Retirement Options for Small Business Owners: What You Need to Know

Laura Shin
Posted

Small business owners get to live the dream that many of us have of being their own boss and pursuing their passions.

If you’re one of the lucky souls making this work, then congratulations to you!
But if you are living this dream, you should also be careful to avoid one of the biggest mistakes many small business owners make: basing your retirement plan on maximizing your business value.

This isn’t a plan–it’s a gamble.

Unfortunately, this is a gamble that’s all too common among small business owners: According to a study conducted by the non-profit American College of Financial Services, a third of female small business owners and a quarter of male small business owners have not prepared for retirement. And considering that the median age of the respondents was 50, this fact is a serious cause for concern.

That’s why you, as a small business owner, need to set up a retirement account for yourself–and if you have them–your employees.

But what type of account do you need?

Retirement Plan Options for Small Business Owners

If you don’t have employees, then an IRA (Roth or traditional) might work best for you, if you can only contribute up to the max for those ($5,000 for the 2012 tax year and $5,500 for 2013). However, if you can contribute more than that, you should consider opening up an SEP (Simplified Employee Pension) IRA because it allows you to save more.

If you have employees, then you have more options than just an IRA. Use the handy chart below to see what types of plans are out there to suit your needs.

Plan Details Maximum Annual Contribution Taxes and Withdrawals Administration Number of Employees
Simplified Employee Pensions (SEP) An IRA-based plan with a greater maximum contribution than a Payroll Deduction IRA The lesser of 25% of pay or $51,000 Withdrawals are permitted at retirement age (59½) and are taxed as ordinary income. Early withdrawals are subject to taxes plus penalties. Easy to set up and maintain. Employer can opt to contribute a uniform percentage of pay for each employee, but not required to contribute each year. Only the employer can contribute. Any employer with one or more workers
Payroll Deduction IRA An IRA-based plan that allows employees to contribute an amount determined by them each pay period $5,500, with catch-up contributions of $1,000 for those 50 and over Withdrawals are permitted at retirement age (59½) and are taxed as ordinary income. Early withdrawals are subject to taxes plus penalties. Easy to set up and maintain. Only employees contribute. Any employer with one or more workers
Simple IRA An IRA-based plan that allows employees to contribute a percentage of their salary and requires employer contributions $12,000, with catch-up contributions of $2,500 for those over 50 Withdrawals are permitted at retirement age (59½) and are taxed as ordinary income. Early withdrawals are subject to taxes plus penalties. Bank or financial institution handles most of the administration and there is no annual filing requirement for employer. Employer must contribute, but they can opt to match employeecontributions or contribute 2% of pay. Any employer with 100 or fewer employees
Traditional 401(k) A savings plan that allows employees to defer a portion of their pay and place it in a plan administered by the employer $17,500, with catch-up contributions of $5,500 for those over 50 Withdrawals are permitted at retirement age (59½) and subject to ordinary income tax. Plan may permit loans and early hardship withdrawals, and may be subject to taxes and penalties. 401(k) plans vary greatly in their complexity and are administered by the employer. Annual filing is required and some plans have other requirements. Employer may contribute according to the terms of the plan. Any employer with one or more workers
Profit Sharing A plan allowing large discretionary contributions from the employer The lesser of 25% of compensation or $51,000, according to terms of plan, with catch-up contributions of $5,500 for those over 50 Withdrawals are permitted at retirement age (59½) and are taxed as ordinary income. Plan may permit hardship withdrawals, but most withdrawals are subject to taxes and penalties. Profit-sharing plans vary greatly in their complexity and are administered by the employer. Annual filing is required. Employer contributes significant amounts. Any employer with one or more workers

Which Plan Should I Choose?

Based on this chart, here are some key questions you should ask yourself that may help you decide the direction that’s right for you:

  • How many employees do I have? As you’ve seen, all of the plans will work for a single owner operator of an organization with any number of employees. Only the Simple IRA caps at 100 employees.
  • Will my income be predictable? If it won’t be when you start up or isn’t currently, plans like the Payroll Deduction IRA, the SEP and profit sharing allow employers to be flexible when it comes to how much they contribute based on annual cash flow.
  • Do I have resources for administration? Profit sharing and 401(k) plans are more complex to set up, and usually require the assistance of a financial institution or an advisor. They also require annual reporting to the IRS, whereas the IRA-based plans are established with a few forms and operate without significant administration.

Ultimately, the ideal retirement plan for you is determined by a dynamic set of variables. While the above chart should help you narrow down your choices, consider consulting with your tax or legal advisor before implementing any plan.

How Much Should I Contribute?

This will vary from person to person. Some solo business owners with a Roth or a traditional IRA who know that they can’t contribute more than the limit might want to make a regular monthly contribution–i.e. spreading out a $5,000 annual contribution over 12 installments throughout the year. Others who are using a SEP will likely want to decide what their contribution will be as part of an overall tax strategy. In general, these are complex issues best discussed with your tax advisor.

In order to set up your plan, contact a retirement professional or a representative of a financial institution that offers these types of plans.

Once you’ve got your account set up, pat yourself on the back–not only do you have your dream job, but now you’ll have your dream retirement, too!

January 4, 2013: The chart has been updated to reflect the maximum contributions allowed for the 2013 tax year.