Retirement Savings Plans: Limits and OptionsAug 24, 2021
When you first start your business you have a lot to do from generating revenue to marketing to hiring workers. You may not make enough in the very beginning to pay yourself, much less save for retirement. Once your business is established it's time to think bigger picture and part of that includes retirement planning.
Once you have reviewed the options below, consider contacting a financial planner who can assess your overall financial picture and create a plan that aligns with your goals. For more information on non-retirement employee benefits, see Employee Benefits: Rules and Options.
Pre-tax vs. post-tax plans
Retirement plans change when your money is taxed. There are two types, pre-tax and post-tax. Having some retirement money saved that is pre-tax and some that is post-tax can give you more options in retirement, because you can decide which account to pull money from, and better manage your retirement taxable income and therefore your tax rate.
Pre-tax retirement plans allow you to avoid paying tax on the money you contribute this tax year, but you will pay tax later when the money is withdrawn in retirement. If it is taken out before retirement age, you may have to pay the tax plus penalties for early withdrawal.
Taxpayers choose pre-tax retirement plans when they expect their tax rate is higher now, in their working years, than it will be in the future when they retire and living on a limited income.
For example, say that today you are paying taxes on your income at a rate of 28%, but in retirement you expect your tax rate could be as low as 12% because you will be able to live off less income than you are today. You decide you can contribute $12,000 per year to a retirement plan and you make steady pre-tax contributions every year for 25 years. You may end up with between $650,000-$700,000 in that account at the end of 25 years. You can then decide to withdrawal a little at a time to keep your tax rate low.
Types of pre-tax plans include:
- Traditional IRA for individuals
- 401(k) for for-profit business entities
- 403(b) for certain tax exempt organizations
- SEP IRA for small business owners
- SIMPLE IRA for small business owners
Some retirement contributions are made with income that has already been taxed. These plans allow the funds to grow tax-free and not be taxed when the funds are withdrawn in retirement. Using the example above, if $12,000 was contributed each year but tax had already been paid on that money in the current year, the balance could grow to $650,000-$700,000 over 25 years and none of it would be taxed when it was withdrawn in retirement. There can be penalties for withdrawing early before the designated retirement age, depending on how much is withdrawn.
Types of post-tax retirement accounts include:
- Roth IRA for individuals
- Roth 401(k) for for-profit business entities
- Roth 403(b) for certain tax exempt organizations
Note: This post primarily focuses on individual plans and plans for for-profit business entities. If you operate a non-profit entity, consult with your business financial advisor in setting up a 403(b) or Roth 403(b).
For many plans, taxpayers age 50 and older can contribute more than taxpayers under 50 years old. These are known as catch-up contributions. The government recognizes that those who are closer to retirement may need to save extra to be able to have enough funds when they retire, so they allow extra contributions.
There are a many types of retirement plans and only some of them are listed here. Each have their own contribution limits and rules. Some can be opened individually, whether you have an employer sponsored plan or not. Others can only be offered by an employer. If you own your own business, you can create an employer plan.
Some plans allow you to make contributions after December 31st but before you file your tax annual return, applying the contribution to the prior years taxes. This can help taxpayers determine their actual contribution limits which may not be known until after the end of the year due to income limitations. It also gives a little more time to get the cash together to make the contribution.
More than one plan
It is usually possible to have more than one current retirement plan, such as an individual and an employer provided plan or two employer plans from different employers if you have two jobs, or run your own business and have a job. However, rules will be more complex if you do have multiple current plans.
It is difficult to list out every possible combination of plans (IRA, Roth, 401(k), SEP, SIMPLE), filing status (single, head of household, married filing separate, married filing jointly), age (under 50 or not) and income level (limits vary based on several factors). If you have more than one plan, read the rules for each and then seek the help of a tax professional to understand how your limits will be applied to your specific situation. If you first know 1) "yes I can have each plan separately" you can then establish 2) "are my contribution to either limited when I have both."
Modified Adjusted Gross Income (MAGI)
There can be income limitations on who can contribute how much to what plans. Limitations may be based on modified adjusted gross income (MAGI) and your filing status. MAGI is your adjusted gross income (AGI), which can be found on your tax return, with a few items added back. The items that are added back to AGI include:
- IRA deduction.
- Student loan interest deduction.
- Tuition and fees deduction.
- Foreign earned income exclusion.
- Foreign housing exclusion or deduction.
- Exclusion of qualified savings bond interest shown on Form 8815.
