As a solo-practicing attorney seeking to hire an employee, I am quite upset with the tax laws and regulations regarding retirement accounts. If you are self-employed or own a small business, you likely share my frustration with the current tax laws and regulations surrounding retirement accounts such as Traditional IRAs, Roth IRAs, SEP-IRAs, Individual 401(k)s, and 401(k) Plans.
If you are an employee working for a company that offers a 401(k) Plan, it’s extremely easy to save for retirement. You simply enroll in your employer’s 401(k) Plan and can stash away $16,500 in tax-deferred income for retirement per year. But what are sole proprietors and small-business owners supposed to do if they want to take advantage of retirement accounts?
The first and easiest option for the sole proprietor or small-business owner is to open an IRA — Traditional IRA, Roth IRA, or both. However, you’ll be confined to a maximum $5,000 total contribution to both IRAs if you’re under 50-years-old and get a mere extra $1,000 contribution if you’re over the age of 50. You can’t even contribute $5,000 to both. If you want to fund a Traditional IRA and Roth IRA, your combined contributions cannot exceed $5,000.
There are also further regulations on how much you can contribute to a Roth IRA. If you are single and earn over $120,000, guess what, you cannot contribute to a Roth IRA because you make too much money. Fortunately, as long as you are not covered by an employer-sponsored retirement plan, you can still contribute $5,000 to your Traditional IRA.
You are probably thinking what can I do to save for retirement, take advantage of tax laws, and reduce my current tax burden if I am self-employed or a small-business owner? The plans that you’ll want to explore in more detail include Individual 401(k)s and SEP-IRAs. Like the 401(k), you can significantly reduce your current year taxable income by deferring the taxation my placing it into these retirement accounts. However, setting up and understanding these accounts does not come without headaches.
I am particularly in a rough spot because I have been a self-employed sole proprietor, but I am now thinking of hiring one single employee. An Individual 401(k) would be the perfect retirement vehicle for me if I could rule out the possibility of hiring an employee, but as soon as I hire a full-time employee, the simplicity of the Individual 401(k) goes out the window and I’ll have the burden of establishing a regular 401(k) Plan to offer to my employee.
If I hire a part-time employee who works less than 1,000 hours per year (slightly less than 20 hours per week), I am still eligible for an Individual 401(k), but as soon as I hire a full-time employee or a part-time employee who works over that 1,000 hour limitation, I am forced to offering them a regular 401(k) Plan.
What’s the alternative to the 401(k) for the small-business owner with one single employee? The alternative would be the SEP-IRA. An SEP-IRA can be setup regardless of whether or not you have employees and has similar tax-deferring benefits as the 401(k). The SEP-IRA has 401(k)-like advantages in that you can receive a substantial deduction for contributions made towards the plan. You can contribute up to $49,000 per year and defer the taxation of that income. The limit on your contribution is 20% of your net adjusted self-employment income, which is a fancy way of saying take your gross income, subtract your business expenses, and then half of your self-employment tax.
The SEP-IRA comes with a whole host of regulations. The SEP-IRA requires IRS Form 5305 stating the rules for who is an eligible employee. Essentially, if you have an employee who is over 21-years-old, earns over $450, and has worked for you in three of the last five years, the employee is entitled to contributions under the SEP-IRA. While contributions to the SEP-IRA are completely voluntary, if you have an eligible employee and make a contribution to your SEP-IRA, you must also contribute to your employee’s SEP-IRA proportionately. Further, all contributions to the SEP-IRA are made by the employer. An employee cannot make contributions to their SEP-IRA.
After we work through our options, if you are a small business owner with just one single employee and want to take advantage of retirement accounts, you’ll have to setup a 401(k) Plan or establish a SEP-IRA.
Why can’t Congress simply pass an Act that states that small-business owners with less than 50 employees that do not have a 401(k) Plan can contribute up to $16,500 to their IRA so they can receive the benefits of a 401(k) without having to go through the headache, hassle, and cost of setting up their own 401(k) Plan? Congress should do more to encourage small business owners to save more for retirement.
