Tax Strategies for Business Owners
Several different types of retirement plan - 401(k), defined benefit, and profit-sharing - can be made to suit a prosperous small business or professional practice. But if yours is a really small business such as a home-based, start-up, or sideline business, maybe you should consider adopting a SIMPLE IRA plan.
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A SIMPLE IRA plan is a type of retirement plan specifically designed for small business and is an acronym for "Savings Incentive Match Plans for Employees." SIMPLE IRA plans are intended to encourage small business employers to offer retirement coverage to their employees but work just as well for self-employed persons without employees.
SIMPLE IRA plans contemplate contributions in two steps: first by the employee out of salary, and then by the employer, as a "matching" contribution (which can be less than the employee contribution). Where SIMPLE IRA Plans are used by self-employed persons without employees - as IRS expressly allows - the self-employed person is contributing both as employee and employer, with both contributions made from self-employment earnings.
One form of SIMPLE IRA plan allows employer contributions without employee contributions. The ceiling on contributions, in this case, makes this SIMPLE IRA Plan option unattractive for self-employed individuals without employees.
To establish a SIMPLE IRA Plan you:
And, here is a quick list of pros and cons:
Those with relatively modest earnings will find that a SIMPLE IRA Plan lets them contribute (invest) and deduct more than other plans. With a SIMPLE IRA Plan, you can put in and deduct some or all of your self-employed business earnings. The limit on this "elective deferral" is $13,500 in 2020 ($13,000 in 2019).
If your earnings exceed that limit, you could make a modest further deductible contribution--specifically, your matching contribution as an employer. Your employer contribution would be three percent of your self-employment earnings, up to a maximum of the elective deferral limit for the year. So employee and employer contributions for 2020 can't total more than $27,000 ($13,500 maximum employee elective deferral, plus a maximum $13,500 for the employer contribution.)
Catch up contributions. Owner-employees age 50 or over can make a further deductible "catch up" contribution as employee of $3,000 in 2020 (same as 2019).
Low-income owner-employees in SIMPLE IRA Plans may also be allowed a tax credit up to $2,000 in 2020 for single filers ($4,000 married filing jointly). This is known as the "Saver's Credit" and income must not be more than $65,000 for married filing jointly, $32,500 for singles and $48,750 for heads of household.
SIMPLE IRA plans are an excellent choice for home-based businesses and ideal for full-time employees or homemakers who make a modest income from a sideline business.
If living expenses are covered by your day job (or your spouse's job), then you would be free to put all of your sideline earnings, up to the ceiling, into SIMPLE IRA plan retirement investments.
An individual 401(k) plan, however, could allow you to contribute more, often much more, than SIMPLE IRA Plan. For example, if you are less than 50 years old with $50,000 of self-employment earnings in 2020, you could contribute $13,500 to your SIMPLE IRA PLAN plus an additional 3 percent of $50,000 as an employer contribution, for a total of $15,000. A 401(k) plan would allow a $32,000 contribution.
With $100,000 of earnings, the total for a SIMPLE IRA Plan would be $16,500 and $44,500 for a 401(k).
There's no legal barrier to withdrawing amounts from your SIMPLE IRA Plan, whenever you please. There can be a tax cost, though: Besides regular income tax, the 10 percent penalty tax on early withdrawal (generally, withdrawal before age 59 1/2) rises to 25 percent on withdrawals in the first two years the SIMPLE IRA Plan is in existence.
A SIMPLE IRA Plan really is a "simple" plan to set up and operate than most other plans. Contributions go into an IRA that you set up. Those already familiar with IRA rules investment options, spousal rights, and creditors' rights don't have a lot new to learn.
Requirements for reporting to the IRS and other agencies are negligible, at least for you, the self-employed person. Your SIMPLE IRA Plan's trustee or custodian, typically an investment institution, has reporting duties and the process for figuring the deductible contribution is a bit simpler than with other plans.
Other types of retirement plans are often better than the SIMPLE IRA Plan once self-employment earnings become significant. Other not-so-good features include the following:
Because investments are through an IRA, you're not in direct control. You must work through a financial or other institution acting as trustee or custodian, and will in practice have fewer investment options than if you were your own trustee, as you could be in a Keogh. For many self-employed individuals, however, this won't be an issue. In this respect, a SIMPLE IRA Plan is like the SEP-IRA.
Other plans for self-employed persons allow a deduction for one year (say 2020) if the contribution is made the following year (2021) before the prior year's (2020) return is due (April 2021 or later with extensions). This rule applies to SIMPLE IRA Plans, for the matching (3 percent of earnings) contribution you make as an employer. But there's no IRS pronouncement on when the employee's portion of the SIMPLE IRA Plan is due where the only employee is the self-employed person. Those who want to delay contribution would argue that they have as long as it takes to compute self-employment earnings for 2020 (though not beyond the 2020 return due date, with extensions).
You can't set up the SIMPLE IRA Plan after the year ends and still get a deduction for that year, as is allowed with SEPs. Generally, to make a SIMPLE IRA Plan effective for the year it must be set up by October 1 of that same year. A later date is allowed where the business is started after October 1. In this instance, the SIMPLE IRA Plan must be set up as soon thereafter as administratively feasible.
Then there's a problem if the SIMPLE IRA Plan is intended for a sideline business and you're already in a 401(k) plan in another business or as an employee. In this scenario, the total amount you can put into the SIMPLE IRA Plan and the 401(k) plan combined can't be more than $19,500 in 2020 or 56,00 if catch-up contributions are made to the 401(k) by one age 50 or over.
Here's an example: If someone who is less than age 50 puts $10,000 in her 401(k), they can't put more than $9,500 in her SIMPLE IRA Plan in 2020. The same limit applies if you have a SIMPLE IRA Plan while also contributing as an employee to a "403(b) annuity" (typically for government employees and teachers in public and private schools).
You can set up a SIMPLE IRA Plan on your own by using IRS Form 5304-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE)--Not for Use With a Designated Financial Institution, or Form 5305-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE)--for Use With a Designated Financial Institution, but most people turn to financial institutions to take care of the paperwork for them. SIMPLE IRA Plans are offered by the same financial institutions that offer IRAs and 401(k) plans.
You can expect the institution to give you a plan document (approved by IRS or with approval pending) and an adoption agreement. In the adoption agreement, you will choose an "effective date," which is the beginning date for payments out of salary or business earnings. Remember, that date can't be later than October 1 of the year you adopt the plan, except when a business is formed after October 1.
Another key document is the Salary Reduction Agreement, which briefly describes how money goes into your SIMPLE IRA Plan. You need such an agreement even if you pay yourself business profits rather than salary.
Printed guidance on operating the SIMPLE IRA Plan may also be provided. You will also be establishing a SIMPLE IRA Plan account for yourself as a participant.