Tax-Deferred Savings Options for Small Business Owners

Tax-Deferred Savings Options for Small Business Owners

by Kent Smetters, May 2011

According to the Small Business Administration, there are over 29 million small business in America. If you happen to own one of them, you know all the advantages that come with being your own boss and not doing the 9-to-5 grind. You are also aware of the perks that you give up, including losing access to a tax-advantaged retirement plan. Having the right plan at your company will not only help ensure a comfortable future for your family, it will also help you diversify investments, cut your tax bill, and even attract good employees. Fortunately, you do have some options as a small employer.


What it is: A Simplified Employee Pension, also known as a SEP, allows you to defer taxes on 25% of your earnings up to a maximum of $49,000 per year by putting money into an account that works much like a traditional IRA. Unless you make at least $196,000, however, the 25% limit will hit you before the $49,000 threshold. Contributions are not required in any given year.

What it is not: The SEP doesn't have a lot of flexibility or bells and whistles. You make the contributions for your employees. There is no Roth option, employee contributions, or loan option. You must make the same contribution (usually calculated as a percentage of income) on behalf of all eligible employees—including yourself. In other words, if you have a lean year and do not want to contribute to your employees' SEP, you cannot contribute to yours either.

Who it is good for: A SEP's high contribution allowance and easy administration makes it ideal for many small business owners, especially sole proprietors. If you're moonlighting and earning 1099 income, it won't interfere with your ability to participate in the 401(k) at your regular day job. Procrastinators can also wait until their filing deadline (usually April 15, but April 18 this year) to contribute. A SEP also makes sense for smaller firms where employees really value the retirement saving and reward you by demanding a smaller base income. SEP contributions can also be suspended in a given year, which is especially useful for smaller professional firms that might see considerable fluctuations in their incomes (e.g., architectural firms).

Individual 401(k)

What it is: An Individual 401(k) account allows a sole practitioner to set up a 401(k) without all the usual administrative complications associated a traditional 401(k). Even with the same $49,000 contribution cap like a SEP, Individual 401(k)s often provide larger limits due to the ability to contribute 100% of the first $16,500 of your self-employment income ($22,000 if you are over 50). Individual 401(k)s also give you the option of a ROTH component.

What it is not: An Individual 401(k) is just that—you're not eligible if you have any employees other than a spouse. The contribution limit applies to all of your 401(k)s, so if you are maxing out your contributions at another company, you may be better off with a SEP. Also, this type of plan involves a bit more administrative details than a SEP.

Who it is good for: It's suitable for sole proprietors who make less than six figures and who really want to max out their contributions from this income source because they cannot do it with their other jobs. Sole proprietors who expect to be in a higher tax bracket later in life can also benefit from the Roth option.

Simple IRA

What it is: A SIMPLE (Savings Incentive Match Plan for Employees) IRA is a variation of the SEP with a lower maximum contribution limit ($11,500, or $13,500 if age 50 or over). You cannot defer contributions during lean years.

What it is not: It is not really as “simple” as it might seem. If you have employees, you will be required to offer a 2–3% match (or “non-elective contribution”) and it is immediately vested, which can be a problem in lean years or in the case of high turnover. The early withdrawal penalty is also higher than those of other plans, and all contributions must be made by year end.

Who it is good for: For most small businesses, Veritat Advisors does not recommend creating a SIMPLE account. However, there are some limited cases where it makes sense, especially if you want to save a higher percentage of your income than your employees. Recall, under a traditional SEP, the percentage contribution must be the same across all employees. Hence, you might need to fork out a lot of money to help your other employees save aggressively like you. But, under the SIMPLE, after you effectively pay your “matching tax,” you can still contribute more to your own account, thereby increasing your own percentage of income saved. However, given its low contribution limit, it rarely makes sense.

The Bottom Line

For sole proprietors, your choice is usually between a SEP and Individual 401(k). For most people, the SEP is the easy choice. But for those wanting a Roth option, or making less than $196,000 and really want to max out their contributions, then the Individual 401(k) might be the best bet. For small business owners with employees, the SEP is usually the winner. But you might need to give some of your less compensated employees a little pep talk about the value of all the retirement saving that you are doing for them.

About the Author: Kent Smetters is The Boettner Chair Professor at The Wharton School at The University of Pennsylvania. He is also co-founder of Veritat Advisors, a mission-driven firm that makes objective and personalized financial planning affordable for all households.

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