by Trent Krassow
From time to time, I hear small business owners and even sometimes employees of small businesses lament that they do not have a big company pension or retirement plan, and therefore no way to save for retirement. However, there are many tax-friendly ways for both the self-employed and their team members to save for retirement. In fact, in some cases, there may be MORE options for the small business and its team members than for their big corporate counterparts. We'll do a brief overview, here, and in future articles, we'll explore the mechanics and rules of each of these in greater detail, as well as strategies for when a small business should incorporate each strategy.
To start with, most people with any earned income can participate in an IRA (short for Individual Retirement Arrangement - some people also call it an Individual Retirement Account), or its non-identical twin, the Roth IRA (named after Senator William Roth of Delaware, who was one of the primary sponsors and advocates of the legislation that ultimately allowed this form of retirement account). Notice that these accounts are called "Individual,” which means they are NOT tied to a company. Thus, anybody who earns money (not investment income) — subject to some basic restrictions — can open up a retirement account, even if the company they work for doesn't offer a retirement plan (or if they are self-employed). If you do have access to a separate retirement account at work, you can still open an IRA, but the rules are a little different, so it is important to make sure you know the tax implications. As mentioned, we'll dive into the specifics of those separately from this article. For now, it is important to know that anybody can save for retirement, even if your workplace doesn't sponsor a plan. Got it? No excuses, now — it’s time to save!!
Let's spend a little time comparing the IRA and the Roth IRA. For both types, the same general concept applies - these are both INDIVIDUAL accounts, not tied to an employer, and therefore, almost anybody can open such accounts. They go with you when you change jobs because they are not connected to your job at all. But there is a key conceptual difference between a traditional IRA and a Roth IRA, and this is very important for tax purposes. Both types allow you to contribute up to a set amount each year (it goes up a little each year, but it is $6,000 for 2020 if you are under age 50, and $7,000 if you are over age 50). When you contribute to a traditional IRA, you get a tax deduction for the amount contributed that year — Congress is trying to encourage us to save. However, when you take the money out in retirement, it is generally fully taxable (there are some caveats to this, which will be addressed elsewhere — we're establishing a concept, here). By contrast, when you contribute to a Roth, you do NOT get a deduction in the year you contribute, but then when you take the money out in retirement, you do not pay any tax. Which one is better depends on a lot of factors, but generally speaking, the more time you have to let the money grow, the more attractive the Roth will be.
To illustrate the Roth concept, imagine two unrelated individuals, Tom and Jane, with the exact same income and tax situation, each contributes $6,000 a year to a traditional IRA and a Roth IRA, respectively, beginning at age 25 and continuing through age 65. Both contribute for 40 years, so both contribute $6,000 x 40 = $240,000.00. Not bad. Both achieve average growth rates on their investments of 8% (some years are down, and some years are higher). As a result, both will have a balance at age 65 of approximately $1.5 million - definitely not bad! (Side note, time is your friend when saving for retirement. Einstein was right — "Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.") Along the way, Tom has been able to reduce his taxable income (not his tax!) by $240,000. However, now, he will pay tax on the full $1.5 million (probably not all in one year, though). Jane, having paid tax on the $240,000 along the way, will now enjoy her $1.5 million tax-free. Would you rather pay tax on $240,000 over the course of 40 years, or pay tax on $1.5 million over the course of 20 or 30 years? The determination is a bit more complex than this, and each type of account has its appropriate use — again, we are talking concepts, here.
Okay, now that we have established that anybody who earns money has tax-friendly retirement accounts available to them, let's look at some of the other options available specifically to self-employed individuals or owners of small businesses. Keep in mind the IRA and Roth IRA above are generally available to the employed and self-employed alike. A few additional retirement savings options are the SEP (Simplified Employee Pension) and the SIMPLE (Savings Incentive Match for EmPLoyEes.) Both of these are technically an IRA, and share some of the same tax characteristics of the traditional IRA, though with some special rules for contributions.
The SEP is popular among the truly self-employed (think of the independent contractor, the small mom-and-pop shop with no employees, the solo repairman, etc.). The reason is clear: this account has a relatively high contribution limit compared to income. For example, a solo self-employed person could contribute up to 20% of his self-employed income after certain deductions, and then further reduce his taxable income by the amount contributed. For the thrifty at heart, this can be a powerful tool both for current tax reduction and for long term retirement savings. If there are employees in addition to the owner, it is important that the business owner contributes to his employees, too, so setting the contribution amounts takes a little bit of planning and math.
A SIMPLE is specifically for small businesses with few than 100 employed team members. These plans look a little more like a 401k at a big company because they have a payroll deduction and match component, but they are simpler to administer. While they have the match component of the 401k, they are still an IRA at heart. Thus, each account is owned by the employee, and the investment options belong to the employee and are not dictated by the plan itself.
There is always the option, even for a small business, to set up a 401k retirement plan. The reason many do not do so is the expense of running such a plan usually outweighs the benefit for only a few employees – it is more efficient fund a SEP or SIMPLE in such cases so that the “expense” is directed to the actual savings, not the management of the plan. Besides this, many small businesses simply do not have the extra cash to pay for the management of these more complex retirement plans, in addition to the contributions themselves. 401k and other “big company” plans make more sense when the expense can be spread over more employees, and when the business itself can actually afford the expense, but such plans are an option if the small business chooses to go that route.
There are "best use cases" for each of the above, and in some cases, strategizing how and when to implement these types of accounts can result in significant savings for the small business. Sometimes, they can even be combined. They can also offer the ability to attract great employees who want a company-sponsored retirement plan. However, even when there isn't a "company" plan, it is important to remember that all workers, employed and self-employed, have the opportunity to save for retirement. Is money tight? Start small, but start.
If you would like help figuring out which type of account is right for your situation, we would love to help. If you simply want to get your budget in order so that you can even start saving, we welcome that conversation, too. But whether you contact us or not, start saving TODAY!