- Business owners must save for their own retirement and plan accordingly, because they do not have the luxury of employer-sponsored plans.
- There are many different types of retirement plans, like solo 401(k)s and Roth IRAs, that entrepreneurs might choose to utilize.
- Which you choose should depend on your own circumstances and your portfolio. Consult with a financial advisor for fiduciary advice.
- This article is for small business owners who want to plan for retirement and save money accordingly.
Small business owners and gig economy workers may enjoy freedom and often benefit from increased flexibility, but many miss out on the retirement plans and contributions that many full-time workers receive. How should a small business owner plan for retirement in the absence of company-sponsored plans? Angela Park Sheldon of Tortuga Wealth Management, based in Los Angeles, offers some tips.
What is the biggest challenge for small business owners and retirement?
In short, a lack of information. Many small businesses don’t know when to hire a HR department. Many are allocating their budget right back into the business, failing to set aside funds for retirement plans or a financial consultant. Sure, you get to call your own shots, but you don’t know what you don’t know. This is where many small business owners take their biggest misstep: They either fail to invest in a retirement strategy or make critical mistakes on the front end that could cost them in fees and taxes in the long run.
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What is a SEP IRA?
First, consider opening a SEP IRA, shorthand for a simplified employee pension plan. These plans allow you to pack away a lot more money than what traditional IRAs allow. The amount of money you can put into your SEP is based on your earnings. Whereas with a traditional IRA, you can only put in $6,000 if you’re under age 50 (for 2021), you can do up to $57,000 or 25% of your earnings – whichever is less – with a SEP.
“A SEP is also highly desirable because it’s easy to achieve,” Sheldon said. “You don’t need a third-party administrator; you can open a SEP IRA and start saving immediately.”
But note: only the employer contributes. If you’re a business of one – say, a freelancer – this is a no-brainer. However, if you’re a business with 10 employees, your contribution rate must be the same for all employees, and you’re the only contributor to the account; your employees cannot contribute. This is where things can get more complicated, and it’s highly recommended to hire a plan administrator.
Key takeaway: An SEP IRA allows you to save based on your earnings and is a simple investment that can be managed without a third party.
What is a solo 401(k)?
The solo 401(k), also known as a one-participant 401(k), allows you to make contributions to your retirement account as both an employer and employee. You can contribute up to $19,500 for 2021 ($26,000 for age 50 or older), as well as 25% of compensation for employer contributions, maxing out at $58,000 per year ($64,500 if you are age 50 and older).
For a single, self-employed individual, you must calculate how much you can contribute, but you’ll typically benefit far more than you would from a SEP IRA, saving much more money and significantly reducing your tax liability.
Key takeaway: A solo 401(k) is much like the retirement plans offered by many companies, except it’s for one person. This is a strong option for sole proprietors and independent contractors.
What is a SIMPLE IRA?
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a retirement account through which employees and employers can contribute to a traditional IRA (whereas SEP IRAs only permit employer contributions).
Any business with 100 employees or less can set up a SIMPLE IRA, and if your business is a sole proprietorship, you are both the employer and employee, so you, too, qualify for SIMPLE IRAs. In this case, all your annual self-employment net earnings are valid for investment in your SIMPLE IRA.
If you choose a SIMPLE IRA, then you must meet one of two annual contribution requirements for each of your employees. You must either match all employee contributions, with a cap of 3% of the employee’s compensation or – for employees who don’t add their own money to the SIMPLE IRA – contribute 2% of the employee’s compensation, with a cap of $290,000 for 2021.
Key takeaway: A SIMPLE IRA is a retirement plan in which the business owner and employee can make contributions to their retirement savings. This plan is suitable for businesses with 100 or fewer employees.
What is a Roth IRA?
A Roth IRA is a retirement plan in which investments grow tax-free and withdrawals during retirement are also tax-free. You pay taxes when money is invested into the account; your contributions are not tax-deductible.