- Exclusion of employer-provided adoption benefits shown on Form 8839.
Calculating your MAGI can help you determine if you exceed income limits to contribute fully to an IRA.
Individual retirement plans
There are several types of Individual Retirement Arrangement (IRA) plans you can set up on your own personally. The two main ones are a traditional IRA (pre-tax) and a Roth IRA (post-tax).
You can choose either of these individual type plans even if you also have a retirement plan sponsored through your employer, subject to certain income limitations.
Opening a personal IRA is fairly simple. You need to open an account with a provider. See this list of top rated investment companies from
- Nerd Wallet: 14 Best IRA Accounts of August 2021
- Forbes: Best Places to Open an IRA
- Business Insider: The best IRA accounts of July 2021
A traditional IRA allows you to contribute $6,000/year or 100% of earnings, whichever is lower. If you are age 50 or older, this contribution limit raises to $7,000. If your income is lower than these limits, say $4,000, you can contribute up to your amount of income, which would be $4,000. Funds in the traditional IRA will not be taxed when the contribution is made, and will be taxed when it withdrawn in retirement.
These contributions can be limited if you or your spouse have an employer provided plan or make over a certain income amount. Your MAGI determines whether your traditional IRA contribution is limited, as well as whether you or your spouse is covered by an employer plan. For 2021 limits see this links:
2021 IRA Deduction Limits - Effect of Modified AGI on Deduction if You Are Covered by a Retirement Plan at Work
- 2021 IRA Deduction Limits - Effect of Modified AGI on Deduction if You Are NOT Covered by a Retirement Plan at Work (note for married taxpayers: there are different limits if your spouse is covered by an employer plan or not).
The Roth IRA contributions are made after tax, the funds grow tax-free and withdrawals in retirement are not taxed. Limits are the same as the traditional IRA, $6,000 for under 50 years old and $7,000 for age 50 and older. However, the Roth IRA has an income cap meaning if you earn too much you may not be able to contribute to a Roth IRA. See this IRS page for Roth contribution limits: Amount of Roth IRA Contributions That You Can Make For 2021.
Roth conversions (back-door Roth)
For those who cannot contribute to a Roth IRA because their income is too high, a Roth conversion may be an option. This is also known a back-door Roth. The process involves making a specific type of transfer from a traditional IRA to a Roth IRA account. There is income tax to be paid on the conversion amount, which may involve some complicated math if the money has been in the traditional IRA a while. Despite the complexity, this may be an option for those who can't contribute directly to a Roth IRA account.
Employer sponsored plans
If you own a small business, there are a number of plans you can create to benefit yourself and your employees.
Owner contributions and non-discrimination rules
Typically, a solo business owner can contribute the maximum allowed under the IRS rules for the retirement plan. If the business has eligible employees, the owner contribution may be limited to amounts that the employees are also eligible. These are called non-discrimination rules which are designed to ensure that retirement plans do not discriminate in favor of highly compensated employees or owners. Not all plans are subject to non-discrimination rules, but most are.
A business can create a solo 401(k) plan for an owner-only company, create a traditional 401(k) plan that can include eligible employees, or can create a Roth 401(k) plan for after-tax contributions. A 401(k) plan permits employee and employer contributions.
To begin a 401(k) plan you need expert assistance. A 401(k) plan requires a plan document which dictates how the plan will operate. This is a legal document that must be followed as written. The plan requires record-keeping, reporting, and has to be communicated in writing to employees. To find a provider to help open a 401(k) plan visit these articles:
- Investopedia: Top 10 Small Business 401(k) Plan Providers
- Nerd Wallet: 7 Top 401(k) Providers for 2021
- US News: How to Pick the Best Small Business 401(k) Plan Provider
Employee contribution: In 2021, employees can make an employee contribution of up to $19,500, or if age 50 and older, then the limit is $26,000. This contribution comes out of the employee paycheck. The employer deducts the amount paid as wages, but the taxable wages from the W2 are reduced by the employee retirement contribution, so the employee is not taxed on the amount.
Employer contributions for employees: The employer decides how much to contribute to employee accounts. For example, and employer may match 6% of the employee salary as long as the employee is putting in at least that much as well. The total contributions for employee plus employer cannot exceed $58,000 in 2021 or $64,500 if the employee is age 50 or older. Contributions also cannot exceed the employees total salary, meaning if an employee earns $40,000, then that is the maximum that can be contributed.
