLE are tax deductible. Employee contributions are also tax deductible. Only distributions are subject to income tax. Distributions must be taken once a person reaches the age of 72, or 70 12 if they reach the age of 70 12 before January 1, 2020. Employees in a SIMPLE plan are always 100 percent vested, which means there is no waiting time before they own employer contributions.
A SIMPLE plan might be a standard IRA (not a Roth) or a SIMPLE 401(k) (k). The two categories share many characteristics. The contribution restrictions remain the same. The ceiling for 2020 is $13,500, with a $3,000 catch-up cap. Furthermore, an employer must make contributions for workers by either matching the employee contribution up to 3% of salary or making a non-elective contribution of 2% of compensation.
A SIMPLE IRA and a SIMPLE 401(k) vary significantly in two respects. A SIMPLE 401(k) may be borrowed from, but not a SIMPLE IRA. A SIMPLE 401(k) needs an annual Form 5500 filing. A SIMPLE IRA does not have this requirement. A SIMPLE 401(k) plan, in particular, is exempt from the yearly nondiscrimination criteria that apply to standard 401(k) plans.
Traditional 401(k) Plans, Safe Harbor Plans, and Solo 401(k) Plans
A 401(k) plan is a kind of retirement plan in which workers may save a portion of their pay into individual accounts. The amount, which is normally the same each pay period, is known as an elective salary deferral and is deducted from the employee’s taxable income. Employers may also contribute to workers’ accounts, which is a critical component of a 401(k). Funds in a 401(k), including any investment profits, are taxed only when they are withdrawn. Contributions to Roth plans are made after income tax is paid, so eligible distributions are tax-free.
401(k) Plans (Traditional)
Employees may make pre-tax contributions to a standard 401(k) plan via payroll deductions. Employers have the option of matching workers’ voluntary contributions or making nonelective contributions. Nondiscrimination rules must be met by the plan.
401(k) Plans with a Safe Harbor
A safe harbour 401(k) plan is a form of 401(k) plan that avoids the difficult yearly nondiscrimination criteria provided the company makes specific annual contributions on behalf of workers and those contributions are instantly vested. The business pays 3% of workers’ wages whether or not they contribute to the plan under a Non-Elective Safe Harbor.
With the Basic Safe Harbor Match, the employer matches 100% of the first 3% of each employee’s contribution and 50% of the following 2%. The employer matches 100% of the first 4% of each employee’s contribution under an Enhanced Safe Harbor Match. To get the match, employees must contribute to the Basic and Enhanced plans.
Traditional and safe harbour plans are available to businesses of any size and may be coupled with other retirement plans.
One-Person 401(k) Plan
A one-participant 401(k) plan is just a regular 401(k) plan for a self-employed individual or that individual’s spouse. It is also known as a solo 401(k), solo-k, uni-k, or one-participant k. The company owner contributes to a single 401(k) as both employer and employee.
As an example, if a person has a one-participant 401(k), as an employee, they may contribute 100% of their income up to the yearly contribution maximum of $19,500 (or $26,000 if age 50 or over in 2020). They are allowed to contribute 25% of pay as an employer. Total contributions to a participant’s account (excluding catch-up payments for individuals over the age of 50) cannot, however, exceed $57,000 in 2020.