Undoubtedly, by now we are all familiar with the quote, “think outside the box” but very few people pay attention to what that quote actually means. We rarely question why it is a good thing and how it can be beneficial to your line of work or business. Thinking outside the box means that you are simply allowing more perspective and are willing to view things differently, consider different solutions and methods to fulfill your desired outcomes. It means you have the desired goal, but you do not want to necessarily take the tried and true route to get there. There are the real power and a paramount potential to thinking differently which is reflected in your career and business. As an entrepreneur (budding or already established) in this article, we will focus on the retirement Strategies available to you. There are some special retirement plans that are available for self-employed individuals.
The Tried & True
Basically, there are five main choices at your disposal; an IRA (traditional or the Roth), a solo 401(k), a SEP IRA, a SIMPLE IRA, or a defined benefit plan. Entrepreneurship has some certain advantages attached to the title, but that doesn’t excuse entrepreneurs to skip out on savings for retirement. In fact, entrepreneurs need to be very cautious and extra vigilant, making sure that they are saving for retirement; unlike an employee who is already guaranteed to access a 401(k).
The first step towards saving for retirement is determining the amount of money you need to save for your retirement. To help you with that, there are many online platforms that can help you with calculating the amount to save for retirement, for instance, Nerdwallet’s retirement calculator or the Bankrate’s retirement calculator. Additionally, you can talk with your bankers who will advise you on how to optimally save for your retirement. After you have figured out the amount to save annually, or monthly, the next step is to determine where to put that money. For an entrepreneur flying solo comes with a lot of perks and one of them is access to the five retirement savings plan.
But let’s talk about SEP-IRAs and Simple Plans. These are plans that allow for a current-year tax deduction and therefore a reduction in the current year’s taxes. Money in these accounts is invested in a similar way to the traditional IRAs. Income taxes are deferred and taxable in the year withdrawn. However, if you have employees, you are required to contribute to their accounts as well.
The SEP-IRA is more for small business owners with no or just a few employees. The contribution limit to this account is the lesser of $58,000 in 2021 ($57,000 in 2020) or up to 25% of compensation or net self-employment earnings, with a $285,000 limit on compensation that can be used to factor the contribution. By “net self-employment” what we mean is the net profit that you have made less than half of your self-employment taxes that are usually paid on your SEP contribution.
The main advantage of the SEP-IRA is that with it, you have the freedom to deduct the lesser of your contribution or 25% of the net self-employment earnings or compensation which is capped at $285,000 per employee in 2020 on your tax returns. Again, the distributions in your retirement will be taxed as income.
This retirement option is more for the larger businesses, which have at least up to 100 employees. Usually, the contributory limit to these accounts is up to $13,500 in 2021 just as it was in 2020. Additionally, for seniors-50 years and older- you will be required to pay a catch-up contribution of $3,000. If you contribute to an employer plan, the total contribution cannot exceed $19,500. The key takeaway for this retirement option is the fact that contributions are deductible; however, distributions in retirement are taxed. The contributions that are made to the employee accounts are deductible as a business expense.
The difference between SEP-IRA and SIMPLE IRA comes from the way the two options treat the employee element wherein in SIMPLE IRA, the contribution burden isn’t solely on the entrepreneur. The employee themselves can step in to contribute through their salary deferral. SIMPLE IRA requires the employers to make either matching contributions to employee accounts of up to 3% of employee compensation, or fixed contributions of 2% to every eligible employee. When the employer/entrepreneur chooses to go with the latter option, it means employees do not have to contribute to earning your contribution.
Supposing you want to save money for yourself without having to save for your employees, the following options are available to you.
The ROTH IRA is an option that is best suited for the people who are just starting out probably leaving their 9-5 jobs to start their own small businesses. The good thing with ROTH IRA is that it is possible to roll your old 401(k) into an IRA. The contribution limit on the ROTH IRA is $7,000 in 2021 for the seniors and $6,000 for other demographics. Depending on your household income, you may be able to contribute to a ROTH IRA. The good thing about this account is that once you pay your tax today, you will never have to pay tax on the growth within your account. This simply means that withdrawals in retirement are tax-free.
What you need to understand about the ROTH IRA is that is the easiest and most sufficient way for self-employed people coming out of employment to start saving for their retirement. With these accounts, there are no special filings and you can actually use them with or without employees.
What most people do not know is that they can actually save for their future without a contribution limit, keeping the creditors at bay and accumulate money that is tax-free. This is a provision of the IRS Code and a properly designed 7702 plan has no income restrictions, age limits, or caps on the contributions. These accounts will grow tax-deferred and the account holder can access the funds anytime tax-free.
With a well-designed 7702 plan, there are no distribution penalties for accessing your money. You can take out what you want; when you want and with no fears of the IRS, or age-based penalties.
As an entrepreneur, you can think outside the box and give yourself an opportunity to design your life just the way you want- and thanks to the IRS Code, you can design a retirement savings vehicle to meet your needs as well.