Need a Retirement Plan for Your Small Business?
My wife started a business 10 years ago and contributed to a regular IRA in the beginning. Three years ago, she incorporated the company and they don't have a 401(k) yet. What's her best option for retirement savings right now?
This is an excellent question for every small business owner—whether firmly established or just starting out. That's because, although contributing to an IRA is definitely a good idea, small business owners have several other options that can significantly increase the amount they can save in a tax-effective way.
Here are some small business retirement plans for your wife to explore. Incorporation isn't the key factor here, but rather whether your wife has employees and, if so, how many. All provide tax advantages without the paperwork, cost, and administration required by a 401(k), but do have different characteristics that might make one plan better than another for her needs.
SEP-IRA: The easiest to set up and maintain, particularly suited to sole proprietors
A SEP-IRA (or a Simplified Employee Pension) can be a great choice for saving a lot and keeping paperwork to a minimum whether or not you have employees. It's easy to open and lets you make fairly high annual contributions. It also gives you the flexibility to vary contributions—or skip them entirely—according to your yearly business needs.
A SEP-IRA can be ideal for a sole proprietor. Annual contributions can be as high as 20% of net self-employment income for an owner, up to $61,000 in 2022. However, there are a few caveats if you have employees.
First, all contributions are made by the employer, not the employee. And, as an employer, you're required to contribute the same percentage of an employee's compensation as you contribute for yourself. That could end up being a hefty sum if you have more than a few employees.
Individual 401(k): Offers higher contribution limits if you have no employees except your spouse
An Individual 401(k) or an Individual Roth 401(k) can be a great choice for contributing a lot, but it's only available if you work for yourself and your only employee is your spouse.
It requires a little more paperwork than a SEP, but allows even higher contributions—20% of net self-employment income for the business owner, plus an additional $20,500 in salary deferrals for 2022, with a maximum of $61,000 for this year. If you're 50 or older, you can contribute an additional $6,500, bringing the maximum to $67,500.
If your spouse is also an employee, they can also contribute up to $20,500 in salary deferrals (plus a catch-up contribution of $6,500 if age 50-plus). And you, as the employer, can match that contribution up to 20% of salary subject to the same maximums. That all adds up to quite a significant sum!
SIMPLE-IRA: Good if you have up to 100 employees and want them to contribute to their own retirement
A SIMPLE-IRA (or Savings Incentive Match for Employees) is available to companies with 100 or fewer employees. With this plan, employees make their own retirement contributions—up to $14,000 for 2022, with a catch-up contribution of $3,000 for those age 50-plus. As the employer, you’re required to make a small matching contribution (up to 3% of employee compensation) or contribute a flat 2% of compensation.
While your obligation as an employer is less, the contributions you can make for yourself are also significantly lower than for a SEP-IRA or Individual 401(k). That's because the business owner is subject to the same contribution limits as employees.
A regular IRA: Still a smart personal choice
The good news is that you can contribute to both a small business retirement plan and a traditional or Roth IRA. You may still be eligible for a tax deduction with traditional contributions, depending on your income. So I encourage your wife—and you, too—to contribute the maximum to an IRA each year. For 2022, that's $6,000 with a $1,000 catch-up contribution if you're 50 or older.
The bottom line: Talk to your tax advisor
As you can see, there are a number of options for small businesses, depending on how many employees there are and the type of opportunity a business owner wants to provide for employees.
The next thing for your wife to do is to talk to her tax advisor—and also any business partners—to determine which plan offers the best combination of savings opportunities and tax advantages for her specific business. While all of these plans require minimal set-up and administration, the details vary. It’s best to get all the facts, and then weigh them in light of current business plans and future goals.
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Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act 2.0, a law governing retirement savings (e.g., the age at which individuals must begin taking required minimum distributions (RMDs) from their retirement account will change from 72 to 73 beginning January 1, 2023). For more information about the SECURE Act 2.0, please read this article or speak with your financial consultant. (1222-2NLK)