An entrepreneur friend asks us: I want to accumulate savings for my retirement in the most appropriate and efficient way, how do I do it?
One of the dilemmas of the entrepreneur is that, having blind faith in his business, he prefers to reinvest the profits to make it grow. If the business were profitable, this could be a good strategy from a performance standpoint. However, it is not so much from the point of view of risk management.
Apart from the normal risks of any business, concentrating assets in one’s own company entails concentration and liquidity risks. Concentration risks due to the fact that both current income and the stability and long-term growth of assets are associated with the same risk. Liquidity risks because divesting from a company is not easy to achieve quickly, at low cost, and at a fair valuation.
Entrepreneurs who have already stabilized their businesses and are beginning to enjoy income levels high enough to accumulate savings outside of them, can benefit from various types of retirement plans[1].
SEP IRA Plans
SEP IRAs allow entrepreneurs working alone or having a few employees to make employer contributions to individual accounts. Contributions are tax deductible. The growth of accumulated savings is efficient since gains are not taxable. Employer contributions are flexible[2] and contribution limits relatively high. Employers can contribute a maximum of 25% of the employee’s income or $69,000 per employee (2024).
In SEP IRAs, only the employer can make contributions. However, contributions do not need to be made every year, but when they are made they must be consistent across all eligible employees. This type of account is easy to manage, since it does not require complicated or expensive reporting. The custodian of the accounts issues the annual IRS forms.
SEP IRAs allow the employee to invest in products and securities and can be transferred over like any other tax-deferred product, i.e., as a Traditional IRA or as a 401k plan.
SEP IRAs allow participants to make penalty-free withdrawals starting at age 59 1/2. Participants must begin receiving distributions no later than age 73, or they will have to pay penalties. Income tax[3] is due at the time distributions are made.
Individual 401k Plans (Solo 401k)
Individual 401k plans, also known as Solo 401k, allow the entrepreneur[4] having no employees (except spouses) to make contributions as both the employer and the employee. Individual 401k plans can be either Traditional or Roth[5]. In the case of Traditional, the annual contribution is deductible. In the case of Roth, the contribution is not deductible. Individual 401k plans also allow for annual “profit sharing” contributions, covering both the employer and the employee.
Individual 401k plans allow employees to make contributions of up to $23,000[6] (2024) and the employer can additionally contribute up to a maximum of 25% of the employee’s compensation or $69,000 (2024). The total contribution including the shares of employees and employers cannot exceed $69,000[7] (2024).
In both plans, the growth of accumulated savings is efficient since the gains are not taxable until distributed (Traditional), or never taxed (Roth).
Individual 401k plans require submitting annual reports to the IRS once plan assets exceed $250,000 and under other circumstances.
The rules for distributions from Individual 401k plans vary depending on whether these are Traditional or Roth. While the rules for distributions from Traditional plans resemble other tax-deferred plans, they do come with some specific requirements.
The rules for distributions from Roth plans differentiate between “qualified” distributions (i.e., after age 59 1/2, and after the plan has been in place for five years) from “non-qualified” distributions. The main difference is that qualified distributions are not taxable and non-qualified distributions are, in addition to having to comply with other requirements such as penalties and withholdings, among others.
There are other types of plans for small businesses (SIMPLE IRAs, for example) whose nature and benefits for the entrepreneur are very different from the two already mentioned and are therefore excluded from this discussion.
In conclusion, entrepreneurs can make use of cost-efficient, high-impact, tax-advantaged plans, according to their needs. The entrepreneur allocating part of his income to accumulate savings to fund retirement expenses is diversifying his risks significantly and efficiently.
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your particular situation.
[1] The operating and tax rules of each of these products can be extensive and detailed, and therefore it is necessary to get good advice before making the decision. This article is an introduction and for reasons of space and clarity we may have omitted details that are important when deciding.
[2] All eligible employees must receive the same percentage.
[3] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
[4] Including partnerships.
[5] This is another relevant difference from SEP IRAs.
[6] $30,500 (2024) for people over 50.
[7] $76,500 (2024) for people over 50.