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Individual 401(k) vs. SEP-IRA For Self-Employed Individuals and Small-Business Owners
As a solo-practicing attorney seeking to hire an employee, I am quite upset with the tax laws and regulations regarding retirement accounts. If you are self-employed or own a small business, you likely share my frustration with the current tax laws and regulations surrounding retirement accounts such as Traditional IRAs, Roth IRAs, SEP-IRAs, Individual 401(k)s, and 401(k) Plans.
If you are an employee working for a company that offers a 401(k) Plan, it’s extremely easy to save for retirement. You simply enroll in your employer’s 401(k) Plan and can stash away $16,500 in tax-deferred income for retirement per year. But what are sole proprietors and small-business owners supposed to do if they want to take advantage of retirement accounts?
The first and easiest option for the sole proprietor or small-business owner is to open an IRA — Traditional IRA, Roth IRA, or both. However, you’ll be confined to a maximum $5,000 total contribution to both IRAs if you’re under 50-years-old and get a mere extra $1,000 contribution if you’re over the age of 50. You can’t even contribute $5,000 to both. If you want to fund a Traditional IRA and Roth IRA, your combined contributions cannot exceed $5,000.
There are also further regulations on how much you can contribute to a Roth IRA. If you are single and earn over $120,000, guess what, you cannot contribute to a Roth IRA because you make too much money. Fortunately, as long as you are not covered by an employer-sponsored retirement plan, you can still contribute $5,000 to your Traditional IRA.
You are probably thinking what can I do to save for retirement, take advantage of tax laws, and reduce my current tax burden if I am self-employed or a small-business owner? The plans that you’ll want to explore in more detail include Individual 401(k)s and SEP-IRAs. Like the 401(k), you can significantly reduce your current year taxable income by deferring the taxation my placing it into these retirement accounts. However, setting up and understanding these accounts does not come without headaches.
I am particularly in a rough spot because I have been a self-employed sole proprietor, but I am now thinking of hiring one single employee. An Individual 401(k) would be the perfect retirement vehicle for me if I could rule out the possibility of hiring an employee, but as soon as I hire a full-time employee, the simplicity of the Individual 401(k) goes out the window and I’ll have the burden of establishing a regular 401(k) Plan to offer to my employee.
If I hire a part-time employee who works less than 1,000 hours per year (slightly less than 20 hours per week), I am still eligible for an Individual 401(k), but as soon as I hire a full-time employee or a part-time employee who works over that 1,000 hour limitation, I am forced to offering them a regular 401(k) Plan.
What’s the alternative to the 401(k) for the small-business owner with one single employee? The alternative would be the SEP-IRA. An SEP-IRA can be setup regardless of whether or not you have employees and has similar tax-deferring benefits as the 401(k). The SEP-IRA has 401(k)-like advantages in that you can receive a substantial deduction for contributions made towards the plan. You can contribute up to $49,000 per year and defer the taxation of that income. The limit on your contribution is 20% of your net adjusted self-employment income, which is a fancy way of saying take your gross income, subtract your business expenses, and then half of your self-employment tax.
The SEP-IRA comes with a whole host of regulations. The SEP-IRA requires IRS Form 5305 stating the rules for who is an eligible employee. Essentially, if you have an employee who is over 21-years-old, earns over $450, and has worked for you in three of the last five years, the employee is entitled to contributions under the SEP-IRA. While contributions to the SEP-IRA are completely voluntary, if you have an eligible employee and make a contribution to your SEP-IRA, you must also contribute to your employee’s SEP-IRA proportionately. Further, all contributions to the SEP-IRA are made by the employer. An employee cannot make contributions to their SEP-IRA.
After we work through our options, if you are a small business owner with just one single employee and want to take advantage of retirement accounts, you’ll have to setup a 401(k) Plan or establish a SEP-IRA.
Why can’t Congress simply pass an Act that states that small-business owners with less than 50 employees that do not have a 401(k) Plan can contribute up to $16,500 to their IRA so they can receive the benefits of a 401(k) without having to go through the headache, hassle, and cost of setting up their own 401(k) Plan? Congress should do more to encourage small business owners to save more for retirement.