Setting up a Roth IRA is possible, but it’s significantly more challenging than just offering the other types of retirement accounts listed here. Instead, the role of Roth IRAs in retirement savings for business owners should be for you to open these accounts entirely outside your company books and treat them just as you would a personal retirement plan.
Key takeaway: A Roth IRA allows for investments that grow tax-free. You can also withdraw funds tax-free in retirement.
Is a traditional 401(k) right for your business?
A traditional 401(k) is appealing – you can make employee deferrals, plus anyone over age 50 can play catch-up with additional contribution allowances. However, before going this route, consider what will benefit your employee base most. Do they understand the benefits of a 401(k), and are they willing to contribute? Is this a benefit they want?
Some business owners may want to consider a safe harbor 401(k) plan. These plans are designed to ensure that no employee is discriminated against. Safe harbor plans do not have to undergo the annual nondiscrimination tests, usually required by law, that evaluate how employees of various compensation levels use your 401(k) plans.
Key takeaway: Consider a traditional 401(k) if you can educate your employees about their options and they understand the benefits.
Retirement savings tips for business owners
Now that you know about the various types of retirement plans available for business owners, follow these tips to make the best of your retirement account.
Hire a professional – it’s worth the investment.
Just like your business, retirement plans can be more complex than they appear. Hiring a certified financial planner (CFP) and a third-party administrator is a smart investment in the longevity of your business.
“It’s a good idea to find someone from a referral,” said Sheldon. “Find someone who has had many years of experience.”
It’s not uncommon, Sheldon noted, to see business owners want to save the money they would spend on a retirement strategy and use it for other things – including putting it back into the business. But, just as it’s critical to hire a reputable bookkeeper or attorney, small business owners should spend the money and hire an experienced CFP, someone who is trustworthy and who will support your business as you grow.
Experienced professionals can advise you on your unique situation and goals, and construct a strategy for you based on a variety of plans.
Diversify your investments.
When it comes to retirement savings for business owners, a key tip is to not put all your eggs in one basket. If you choose to launch SEP or SIMPLE IRAs for you and your team, don’t be afraid to start your own personal traditional or Roth IRA. Doing so diversifies your portfolio – if one of your accounts includes more stock investments than another during an economic crisis, not all your investments are equally impacted.
Choose retirement plans catered to small businesses.
Some retirement plan providers are offering plans aimed at small business owners. These plans should comprise at least a portion of your retirement savings strategy, as they may have features friendly to small business owners that other retirement accounts lack. Retirement savings for business owners can mean looking at opportunities meant not just for everyone, but for people like yourself whose business ownership presents unique saving challenges.
Don’t bank on selling your business for a retirement strategy.
Sheldon said small business owners often think that selling their business will set the foundation for their retirement plan. This can become especially complicated in family owned and operated businesses, as the direction of the company can get a bit tricky with so many passionate owners involved.
“The idea of selling your business when you retire is great in theory,” Sheldon said. “But you are likely not going to get the value out of it that you are hoping for. If you do, great. But planning for it is not a great exit plan. You don’t want to play games with retirement.”
But how much is enough for retirement?
“There is no one-size-fits-all,” Sheldon said. “It’s not like typical budgeting. Everyone has a different time horizon and risk tolerance and lifestyle. Each of these factors matters.”
Retirement is personal. Business owners must also take other things into account, such as their desires to possibly hold another job in their later years, travel, time with family, health concerns, and so on. But Sheldon reminds us that with smart planning and conservative choices, business owners can have a lot of flexibility.
“The millionaire next door is real,” she said. “I have clients who retire early, who earned a modest income throughout their careers. They just made wise choices and investments. And now they can securely retire for a modest amount per month. It’s amazing to see.”
Editor’s note: This information was developed as a general educational guide, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation.
Additional reporting by Max Freedman. Some source interviews were conducted for a previous version of this article.