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Retirement Plan Options for the Self-Employed

As a small business owner, running your business is your main objective. But it is also important to keep in mind that you will have to retire at some point in the future, and the actions you take now will ensure your retirement years are free from financial worry. Are you financially prepared for your future?

The reality is that Social Security will cover less of our retirement living expenses in the future. According to the Employee Benefit Research Institute (www.ebri.org), Social Security covers an average of 44% of living expenses for current retirees, but will only cover 13% for current workers (best case scenario); the rest will come from personal savings such as retirement accounts. Hence, saving for your retirement falls squarely on your shoulders, and the earlier you start the better. Albert Einstein once said: “The most powerful force in the universe is compound interest” (compound interest is interest earned on interest). So regardless of what stage in your life or career you start saving, don’t fret, there are many retirement savings options for every American, including those of you who are self-employed. In fact, establishing any of the retirement plans outlined below can provide significant tax benefits as well.

The 401k retirement savings plan, whereby a worker contributes a portion of their pre-tax earnings into a tax-deferred account until retirement, is an excellent retirement plan for many working Americans. However, a common misconception is that if you are self-employed, you are not entitled to a 401k and/or that your options are limited. However, the reverse is true; self-employed, small business owners have a plethora of options to create their own versions of the “401k” to save for retirement. While each option has benefits and drawbacks, there is a plan to meet almost any need. As a business owner, you work hard to grow your business, and the government offers great incentives for you to simultaneously grow your nest egg. In fact, the IRS will grant a maximum credit (limitations apply) of $500 to set up any of the plans described below.

It is important to note that there are two broad types of retirement plans: defined benefit and defined contribution plans. Defined benefit plans are the traditional pension plans for those who work for a company for several years and are then guaranteed pension payments for life. However, these plans are slowly disappearing because they create tremendous liabilities for the sponsoring companies. Defined contribution plans are those plans that allow employers and employees to make contributions into an account for the benefit of the employee. There is no guaranteed pension payment for life. Both types of plans are available for small businesses, but this article will focus on defined contribution plans.

When it comes to retirement plans for the self-employed, the SEP IRA (Simplified Employee Pension Individual Retirement Account) is the king for its simplicity and cost. But no two businesses are alike, and each has unique circumstances that warrant different types of retirement savings accounts. To this end, the IRS has created several retirement plan options for small businesses modeled after larger well-known plans typically used by governments and large corporations. The following low cost retirement plan options are readily available, and geared towards businesses with fewer than 25 employees.

Many small business owners feel that formal retirement plans are only available to large, well-established firms, or the plans are too cost prohibitive to establish and maintain. As you can see, there are several low cost and easy to set up options available to choose from. The information provided above is a basic overview of pros and cons, and each employer’s specific circumstances should dictate which plan is most appropriate. Employer sponsored retirement plans are not only tremendous vehicles for small business owners to save for retirement, but they also allow small businesses to attract and retain top talent in a tax-efficient manner.

With medical reimbursements to doctors dwindling while health care cost steadily increase, and the future of social security uncertain, it is more important than ever to take charge of your finances and financial future by saving for retirement now. It’s never too late, or soon, to start!

Type of Plan Contribution Limits Pros Cons
SEP IRA (Simplified Employee Pension Plan) The lesser of $49,000 or 25% of employee’s compensation
  • Easy to setup and maintain
  • Sole-proprietors, S & C Corps, and LLCs are eligible
  • Contributions are 100% deductible
  • Contributions are voluntary
  • Plan must cover all qualifying employees
  • Employee contributions are not allowed
  • Vesting is immediate
  • Plan must cover all qualifying employees
  • Employee contributions are not allowed
  • Vesting is immediate
SIMPLE IRA (Savings Incentive Match Plan for Employees) $11,500 (catch-up provisions apply for employees over 50)
  • Easy to setup and maintain
  • Employees can also make contributions
  • Employees can choose to make salary reduction contributions instead of their regular pay
  • Employer match is required
  • Contribution limits are lower than SEP IRA
  • Vesting is immediate
  • Employer match is required
  • Contribution limits are lower than SEP IRA
  • Vesting is immediate
SIMPLE 401(k) $11,500 (catch-up provisions apply for employees over 50)
  • Easy to setup and maintain
  • Allows for participant loans and withdrawals
  • Not subject to the annual nondiscrimination tests that apply to the traditional plans
  • Employer must make either: matching contribution (up to 3%) or a non-elective contribution of 2%)
  • Vesting is immediate
  • Cannot have any other retirement plans (i.e. 401(k))
Profit-Sharing Plans The lesser of 25% of compensation or $49,000 in 2009 and 2010
  • Contributions are voluntary
  • Employer can also have other retirement plans
  • Allows for participant loans and withdrawals
  • Need to file Form 5500 annually
  • Need to test that benefits do not discriminate in favor of the highly compensated employees
  • Employer contributions only
Money Purchase Plans The lesser of 25% of compensation or $49,000 in 2009 and 2010
  • Possible to grow larger account balances than under some other arrangements
  • Employer and employee contributions are allowed
  • Can be a business of any size
  • Employer can also have other retirement plans
  • Contributions are required
  • Administrative costs are higher than with other plans
  • An excise tax applies if the minimum contribution requirement is not satisfied
  • Need to annually file a Form 5500
  • Contributions are required
  • Administrative costs are higher than with other plans
  • An excise tax applies if the minimum contribution requirement is not satisfied
  • Need to annually file a Form 5500
Safe Harbor 401(k) $16,500 (catch-up provisions apply for employees over 50)
  • Possible to grow larger account balances than under some other arrangements
  • May exclude certain employees from coverage as long as annual coverage tests are met
  • Allows for participant loans and withdrawals
  • Costly to set up and operate
  • Employer contributions are required
  • Vesting is immediate
  • Need to file Form 5500 annually
  • Costly to set up and operate
  • Employer contributions are required
  • Vesting is immediate
  • Need to file Form 5500 annually
Traditional 401(k) $16,500 (catch-up provisions apply for employees over 50)
  • Employer contributions are optional
  • Employer contributions may be subject to vesting schedule
  • Contributions are tax-deductible
  • Need to file Form 5500 annually
  • Costly to set up and operate
Source: www.irs.gov and http://www.retirementplans.irs.gov

 

Have a financial question? Contact ACap Asset Management at info@acapam.com or 818-272-8511.

Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” investment management firm located in Los Angeles, CA specializing in helping doctors and physicians make sound financial decisions. Visit us at www.acapam.com