Contributions to a retirement account through your business are one of the best ways to save for the future and claim a large tax deduction. It is entirely possible to deduct tens of thousands of dollars if you max out your contributions. Many times, owners understand that they need to save, but struggle to know which retirement plan is best for them. Here are three of the most common retirement plans to choose from.
SEP IRA
The Simplified Employee Pension, or SEP IRA, is an easy and effective plan to start with. For many small business owners, this plan could be one of the better options. The IRS created the SEP IRA for owners who do not want the hassle of a complicated retirement plan. Virtually no paperwork is filed and approved with the IRS. Instead, you fill out form 5305 and open the accounts to fund them.
The best part about the SEP IRA plan is that you can potentially contribute up to $69,000 for 2024. Contributions are technically completed on the employer side, which means employees cannot voluntarily contribute themselves. Instead, a percentage of “income” (up to 25%) can be contributed to the account. If you have no employees, essentially multiply your self-employment income by 25% and that is your max contribution. This calculation requires a few more steps, but that is the basic idea.
The major downside from an owner’s perspective is that you cannot discriminate between owners and employees. All employees must receive the same percentage that owners do. If the owner contributes 25% to her account, then 25% of each employee’s salary must be contributed as well. Fortunately, SEP plans do not require contributions each year, so you can skip years with lower revenue if you prefer.
Simple IRA
The next plan is the Simple IRA. Similar to the SEP, this plan is technically still an “IRA” (Individual Retirement Account) and not a “401k”. Each account created is owned by the employee and not the company. Simple IRA plans have started to lose favor for small business owners seeking to maximize deductions, primarily due to the lower contribution limits. However, for those looking to provide a good employee benefit without contributing much from the employer side, then Simple IRA plans may work.
Simple IRAs do allow employee contributions. For 2024, up to $16,000 ($19,500 if over age 50) can be contributed from payroll into an employee’s account. This applies to owners working in the business too, if they are on the payroll as well. Employers are required to contribute as well, and there is mainly one of two options. Either set up a 3% matching contribution to any employee contributions or a 2% mandatory employer contribution regardless of whether the employee contributes.
This is usually the drawback of the Simple IRA. Employer contributions must occur each year and must include either a 2% or 3% match. This is why these plans are more suited for employees than employers. Owners working in the business could realistically only contribute the maximum of $16,000 plus a $480 match. Fortunately, these plans also have relatively minimal paperwork to create and still have minimal costs to them.
401ks and Solo 401ks
401k plans are one of the most common retirement plans today, simply because of their functionality. Given the issues with SEPs and Simple IRAs related to employees, the 401k attempts to solve the question of how to provide employers with larger deductions while not discriminating against employees in the process. Because of this, 401k plans are usually more expensive to implement because they must be subjected to testing requirements. More paperwork must be done to verify compliance with the IRS, but if done property could create a great retirement plan for your business.
401k plans offer the same maximum contribution as the SEP plans above ($69,000 or $76,500 if over 50), but fortunately, not all contributions need to be completed on the employer side. 401k plans allow employees to contribute up to $23,000 ($30,500 if 50+) into their accounts. That generally leaves another $46,000 for employer contributions if owners choose. If you have no employees, this “Solo” 401k can become very attractive if your goal is to maximize your deductions. Without any employees, you can contribute both on the employee and employer side without concern.
For those with employees, the testing requirements start to enter the picture. Most have heard about the typical 3% match in 401ks, and many companies match more than that. The reason for this is due to the IRS safe harbor provisions. Since 401ks can be customized more to your business, the IRS created a prototype of sorts so some of the testing requirements can be skipped. It is possible to customize the 401k plan to maximize your contributions, just be aware that all reporting and testing is done correctly. Working with an experienced 401k provider is important for this.
Retirement Plans
Retirement plans are one of the many ways business owners can improve their financial situation. When it comes to a tax deduction that also helps you in the future, contributions to a retirement plan can be a great option. The reason why the retirement plan industry has grown so much in the last few decades is due to the increasing value for business owners. If you do not yet have a plan or believe your current plan is not optimized for your situation, take the time to work on a better plan and involve professionals who can help.
TC Falkner 