Choosing a retirement plan for your business can be complicated, particularly when one type of account may have several variations. But it’s the differences that help you decide which makes the best fit for your company.
Take Individual Retirement Accounts (IRAs) for example. A major advantage of IRAs is the ability to save for retirement while deferring taxes until the money is actually withdrawn. However, the plans carry a lot of restrictions, including stiff penalties if you withdraw funds before the age of 59 1/2 years.
Each type of IRA has its own tax implications and eligibility requirements. This article will deal with three of the possibilities: the SIMPLE-IRA, the Simplified Employee Pension (SEP) plan and the Payroll Deduction IRA (see right-hand box).
A No-Cost Benefit
No matter how big or small your business is, your employees can participate in a Payroll Deduction IRA, at virtually no cost to you. Here’s how it works: Employees who want to participate set up a traditional or Roth IRA with their banks and authorize you, the employer, to make payroll deductions. You forward the deductions to the banks. Your only other responsibility is to make the plan available to all employees. You have no contribution or filing requirements. Participants cannot borrow from the plan or use assets as collateral. They also must pay income tax and a 10 percent penalty for withdrawals made before they turn 59 1/2 years of age. If your business eventually decides to set up a retirement plan that includes employer contributions, your benefits adviser can help you discontinue the Payroll Deduction IRA and make the switch.
SIMPLE-IRA: The Fundamentals
If your business has no more than 100 employees, you can set up a SIMPLE-IRA. Self-employed individuals and one-employee corporations also often use these pension plans. Earnings on the account balance accumulate tax-free until withdrawals start. There is no limit on how much can be accumulated.
Contributions are generally broken down into two elements: elective deferrals made by the self-employed individual or company employee and matching contributions by the employer.
For 2017, the maximum employee contribution is the smaller of:
- 100% of your self-employment income or 100% of the salary from your corporation.
- $12,500 (unchanged from 2016).
Employees can start making “catch-up” contributions in the year they reach age 50. For 2017, they can contribute an extra $3,000 a year (same as 2016).
Employers generally must make a matching contribution that is the smaller of:
- Three percent of salary or self-employment income, or
- 100 percent of the elective deferral.
If you run your business as a sole proprietorship or a single-member LLC treated as a proprietorship for federal tax purposes, you are considered self-employed. So you make the elective deferral and the matching contribution, claiming deductions for both.
If you are employed by your own S or C corporation, the company makes the matching contribution and withholds the elective deferral contribution from your salary. The business gets a deduction for the contribution and your taxable salary is reduced by your contribution.
Simplified Employee Pensions: Stripped-Down Plans
SEPs are intended primarily for self-employed individuals, including sole proprietors, partners and LLC members, as well as small corporations.
If you’re self-employed, you can make an annual deductible contribution of up to 20% of self-employment income. Self-employment income generally equals the net profit shown on your Schedule C, E or F, minus the deduction for 50% of self-employment tax from page one of Form 1040.
If you’re employed by an S or C corporation, the company must set up the SEP. The business can then make a deductible contribution of as much as 25% of your salary. The maximum possible contribution is $54,000 for 2017 (up from $53,000 in 2016).
So how do these two plans compare? They are each simple to set up and identical in several ways, such as:
- Requiring no annual filings with the federal government;
- Allowing minimal or no contributions when cash is tight; and
- Prohibiting borrowing.
In other ways, however, they stack up a little differently:
A SIMPLE-IRA can permit much larger annual deductible contributions if your business produces a modest income. But contribution limits can become a disadvantage as income grows. A SEP allows you to make more generous annual deductible contributions, an advantage if you have a large amount of self-employment income or salary. But, depending on your age and income, you might be allowed to make larger annual deductible contributions to other types of personal retirement accounts, such as a 401(k) or a defined benefit pension plan.
SIMPLE-IRAs allow you to make “catch-up” contributions; SEPs do not.
SIMPLE-IRA plans may require you to make matching contributions if your business has other employees. Matching contributions are 100 percent vested immediately. Your company must allow all employees to participate in a SIMPLE plan if they earned $5,000 or more in any two previous years (consecutive or not), and are reasonably expected to earn at least $5,000 in the current year.
With a SEP, if your business has employees, you would have to make deductible contributions for those who have worked for you during at least three of the past five years. Also, since all contributions to the accounts vest immediately, an employee can quit at any time without losing SEP money. That’s great for the employee. But if your business employs more than just a few trusted staff members, you may want to consider a different option.
You must establish a SIMPLE-IRA by no later than October 1 of the year for which you want to make your initial contribution.
You can establish a SEP as late as the extended due date of the federal income tax return for the year when you make the initial contribution. Later contributions can be extended in the same way.
Conclusion: When your business generates a modest amount of self-employment income or salary and there are no other employees who must be covered, the SIMPLE-IRA is often the best choice. It doesn’t matter if you have additional income from other sources. This is especially true if you are 50 or older, because you can make additional “catch-up” contributions that further sweeten the deal.
On the other hand, if you want maximum simplicity, a SEP may be the best choice, assuming you don’t mind covering your employees. A SEP is your only choice if you want to make a deductible contribution for the preceding year when no plan actually existed at the end of that year.
With the vast array of retirement plans available, contact your benefits adviser to learn more about SIMPLE-IRAs, SEPs or alternatives.