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Retirement Plans for the Self Employed

Self-employed and small business owners have a variety of options to help them save for retirement. Fortunately, these options are becoming increasingly less costly and difficult to administer as more brokers and custodians offer options such as a Solo 401(K). The best plan for you as an entrepreneur will depend on your unique situation, goals, and needs. Each plan has its unique advantages and drawbacks. 

Let’s take a look at your primary options as a small business owner:

A Solo 401(K) plan is essentially a traditional 401(K) plan for a self-employed person with no employees (although it can cover a spouse as well). 

  • 2022 Contribution Limit
    • The total contribution limit for a solo 401(K) is the same as any traditional 401(K) plan, which is $61K for 2022 ($67.5K if 50+). That total contribution is split between your elective deferrals and your employer nonelective contributions 
    • Elective deferrals can be 100% of your compensation up to the annual contribution limit ($20.5K in 2022, $27K if 50+) 
    • The employer nonelective contribution is limited to 25% of compensation or net self employment income
      • Net self employment income is equal to your net profit less your elective deferral and half your self-employment tax. 

Like other 401(K) plans you can choose a traditional tax deferred plan or a Roth 401(K) plan.  The contribution limit to a 401(K) plan applies on a per person basis. If you have another job with a 401(K) then your total contribution limit between the plans is still $61K. 

Most brokerages now allow you to set up a solo 401(K), you just need an employer identification number. When assets in a Solo 401(K) exceed $250K, Form 5500 EZ must be filed annually with the IRS. While filing with the IRS can sound intimidating, this is just a two page document that should be relatively easy to fill out. 

Simplified Employee Pension (SEP) 

The SEP IRA works similarly to a Solo 401(K) with a few key differences. All contributions to a SEP are considered employer contributions and are limited to 25% of compensation up to the $61K annual contribution limit for 2022. Because there is no personal elective deferral in a SEP like in a Solo 401(K), business owners with less than $244K in net income may find they can contribute less to a SEP than a Solo 401(K). Those 50+ will also find they can contribute less into a SEP as there is no catch up contribution in a SEP IRA. There is also no Roth option for a SEP plan. 

SEP IRAs can be simpler to set up and sometimes less expensive than a Solo 401(K) plan. You can also set up a SEP IRA if you have employees. You must contribute the same percentage of each eligible employee’s compensation into the plan. Thus if you want to save 15% of your compensation, you must contribute 15% on behalf of all employees. 

Savings Incentive Match Plan for Employees (SIMPLE) IRA

SIMPLE IRAs were designed for small businesses with up to 100 employees. 

  • 2022 Contribution Limit: $14K ($17K if 50+)

Employees in a SIMPLE plan can make elective salary deferrals into the plan. The employer is required to either match contributions up to 3% of employee compensation or make a fixed contribution of 2% for every employee. There is no Roth option for a SIMPLE IRA plan.

SIMPLE IRAs offer much lower contribution limits and less flexibility for employers than traditional 401(K) plans. However, small business owners with employees might prefer the simplicity in managing a SIMPLE IRA plan as opposed to a more costly and complex traditional 401(K) plan. 

Defined Benefit Plans & Cash Balance Plans

Defined benefit plans are best for high income earners with no employees looking to save the maximum possible for retirement. These plans allow some business owners to save in excess of $200K into the plan. Actual contribution amounts are based on several factors including age, compensation, retirement age, and investment performance. Contributions are adjusted each year. 

Defined benefit plans are costly and complex. Contributions to a defined benefit plan are based on actuarial assumptions and computations. You’ll need an actuary to compute your contribution range each year to ensure that the plan is being funded according to IRS guidelines.

Additionally, your defined benefit annual contributions are limited to the lesser of $245K or 100% of your average compensation for the highest 3 consecutive calendar years.  

The funding is based on a future income benefit at retirement. Thus annual contributions are made to fund a specified level of income at a predetermined future retirement date. Funding requirements can also vary significantly with investment performance. 

With a cash balance plan each participant has a hypothetical individual account with a ‘cash balance.’ The portion set aside into the plan grows at a predetermined interest credit (which can be fixed or variable). Thus your account balance doesn’t reflect actual gains and losses on the underlying assets in the plan and the business bears the risk of funding the plan if investments do poorly. 

Upon retirement, assets in a defined benefit plan or cash balance plan can be rolled over to an IRA.

Defined Benefit plans can be used in combination with a 401(K) plan to really supercharge your overall retirement savings. 

Traditional IRA or Roth 

  • 2022 Contribution Limit: $6K ($7K if 50+)
  • Income Limits:
    • Traditional IRA – None if not covered by a workplace retirement plan 
    • Roth IRA – 
      • Married Filing Jointly limits contributions beginning at $204K and completely phases out at $214K of modified adjusted gross income. 
      • Single or Head of household limits contributions beginning at $129K and completely phases out at $144K of modified adjusted gross income. 

Each business owner may be drawn to different plans based on their situation. If you want to discuss which plan might be best for you, please feel free to reach out. 

Scott Caufield, CFA, CPA