If you are self-employed with no employees, establishing a retirement plan for your business may sound like a daunting process, but it does not need to be. The Internal Revenue Service (IRS) offers a variety of retirement savings plan options.
The plan you select depends on several factors, including how your business is structured, the amount you can afford to contribute per year, and how much income you generate annually. Self-employed individuals have the benefit of being treated as both employer and employee, which can be beneficial when contributing to certain retirement plans.
Each situation is unique and must be must be looked at individually. In order to help make decisions that align with your best interest, it is important to review the options available. They include:
Sep IRA: A Simple Solution
A Simplified Employee Pension (SEP) Individual Retirement Account (IRA) is one type of retirement plan to consider when comparing plan options for self-employed individuals. No lengthy plan document or annual Form 5500 filing is required, and there is typically minimal paperwork needed to establish a SEP IRA.
The contribution rules for SEP IRAs are simple and straightforward. You can contribute up to 25% of your net compensation* up to $66,000 (in 2023).
Any self-employed individual earning over $265,000 can make the maximum SEP IRA contribution. SEP IRA contributions are discretionary and are not required each year. If you currently have a Traditional IRA, it can be converted to a SEP IRA using Form 5305-SEP.
There is no need to fund the account until you file your tax return, which provides some flexibility. For example, if your income turns out to be higher than expected, you can make a larger contribution and thereby reduce your tax bill. If your income is lower than expected, you can make a smaller contribution.
Mark is a 30-year-old new business owner with compensation* of $100,000 and is interested in saving $25,000 a year. A SEP IRA may be a good fit for Mark, as it is easy to set up and administer, and his SEP IRA contributions can increase as his income grows.
Solo 401(K): Greater Contributions Levels
A Solo 401(k) retirement plan, sometimes known as a One-Participant 401(k) Plan, may be a good retirement savings plan to consider for business owners who want to maximize their contributions each year above SEP IRA limits (see above). However, it requires the adoption of a formal plan document and the annual filing of Form 5500**, and you must adhere to the terms of the plan document. Depending on the complexity of your business structure and/or the possibility of adding an employee in the future, you should consider working with a qualified third-party administrator or accountant to administer your plan.
The Solo 401(k) retirement plan allows the highest possible contribution among defined contribution retirement plans. Contributions consist of both an employee and a discretionary employer contribution. Since you represent both the employee and employer, your total contribution is the sum of those components. You can contribute up to 100% of your W2 compensation* into the plan up to $22,500 (in 2023), plus an additional $7,500 if you are 50 or older, for a total of $30,000.
In addition, an employer contribution of up to 25% of compensation* is permitted. Combined, the total limits are: $66,000 if under age 50 and $73,500 if over age 50. If you are interested in even greater contribution levels, there is the option to establish a Defined Benefit Plan as well.
Generally, if your compensation is below $260,000 or you are over age 50, your maximum contribution is higher with a Solo 401(k) than a SEP IRA. The level of difference will vary based on your income and type of entity. Consult with your accountant to assist you with the calculations so you can select the plan most suitable for you.
Maureen, 52, is a self-employed computer programmer with compensation* of $168,000 a year. She would like to contribute $50,000 - $60,000 into a retirement plan. A SEP IRA would only permit her to contribute 25% of her compensation, which would equate to roughly $42,000. A Solo 401(k) would allow her to defer $30,000 of her income and also an additional profit sharing contribution of $40,500 for a total of $72,000.
Traditional or Cash Balance Defined Benefit Plan: Maximize Your Contributions
A Cash Balance Plan is also an option to consider when comparing retirement savings plans for self-employed individuals, as it allows you to potentially contribute in excess of $100,000 or more annually.
A Cash Balance arrangement is an IRS tax-qualified “hybrid” retirement plan. It combines the high contribution limits of a Defined Benefit Plan and the simplified contribution formula and portability of a Defined Contribution Plan.
The plan has a minimum intended commitment of at least three to five years, with typical plans existing much longer. Cash Balance Plans are often combined with a Solo 401(k), to maximize the amount you can save for retirement each year. It also require the services of a third-party administrator and an actuary. Businesses with older owners and stable year-to-year income are generally good candidates to implement a Cash Balance Plan.
Rick, 55, is a self-employed attorney with no employees and compensation of $330,000. He currently does not have a retirement plan and is looking start contributing large amounts of at least $100,000 a year to reduce his taxable income and save for retirement. Based on Rick’s age, income, projected retirement age of 65, and his business being in existence for five years, he could make a maximum contribution of $241,000 or $289,500*** if he combines it with a 401(k) plan.
Because of the Secure Act, plans can now be adopted retroactive for the prior plan year. Businesses have up until their tax filing deadline plus extensions to establish and fund a plan.
Working With Janney
Depending on your financial needs and personal preferences, you may opt to engage in a brokerage relationship, an advisory relationship or a combination of both. Each time you open an account, we will make recommendations on which type of relationship is in your best interest based on the information you provide when you complete or update your client profile.
When you engage in an advisory relationship, you will pay an asset-based fee which encompasses, among other things, a defined investment strategy, ongoing monitoring, and performance reporting. Your Financial Advisor will serve in a fiduciary capacity for your advisory accounts.
For more information about Janney, please see Janney’s Relationship Summary (Form CRS) on www.janney.com/crs which details all material facts about the scope and terms of our relationship with you and any potential conflicts of interest.
By establishing a relationship with us, we can build a tailored financial plan and make recommendations about solutions that are aligned with your best interest and unique needs, goals, and preferences.
Contact us today to discuss how we can put a plan in place designed to help you reach your financial goals.
* Based on your entity, the definition of compensation will vary. Contact your Accountant for guidance.
** Generally, you are exempt from the Form 5500 filing requirement if plan assets are below $250,000 with no eligible employees (other than a spouse or partner. However, a final Form 5500 is always required when terminating the plan regardless of plan asset size.
*** This contribution amount is an estimate. In future years, the contribution range may change due to investment performance, changes in compensation or changes in pension law.
The examples provided are all hypothetical and do not take into account any specific situations. The hypothetical examples are provided to help illustrate the concepts discussed throughout and do not consider the effect of fees, expenses, or other costs that will effect investing outcomes. Any actual performance results will differ from the hypothetical situations illustrated here. Please consult a professional to help you evaluate your situation before implementing any of the strategies discussed here.
Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
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