Owners of small businesses have a raft of options for retirement savings — the SEP IRA, the SIMPLE IRA, solo 401(k), Keogh, traditional or Roth individual retirement accounts. It’s enough to make the head spin.
“It’s very rare for me to find a client that truly understands how to select the right type of plan for their business,” says Hampton Bourne, financial advisor with First Advantage Investments in Nashville, Tennessee. Even accountants and financial advisors have a hard time figuring which type of plan is best for a given business owner, he says.
Each type of plan has its own pros and cons, so the choice depends on factors like how much the business owner wants to set aside, the type of investing options desired and time horizon.
All except the Roth versions allow tax deductions on contributions and penalty-free withdrawals after 59.5. Investment gains are tax-deferred. Withdrawals are taxed as income and, except for the Roths, must begin after age 70.5. Many allow investors 50 and older to invest even more through catch-up contributions.
[See: 9 Ways to Avoid 401(k) Fees and Penalties.]
What is a SEP IRA? A Simplified Employee Pension Plan, or SEP IRA, works much like a traditional IRA except the business owner and his or her employees can invest much more — up to $54,000 this year, deducted from income to reduce taxes.
“In my opinion, the biggest bang for the buck at the lowest cost (administration fees) is the SEP IRA,” says Tim Shanahan, principal at Compass Securities Corp. in Braintree, Massachusetts. “Typically, a SEP IRA might bear an annual fee of $25 to $30, versus a 401(k) plan that might have a base fee of $2,500-plus per participant, plus some basis points for administrative costs.”
Generally, SEP contributions are limited to 25 percent of net business profit, less adjustments for things like self-employment tax. A 40-year-old sole proprietor making $100,000 per year could contribute $18,587.05, according to calculators offered by several financial services firms.
“SEPs are the leading horse in the world for sole proprietors,” Bourne says. “They are relatively easy to set up, allow for high income deductions, and can offer a slew of investment options from conservative money markets to aggressive stocks.”
What is a SIMPLE IRA? A SIMPLE IRA — officially a Savings Incentive Match Plan for Employees Individual Retirement Account — also offers tax-deductible contributions but with a lower annual limit of $12,500.
Bryan Ellis, of SelfDirected.org , an Acworth, Georgia-based website for savvy investors, says the SIMPLE has lost ground to various types of 401(k)s, which are just as good and not as complex.
What is a solo 401(k)? An individual 401(k), or solo 401(k), has high contribution limits — up to $54,000, with the 40-year old owner described allowed to put in $36,587.05. Again, the law allows just about any kind of investment, though the investor needs a brokerage-style account for the broadest range.
It can be set up as a traditional 401(k), with tax deduction on contributions but tax on withdrawals, or a Roth type with no up-front deduction but also no tax when money is taken out. This distinguishes the solo 401(k) from the SEP and SIMPLE accounts, Ellis says.
“It’s the Mercedes-Benz of retirement accounts for small business owners … superior to other options — head and shoulders above them — in every substantive way,” Ellis says.
A regular 401(k) plan, rather than a solo 401(k), is generally best if the business has 25 or more employees, though administrative costs can be high, Bourne says. With fewer than 25 employees, a SIMPLE plan can be cheaper to manage, he adds.
[See: 10 Tips to Boost Your IRA Balance.]
What is a Keogh plan? The Keogh plan is probably one of the most familiar names, since it’s been around the longest. Investment options are wide open and contribution limits are 25 percent of compensation up to $54,000. The investor in the example could contribute $18,587 this year.
In recent years, Keoghs have fallen out of fashion due to the rise of 401(k)s, Ellis says.
Other considerations. Experts say new business owners can be tripped up when selecting investment options. People striking out on their own after working for others are generally familiar with standard 401(k) plans in which the employer offers a variety of investing options, usually bundles of mutual funds and target-date funds. In some cases, a sole proprietor or small business owner may do the same, especially if the plan must also cover employees.
But by choosing a self-directed plan, the boss can allow just about any kind of investment. This choice is available in SEP, SIMPLE and 401(k) plans, says Jaime Raskulinecz, CEO of Next Generation Trust Co., in Roseland, New Jersey.
“Self-direction allows for a broad array of nontraditional investments not allowed in typical retirement plans,” Raskulinecz says. “Savvy business owners who know and understand alternative assets — and may already be investing in them outside of their existing retirement plan — can develop a more eclectic, and potentially more lucrative, retirement portfolio with a self-directed plan.”
A self-directed account can include real estate, precious metals, commodities, private placements of non-public companies, and other options not found in a standard corporate plan. Of course, that can produce a lot of risk, but small-business owners are used to that.
John Ingoglia, investment advisor at Socotra Capital in Sacramento, says small business owners should also consider Roth IRAs and Roth 401(k)s, which have no deduction on contributions but offer tax-free withdrawals and no required minimum distribution after 70.5. The trade-off favors younger investors because the tax savings at the end, many years later, can outweigh the tax deduction missed at the start, he says.
[See: 12 Steps to a Stronger 401(k).]
The contribution limit this year is $5,500 for people under 50, $6,500 for those 50 and over, and most people can contribute to an IRA even if they have another retirement plan.
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Retirement Plans for Owners of Small Businesses originally appeared on usnews.com
