Perhaps you’re thinking about starting a business, or maybe you own a business that’s been open for years. Either way, you will need or want to turn that business into retirement income for the future.
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The thought of saving enough money to sustain your current lifestyle for a long retirement can be daunting even without concerns about the solvency of Social Security -- especially for small business owners who face the daily pressures of running a business. Even when the business reaches a significant profit level, traditional retirement plan options do not allow the business owner to save large amounts of money in a tax-advantaged manner.
The most common retirement savings vehicles such as traditional and Roth IRAs offer modest contribution limits ($5,000 yearly limit, $6,000 if over age 50). These limits make it difficult for small business owners to save enough to support the desired retirement lifestyle.
However, small business owners can offer and take advantage of retirement plans with significantly higher contribution limits and tax benefits. Here, I’ll focus on four options available to small business owners and their employees.
A Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) allows a business owner to contribute a portion of the company profits to each employee (and themselves, of course). These contributions are based on a percentage of each employee’s earned income. The maximum contribution for 2012 is $50,000 and all contributions grow tax-deferred until they are withdrawn at retirement. All plan contributions can be taken as a tax deduction to the business, thereby lowering taxable income.
A Savings Incentive Match Plan for Employees (SIMPLE) IRA gives each employee the option to defer a portion of their own salary before tax (up to $11,500 in 2010) into a savings vehicle. Participants over the age of 50 can contribute an additional $2,500 per year. The company owner is then required to match up to 3 percent of the employee’s compensation. As with an SEP IRA, the employer contribution is tax-deductible. While the contribution limits are not as high as the SEP, the SIMPLE IRA is a great solution for companies with employees that want to save a portion of their own income for retirement.
The Individual 401(k) is designed to help sole proprietors (and their spouses) save more for retirement. Contributions are based on a percentage of income and in 2012, each participant can save up to $50,000 in the plan (those over the age of 50 can contribute an additional $5,500 in 2012). These contributions grow tax-deferred until they are withdrawn for retirement, and a portion of the contributions can be used as a tax deduction for the business. The Individual 401(k) is appropriate for a sole proprietor with no plans to add additional employees. The biggest advantage of the Individual 401(k) over the SEP is that it allows the business owner to reach the maximum contribution level ($50,000) at a lower level of income.
Defined Benefit Plan
Defined Benefit (DB) plans offer business owners the opportunity to save significantly more than they could if using a SEP, SIMPLE or 401k. With a DB plan, the contributions are based on a projected retirement “benefit.”
In other words, a business owner decides how much income they want at retirement (up to the 2012 benefit maximum of $200,000) and an actuary determines how much is needed to contribute to the plan each year.
The DB plan is a great savings tool for a sole proprietor or a business owner with a small number of “rank and file” employees. DB plans can be more costly to implement and administer than other retirement plans and the plan sponsor needs to engage an actuarial firm to create the plan document and calculate the contribution amounts. It is also worth contacting an investment advisor to assist with the management of the portfolio.
Finding the right plan is a critical piece of the retirement savings puzzle. Company-sponsored retirement plans offer the benefits of tax-deferred growth, tax-deductible contributions and high contribution limits. The decision about which plan to choose should be made within the context of your overall goals and the size and profitability of your business.
Greg Stevens of Cabot Money Management. He is a Certified Financial Planner® and a Chartered Retirement Plans SpecialistSM. He is responsible for providing financial planning and investment advisory services to clients of Cabot Money Management, Inc. and also acts as the firm's corporate retirement plan specialist. In addition, Greg is responsible for assisting individuals' transition into retirement by providing cash flow analysis, asset allocation and tax minimization strategies.