When you own a small business, it’s easy to overlook investing in a retirement plan. After all, you don’t have “the man” to remind you that you should have a retirement plan — and you don’t have that matching contribution.
The good news, though, is that you have the potential to contribute more to a retirement plan if you are a small business owner.
No matter how much money you make, your contributions to a retirement plan offered by your employer are limited to the current year’s contribution cap, or $17,500 in 2014 for a 401(k).
On the other hand, as a small business owner, you can choose from several different options — some of which allow you to contribute more to your retirement.
As a business owner, you need to follow one of the basic tenets of financial literacy and set up a retirement plan. Two common and simple choices are the SEP IRA and the solo 401(k).
Your SEP IRA works a lot like a traditional IRA. However, this type of plan is aimed at small business owners and the self-employed. It’s easy to set up, and offers an above the line tax deduction for your contributions.
With a traditional IRA (and a Roth, for that matter) they come with rather low contribution limits. The main advantage of the SEP IRA is that, in addition to a simple set up, it allows you to make larger contributions: The lesser of 25% of your net earnings as someone self-employed or $52,000 (for 2014).
Sometimes, you will see this type of plan referred to as a solo 401(k). As you might expect, it functions very much like a regular 401(k), with your pre-tax contributions helping you out.
However, the solo 401(k) is where you really shine when it comes to contributions. You can make an employee contribution of up to $17,500 (for 2014), and also also get to make an employer contribution to your account (seeing how you’re both the employee and the boss), using the 25% of earnings as a guide. Your total contribution is capped at 100% of your net earnings, or $52,000.
What is 25% of Your Earnings?
Both of these plans refer to 25% of your net earnings. Realize that your net earnings consist of your revenues, minus your expenses. On top of that, you have to deduct one-half of your self-employment tax, and you have to consider contributions you make to your retirement plan.
In order to simplify this process, many experts recommend you figure up your net earnings without including your contribution, and then take 20% of that number to account for the retirement account contributions you haven’t made yet.
Which is Better? SEP IRA vs. Solo 401(k)
If you are going strictly by which plan allows you to make higher contributions, the solo 401(k) is the way to go. Let’s say that your net earnings before you deduct your contributions is $100,000 for 2014. With the SEP IRA, you can contribute $20,000. If you have an solo 401(k), though, you can contribute $17,500 as an employee, and then also make an employer contribution of 20% of your earnings, for a total of $37,500. That’s a big difference.
However, you should realize that if you have even one employee (other than your spouse) that works more than 1,000 hours in a year, you can’t use the solo 401(k) (although you can offer a 401(k) plan as a business owner). If you have employees, you need to use a SEP IRA for your self-employed retirement planning.