Small Business Retirement Plans

Recent statistics confirm what small business owners have known for a long time—the number of small businesses in the United States is increasing at an exponential rate. How exponential? According to the Small Business Administration, there are nearly 25 million small businesses in America. Amazingly, small businesses employ more than half the nation’s private workforce, account for the majority of private sector output and are consistently responsible for creating around 75% of net new jobs.

Any small business owner will tell you that accomplishments like these don’t come easy. Maintaining a small business, and all that that entails, involves equal amounts of hard work and risk, but the rewards can be well worth it. Managing employees, clients, and keeping tabs on operating costs can all cut into a small business owner’s time, and though income taxes aren’t high on the list of what small business owners love most about self employment, it is important to note that the IRC (Internal Revenue Code) offers some very favorable tax rules designed to help self-employed individuals and their employees save for retirement.

Retirement Accounts For Small Businesses

Most of us are familiar with 401k Plans and Traditional IRAs. These accounts provide an up-front tax break, as well as the ongoing benefit of tax-deferred compounding. Here are some additional retirement accounts that provide the same tax advantages, available to smaller companies with fewer (if any) employees:

• SIMPLE IRA. A savings incentive match plan for employees—better known as a SIMPLE IRA—is easy to set up and might be a good choice if you have employees and want to let them make their own contributions. As the employer, you’re still required to make a small matching contribution of 1% to 3% of each employee’s compensation, including your own. Beginning in 2006, eligible employees are now allowed to contribute 100% of their income up to a limit of $10,000. Participants who are 50 or older have the option of making an additional $2,500 “catch-up” contribution in most cases, which can be a significant retirement savings boost.

It is important to note that A Simple plan must be in existence by Oct. 1 of the year for which contributions are claimed. You have until the due date of the tax return plus extensions to deposit employer contributions.

• SEP-IRA or QRP (Keogh). SEP stands for simplified employee pension, and a QRP is a qualified retirement plan for the self-employed, sometimes referred to as a Keogh plan. With a SEP-IRA or QRP, the employer makes the contributions. (employees can’t contribute) Importantly, the tax-deductible contribution limits are potentially much higher than a SIMPLE IRA: 25% of employee compensation (which works out to 20% of net self-employment income for the owner) up to a $44,000 limit.

You can set up a SEP-IRA as late as the date the tax return is due (including extensions) for the year in which you claim the tax-deductible employer contribution. However, a QRP has to be in existence by Dec. 31 of the year for which contributions are claimed, even though employer contributions themselves can be deposited as late as the due date (plus extensions) for that year’s tax return.

• Individual 401(k). An Individual 401(k) offers benefits similar to a traditional 401(k), but requires less administration. These plans allow for contributions up to 25% of compensation (20% of net self-employment income for the owner) and an additional $15,000 salary deferral (to the maximum limit of $44,000 (maximum of $49,000, including the catch-up contribution of $5,000 for those 50 or older).

An employer has to establish an Individual 401(k) before the end of the year, but can make contributions by the tax-filing deadline, including extensions. Remember, you can contribute to your own traditional IRA or Roth IRA (if you’re eligible) in addition to these employer plans.

Which Small Business Retirement Plan Is Best For Me?

There are a number of variables to consider. SEP-IRAs and SIMPLE IRAs are both relatively easy to establish and maintain, and can provide greater control over the size and frequency of contributions. An Individual 401(k) or QRP plan takes a little more paperwork and maintenance.

If you have employees and want them to fund the bulk of their own retirement, a Simple Ira would probably be the best choice.

On the other hand, if you have very few or no employees and the ability to save for yourself is most important, you might want to look at a SEP-IRA, Individual 401(k) or QRP, which could allow for larger contributions.

Your age and self-employment income may play a role in your decision. For instance, there’s a certain income level at which the maximum contribution you can make to a SIMPLE IRA vs. a SEP-IRA or QRP is the same. Income above or below this level determines which account will allow you to contribute more. If you’re 50 or older, you need to factor in catch-up contributions as well, which are allowed for SIMPLE IRAs (and Individual 401(k)s), but not for SEP-IRAs and QRPs.

For example, if you’re under age 50 (no catch-up contribution allowed), the Simple IRA vs. SEP IRA/QRP break-even income level is $63,225. At this level, a Simple IRA allows a contribution of $11,752—the same as a SEP-IRA or QRP. Business income above $63,225 would favor a SEP-IRA or QRP because of the lower contribution limit on Simple plans, but income below that level would favor a Simple IRA because contributions to a SEP IRA or QRP are based on a percentage of income only (Simple IRAs allow a $10,000 contribution on top of the percentage calculation—see the calculation below). For those 50 or older who can make the Simple catch-up contribution of $2, 500, the break-even income level is $79,030.

Of course, an Individual 401(k) could be an even better deal. It allows for the same 25%-of-earnings limit (20% of net self-employment income) as a SEP or QRP, and in addition, allows you make an elective deferral of $15,000. In the example above, a self-employed person under age 50 with business income of $63,225 could contribute $26,752 ($11,752 + $15,000) to an Individual 401(k) —$31,752 for those 50 and older.

Keep in mind, Individual 401(k)s are currently subject to the same $44,000 cap as a SEP or QRP. So, if you’re under age 50 the contribution advantage is lost as business income exceeds $228,905 ($220, 00 net self-employment income). At that point, you reach the maximum contribution with any of the three plans, and other considerations—ease of implementation and administration, number of employees (Individual 401(k)s are ideal if you have no employees) and so on—should drive your decision. Of course, if you’re 50 or older you can contribute an additional $5,000 to the Individual 401(k) in 2006 for a total of $49,000 (no catch-up contributions are allowed for the SEP or QRP accounts).

Finally, older small business owners who need to catch up on their retirement savings may want to consider another option—setting up their own defined benefit pension plan (DB plan). If your business is generating high levels of income, this type of QRP could allow you to exceed the regular contribution limits, because with a DB plan those limits are based on actuarial factors as well as business income. There’s a bit more complexity involved, but some providers offer convenient turnkey solutions. Your personal financial planner is the person best qualified to help you determine which small business retirement plan is the right one for you, so always remember to consult them first before making any and all types of fiduciary decisions.