Retirement Planning Considerations for Small Business Owners
For many business owners, planning for a retirement often decades into the future might seem like distraction when there’s an enterprise to run with endless day-to-day demands. As a small business owner, I recall the adrenaline rush from walking in the door every morning and hitting the ground running, knowing that everything I did that day was to build something that I owned. The furthest thing from my mind as a 30-year-old business owner was “what will my retirement look like?” However, as the business matures, the cash flows stabilize and the hairs begin to gray its natural to begin thinking about how the exit may look.
Some business owners may be fortunate enough to be able to sell their business to a third party and provide a significant boost to their retirement lifestyle. However, many sole proprietorships or closely held businesses discover that their value in the marketplace may not be what they anticipate. It is prudent to craft a plan where the owner is in control of the outcome vs. hoping for a windfall that may not materialize.
Here are some retirement planning considerations for small business owners:
- What does your retirement look like and what will it take to fund it?
We need to know what we want our retirement to look like and what it will cost to fund it…10 – 30 years from now.
- Retirement Time Horizon: When does the business owner plan to retire?
This helps to calculate the appropriate rate of savings, in order to meet the income needs of their vision.
- What tax advantage savings structure is most appropriate for their business and savings goals?
Fortunately, small business owners can choose from many attractive retirement plans under the federal tax code. The best plan for you depends on factors such as the size of your company, how much you’re able to contribute each year and how many administrative duties you’re prepared to take on. The following discussion of options for small employers assumes that the business owner has self-employment earnings or employee compensation from the business.
The SEP IRA
The simplified employee pension (SEP) plan is an employer-sponsored retirement arrangement for companies with one or more employees, and employer contributions are made to individual retirement accounts (IRAs) established for each eligible employee. Many smaller companies opt for SEP IRAs because they are cost-effective and relatively simple to run while still allowing the business owner to help their employees save for retirement. In this plan, you make contributions to IRAs you set up for yourself and your employees. SEP IRAs can offer a full range of investment options, including stocks, bonds, mutual funds and exchange-traded funds (ETFs). The SEP IRA also may be a good choice or option for sole proprietors who want to maximize their retirement savings.
The maximum employer contribution that you can make to each participant’s SEP IRA is the lesser of (1) $58,000 for 2021 and $61,000 for 2022 or (2) 25% of employee compensation (or 20% of net earnings from self-employment). The maximum compensation that can be taken into account is $290,000 per employee in 2021 and $305,000 in 2022. (Maximum contribution limits are subject to change annually so check the IRS website for the most current information.) Employer contributions generally must equal the same percentage of salary for all participating employees, including you as the business owner. So, if you’re making an employer contribution equal to 10% of your salary, for example, participating employees also must receive an employer contribution equal to 10% of their compensation.
The SIMPLE IRA
Designed for sole proprietors and businesses with 100 or fewer employees, the employer-sponsored SIMPLE IRA can be a cost-efficient way to contribute to both your and your employees’ retirement.
To give you a rough idea of how much you potentially can save this way, a SIMPLE IRA allows eligible employees to make pretax salary reduction contributions of up to $13,500 for 2021 and $14,000 for 2022 ($16,500 and $17,000, respectively, for those ages 50 and older at any time during the year). (Maximum contribution limits are subject to change annually so check the IRS website for the most current information.) Annual employer contributions are mandatory.
As the employer, you must make either a 100% matching contribution up to 3% of employee compensation, or a nonelective contribution equal to 2% of their annual compensation, but you cannot provide both. The maximum compensation that can be taken into account is $290,000 per employee in 2021 and $305,000 in 2022. Investment choices vary by IRA provider, but generally include individual stocks, bonds, ETFs and mutual funds.
Small business 401(k)
A 401(k) plan can be established and maintained by most companies, including for-profit corporations, nonprofit corporations or partnerships.
Individual plan participants may elect to defer up to $19,500 in 2021 and $20,500 in 2022, whether on a pretax basis or made as Roth contributions on an after-tax basis, depending on how you have set up the plan. Individuals ages 50 and older at any time during the year can contribute another $6,500 in catch-up contributions, bringing the total employee contribution to $26,000 and $27,000 respectively. A 401(k) plan also may be designed to permit participants to make after-tax contributions. Employers may make matching contributions, profit sharing contributions, or other special types of contributions.
Total contributions, including those from the employer and plan participant, are limited to the lesser of 100% of compensation or $58,000 for 2021 and $61,000 for 2022, or for those age 50 or older at any time during the year, $64,500 for 2021 and $67,500 for 2022. The maximum compensation that can be taken into account is $290,000 per employee in 2021 and $305,000 in 2022. For the most up-to-date contribution limits, see the IRS page 401(k) and Profit-Sharing Plan Contribution Limits.
If you’ve opted for a traditional 401(k), where employee contributions are made on a pretax basis, participants do not pay federal income taxes on contributions or potential earnings until they are withdrawn. If you’ve opted under the plan to allow participants to make Roth contributions, distributions of designated Roth earnings on those contributions will be federal tax free if they are qualified distributions.
The IRA
If you’re a sole proprietor, you may find that an individual retirement account, or traditional IRA, is one of the simplest ways to save money for retirement. It’s possible to invest your contributions in stocks, mutual funds, ETFs and bonds, as well as certificates of deposit (CDs) and money market funds. You can contribute up to $6,000 per year in 2021 and 2022 (up to $7,000 if you are 50 and older at any time during the year), but limits are subject to change. Check the IRA Contribution Limits on the IRS website for the most up-to-date information.
Contributions to a traditional IRA may be tax deductible depending on your modified adjusted gross income and federal tax filing status but the earnings will always be tax deferred until distribution. You also may make nondeductible contributions if you are above traditional IRA deductibility limits. You are required to start taking minimum distributions from your traditional IRA by April 1 following the year in which you turn 72 (or 70½ if you attained 70½ on or before December 31, 2019). Deductible contributions and all earnings are generally taxed as ordinary income when distributed, while nondeductible contributions are not, because you’ve already paid taxes on them. An additional federal tax for early withdrawals applies to the taxable portion of distributions before age 59½, unless an exception applies.
With a Roth IRA, the same contribution limits apply, but contributions are not deductible. Your ability to contribute directly to a Roth IRA depends on your modified adjusted gross income and filing status. When you make qualified distributions from a Roth IRA, the distributions are not subject to federal income taxes and may be exempt from state taxes. Consult your tax advisor about any state or local taxes that may apply.
Bryan C. Jackson, CFP®: National Business Association Board member since 2022.
Mr. Jackson is a capital markets professional who serves as a Senior Wealth Advisor with Beacon Pointe Advisors. Additionally, he is an Adjunct Professor & Program Director for the Certified Financial Planner ™ Program at Southern Methodist University. His clients choose to work with him because of his passion for helping them achieve their vision of financial independence and the overall positive impact he can provide. His experience and skill sets offer a distinct perspective to the NBA on managing personal and business finances for entrepreneurs and small business owners.
The National Business Association has authored and curated resources on various topics and in multiple formats that will help you achieve your goals. Whether you are considering starting your first business or if you are a seasoned entrepreneur, there is something in this Resource section of the NBA website that will be helpful. We hope you find this article useful.
Providing relevant resources in an easy to navigate format is one of the many ways that the NBA accomplishes its mission of helping small businesses succeed. It fulfills our vision of being an indispensable resource for the self-employed, small business owners, and entrepreneurs. If you are interested in a deeper relationship with the NBA, sign up for our free email newsletter or learn about becoming a member by clicking here.