Employer contributions for owners: Owners can make an employee and an employer contribution. On the employer side, the owner can contribute up to 25% of employee pay from the employers own funds. The contributions are different based on your business type:
- S-Corp owners are also employees, therefore the owner can make an employee contribution of $19,500 if under age 50 and $26,000 age 50 and older. The S-Corp can also make an employer contribution of 25% of the W2 owners salary. S-Corp owners cannot count their distributions in calculating the employer contribution.
- Self-employed owners are subject to a limitation which result in a maximum contribution of 20% of their net income (revenue less expenses) and not being able to get the full 25% for the employer contribution. However, because all the self-employed income can be used for the calculation, this may be a higher contribution amount than for the S-Corps owners lower W2 salary amount. The self-employed owner can also contribute as an employee up to $19,500 under age 50 or $26,000 if age 50 and older.
- Whichever form of business and calculation amount, total employee and employer contributions cannot exceed $58,000 under age 50 or $64,500 age 50 and older, in total.
Some 401(k) plans have annual reporting requirements to the IRS. See this link for information on Reporting To Government Agencies.
A Simplified Employee Pension (SEP) IRA is easy to create. It is as simple as opening a SEP account at a firm that has SEP plans and completing a form, therefore a SEP is less costly to establish than a 401(k) plan. To find an investment firm to open a SEP IRA, consider the articles above for IRA accounts.
For a SEP IRA, all contributions must be the same percentage for owners and employees. If an owner want to give themselves 25% of net income, they have to give all eligible employees 25% of their pay. For this reason, a SEP can be most beneficial when there is a sole owner without employees. Once the business hires employees, they may want to switch to a 401(k) plan to divide the employee and employer portions. For more details see the IRS page Simplified Employee Pension Plan (SEP).
Due to limitations on owner contributions, even if the plan is set to contribute 25% the actual maximum contribution will usually be around 20% instead.
- Same percentage for all plan participants.
- Only employer contributions, no employee contributions.
- Contributions are vested immediately.
- Employees who are a minimum age of 21, have at least three years of employment and have earned $650 compensation minimum in 2021, must be allowed to participate.
- Plan details must be communicated to all employees.
- A separate account is established each owner and employee.
- Employers can skip contributions in years when business is down.
- Max contribution for owners and employees is $58,000, there are no catch-up contributions for those age 50 and older.
To establish a SEP IRA, in addition to opening SEP accounts at a financial institution, owners need to complete IRS form 5305-SEP. This form is not filed with the IRS, it is retained by the owner as part of the retirement plan records.
A Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) is a plan where the employee and employer can make tax deferred contributions. Like a SEP IRA, a SIMPLE plan has lower start up and maintenance costs than a 401(k).To find an investment firm to open a SEP IRA, consider the articles above for IRA accounts. For more details see the IRS page SIMPLE IRA Plan.
- The business generally has 100 or fewer employees.
- Employees who were paid $5,000 or more during any two previous calendar years and expected to be paid $5,000 or more in compensation this year can participate.
- Employees are not required to contribute.
- Employers must make a minimum contribution.
- Contributions are vested immediately.
- Contributions are limited to $13,500/year for those under age 50 and $16,500 for those age 50 and older.
- Not subject to non-discrimination testing.
- Cannot have any other employer retirement plans.
To establish a SIMPLE IRA, owners need to complete IRS form 5304-SIMPLE. This form is not filed with the IRS, it is retained by the owner as part of the retirement plan records.
Profit sharing plan
Businesses who wish to share profits with employees can set up a retirement plan with discretionary employer-only contributions. Discretionary contributions are amounts the employer chooses each year based on business profit. Unlike a non-discretionary contribution, such as matching employee contributions up to 3% of employee salary, a discretionary amount could be zero if there is not sufficient profit, or an amount chosen by the employer which may be different each year. For more details see the IRS page Choosing a Retirement Plan: Profit-Sharing Plan.
- A profit sharing plan can be established along with certain other retirement plans.
- An employer cannot contribute more than $58,000/year to a profit sharing plan for employees under age 50 and not more than $64,500 for those age 50 and older.
- Subject to non-discrimination testing.
To establish a profit sharing plan, owners need to complete IRS form 5500 each year. This form must be filed with the IRS.
There are many options to consider when establishing a retirement account. If reading the options is overwhelming, start small and consider a traditional IRA, Roth IRA or SEP IRA if you are self-employed. You can adopt a more complicated plan later. Starting or re-starting your retirement savings is nearly always a wise financial move. Consider what options may suit your personal situation and contact an investment company or financial planner to make it happen!
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