If you’re a sole proprietor starting to save for retirement, you may wonder if you should set up a 401(k) plan or begin contributing to an IRA. What should you do? It depends on your circumstances, and on a number of variables relating to your business.
There are at least six considerations in determining whether a 401(k) or an IRA will be the best choice for you.
1. Do You Want Simplicity?
As far as retirement planning is concerned, it doesn’t get much simpler than a basic IRA. You simply have to complete a few forms with an investment broker, put in a little bit of money, and you’re on your way!
After that, you hardly have to pay attention to it, except when it comes time to determine if you will put money into it for any given year and how much.
A 401(k) plan can be a bit more complicated, but there are solo 401(k) plans that are similar to IRAs in terms of simplicity.
Contribution limits are different with 401(k) plans, in that the calculations have the potential to be more complicated. If you plan to hire employees and include them in the 401(k) plan, then things can get even more involved.
2. Beware of Fees
Generally speaking, account fees should be similar between a solo 401(k) and an IRA, though this may depend upon the fee structure of the individual investment brokerage firm.
Of course, these can also be higher if you expand the 401(k) plan to include employees. Make sure to research the fees associated with each plan and find the best one that fits your needs.
3. How Old is Your Business?
If you’re just starting out in your business –- and not entirely certain as to either the viability of the business or your potential future income –- you may want to stick to an IRA. At this point in the life of your business, you probably don’t have extra funds to maximize retirement contributions anyway, so an IRA will fit the bill.
Even if you do have additional funds you may prefer to reinvest them in the business, rather than contributing them towards retirement. Any business, especially a new one, needs capital for future growth. That should be the priority right now.
In a few years, when your business is more established and the cash flow is more predictable, you can look into accelerating your retirement contributions. But until then, it’s best to stay as liquid as possible.
4. Understand Your Income Tax Situation
Once again, if your business is fairly new and your income is still low, creating tax savings with retirement contributions may not be terribly important. It is often a year or more before a new business breaks even, and you can spend several years after that making relatively little money.
If you’re only in the 10% or 15% income tax bracket, the tax deferral that retirement contributions provide are not nearly as important. An IRA will work just fine for you.
On the other hand, if your business is well-established and is earning you a substantial profit, a tax-sheltered retirement plan is one of the best ways to reduce your income tax liability. Since it has much higher contribution limits that an IRA, a 401(k) will be the retirement plan of choice.
You’ll be able to shelter a much larger amount of money from taxes and your high income status represents the perfect time to be making more substantial contributions towards your retirement.
5. Do You Have Employees (or plan to)?
Many businesses today are single man or single woman shops. You can run such a business all by yourself, and hire subcontractors as the business expands and you need more help or specialized expertise. An IRA is perfectly fine for this type of business, particularly if you are only generating a moderate income.
If your business is large, very profitable, and you’re looking to take on employees, the 401(k) plan will likely be the better choice. Unlike an IRA, a 401(k) plan can be expanded to include employees.
This can be especially important if the type of employees you need are highly specialized and generally well-compensated. The market for such employees is competitive, and they will be looking for employee benefits in addition to salary as an incentive to work for your business. One of the biggest employee benefits is a generous 401(k) plan.
6. How Soon Do You Want to Retire?
If retirement is still decades away for you, you may need nothing more than an IRA. Under the plan, you can contribute up to $5,500 for 2013, or up to $6,500 if you’re age 50 or older. There are also variations of the IRA specifically designed for the self-employed.
Under a Simple IRA you can contribute up to $12,000 for 2013, or $14,500 if you are 50 or older. If you’re interested in an IRA with even larger contribution amounts, you can also opt for a SEP IRA, which will allow you to contribute up to 25% of your gross income, or up to $51,000 total.
Generally speaking, the contribution limits under a 401(k) plan are more generous. For 2013, you can contribute 100% of your income up to $17,500 –- or $23,000 if you’re age 50 or older.
Even better, once you reach the $17,500 threshold (or $23,000 if you are 50 or older), you can contribute an additional 25% of your income above those thresholds, up to a total contribution amount of $51,000.
If you’re fairly close to retirement age –- or if you are seriously considering the prospect of early retirement –- the 401(k) plan will be the better program to have. It will enable you to amass a much larger sum of money in far less time.
Before deciding whether you need a 401(k) or an IRA, consider the factors above and where you stand on each of them.
Does your company have a 401(k) plan or IRA?