Retirement Plans for the Self-Employed Dangle Tax Benefits

As a business owner, you may devote most of your time, energy, and profits to running and growing your business. But working for yourself means that saving money for retirement is also entirely up to you.

This is not the only reason it may be worthwhile to divert a sizable chunk of your earnings into a tax-deferred retirement account. Doing so generally reduces your current taxable income.

Chart showing the share of surveyed workers actively saving for retirement

Here are two types of retirement plans that are relatively simple for small-business owners and self-employed individuals to set up.

Solo 401(k)

A solo 401(k) is a one-participant plan for business owners who have no other employees. Tax-deductible (or pre-tax) contributions to an individual 401(k) can be made in two ways.

As the employee, you can contribute as much as 100% of your annual compensation, up to the $19,500 annual maximum in 2020, or $26,000 if you are age 50 or older. (This is up from $19,000 and $25,000, respectively, in 2019.)

As the employer, you can also contribute an additional 20% of your earnings (25% if the business is incorporated) and deduct it as a business expense. Total contributions are capped at $57,000 in 2020 ($63,500 if age 50 or older). A solo 401(k) plan may also allow plan loans and/or hardship withdrawals.

The deadline to establish an individual 401(k) and formally elect salary deferrals is December 31 of the year in which you want to receive the tax deduction (or before fiscal year-end for corporations). For businesses taxed as sole proprietors and partnerships, salary deferrals and profit-sharing contributions for 2019 must be deposited into the account by the April 15, 2020, personal tax filing deadline (October 15 if an extension is filed).

SEP IRA

If you are self-employed, you can contribute 20% of net earnings, up to $57,000 in 2020, to a Simplified Employee Pension (SEP) plan. (This is up from $56,000 in 2019.) A SEP IRA may also be an appropriate choice for business owners with a small number of employees for whom they would like to provide retirement benefits. All employees age 21 and older who have worked for the employer for at least three of the last five years must be included. The plan may exclude employees earning less than $600 in the current year.

The same percentage of salary (up to 25% of compensation or $57,000 in 2020) must be contributed to each eligible employee's SEP IRA, including the owner's. However, the business is not required to contribute every year. You have until the due date of your business's federal income tax return (including extensions) to set up a SEP IRA and make contributions.

Distributions from 401(k) plans and SEP IRAs are taxed as ordinary income. Early withdrawals (prior to age 59½) may be subject to a 10% federal income tax penalty.

 
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