Self-employed investors, understand more than anyone, the importance of
a return on their investments. Self-employment offers many potential tax
benefits, which can be a lure to those who choose to follow that path. While
there are various tax benefits through tax deductions, a small-business
retirement plan is often overlooked.
Maximizing these benefits for those
that have the free cash flow can be a major advantage of self-employment. In
order to better understand the options available, we’ll divide these plans into
two separate categories, Defined Contribution & Defined Benefit
plans.
Defined Contribution Plans
A Defined Contribution plan is a plan that has a specific
formula for contribution based on one’s self-employment wages. The first plan
we’ll look at is the Simple IRA.
The Simple IRA
This plan is designed for an employer who has fewer than 100 employees,
and those employees earn more than $5,000, and would like to establish a plan
for the employer as well as their employees with very little overhead expenses.
The benefit of the Simple IRA is that since it is an IRA, there are typically
very little or no administrative costs. The plan allows you to contribute on
your own behalf with only a small obligation to match your employees who are
vested after a certain duration of having being employed within that
organization. The negative aspect is the maximum dollar contribution for the
owner is substantially lower than other plan options.
For 2015 the employer can contribute 100% of their compensation up to $12,500.00 or $15,500.00 for
those over age 50. For each employee, the employer can choose to make either a 3% matching contribution or a 2%
non-elective contribution, regardless
of whether the employee chooses to participate in the plan. Once funds are
contributed to a Simple plan on behalf of the employee that is eligible, the
employee is immediately vested and the employee may take the funds with them when
they leave. The plan must be in existence for at least 2 years before the
assets can be rolled to an individual IRA upon the employee or owner leaving
the business.
The SEP IRA
This plan is also an IRA with
little or no administrative expenses. With a SEP IRA the contribution limits
are much higher at 25% of the individuals adjusted gross income to a maximum of $53,000.00for
the year 2015. Each employee of the company, or any affiliated companies,
must receive the same percentage in contributions as the employer. The
employee is fully vested upon funding and cannot make their own separate
contribution, as all funding comes from the employer. However, the employer can
set up eligibility parameters that apply only to full time employees. They can
be as stringent as three years of employment and having achieved at least the age
of 21. Generally the SEP IRA is utilized for an owner and or family members in
a business that does not have long-term employees, or any employees at all. The
reason for this is the burden of the contribution is heavy on the employer.
The Self Employed 401k
This plan is not an IRA, but
a qualified retirement plan under the Employee Retirement Income Savings Act
(ERISA). It allows for a maximum of 100% of salary deductions up to $18,000.00 for
2015 (An additional $6,000 for those over age 55).
Furthermore, beyond the salaried contribution, the owner can make a
profit sharing contribution of another 25% of compensation up to a combined
amount of $53,000.00 for the year 2015 ($59,000 for
those over age 50). This plan has largely replaced the old money purchase
and individual profit sharing Keogh plans of the past with its hybrid approach
to contributions. One specific requirement is the plan is only available to
self-employed individuals and their immediate families. If there is a
non-owner working for the business, the employee may not contribute to this
plan and must utilize a different option. One other key component is the
reporting is a bit more complex. Once the plan assets reach $250,000.00, the
participant is required to have the IRS form 5500 completed each year. This
notifies the IRS of not just contributions, but plan balances as well. This
plan also exists in a ROTH version which offers the tax-free growth, without
the tax deductions. Much like the SEP IRA, this would not be utilized for an
individual with employees.
Defined Benefit Plans
When it comes to individuals with substantial resources
who wish to make contributions beyond that of the options referenced above,
there are various options. A defined contribution can be in addition to one of the plans
mentioned above. This type of plan establishes a future annual benefit in retirement
plans. The annual contribution is typically the actuarial value of what is
required to meet that benefit. Meaning if you are 60 and plan to retire at 65,
the amount of the contribution will be substantial if you just started the
plan. Most typically a defined benefit is simply a pension plan. The maximum
contribution in 2015 is the actuarial value of$210,000.00. It is important to note that these plans have additional
benefits testing that must be done to accommodate employees based on income and
age. There are various versions of these types of plans, and depending on the
demographics of your staff, the employer would want to have an independent
actuary help create the plan design to ensure employees receive the maximum
benefit and remain in compliance. The start-up administrative expenses can be
as high as $5,000.00 with an annual expense of around $1,500.00 per
year for annual filings and plan amendments. It should be noted that
although an employer has an annual benefit to be calculated, typically the plan
is just closed and the lump sum commuted value is rolled to an IRA in
retirement.
Cash Balance Plans are
another option and is somewhat of a hybrid, in that this plan is defined not an
annual benefit in retirement, but rather a future closing value of the plan
balance in retirement. This also requires the assistance of an actuary for plan
design. This plan, can in certain circumstances, favor a more equitable
distribution of funding for business partners that have a varying age range.
There are once again benefits testing requirements that must be
