Ever since making financial planning a career, I’ve developed this habit of listening carefully when people discuss how they save money. One of my observations has been that many people don’t save enough money to warrant any real concern about good investment practices. I don’t criticize these people. I try to switch their focus from past mistakes to improving future habits and developing a realistic strategy going forward. I’ve noticed that even those who have a good discipline about saving money tend to accumulate large balances in checking and savings accounts before looking for better returns. The problem with this isn’t really the extra percentage points that you may earn in a bond fund over a CD or savings account. Tax benefits are the primary reason self-employed individuals and small business owners should utilize retirement plans. Most of these plans provide for tax-deductible contributions and tax-deferred growth on investment earnings. Passing up on these benefits can truly hinder a financial plan. The best way to think of retirement plans is as protection for your money: you go to work each day and put in the time and effort necessary to earn money. Once you have some, it should go to work the same way you do. Why should money sit around, perhaps even losing purchasing power to inflation? If I decided to spend $3,000 on the Babe Ruth baseball card which I’ve drooled over since I was a child, you wouldn’t find it sitting on my kitchen table. It’d be locked in a protective case which could withstand harsh weather, children playing, natural disasters, or anything else. My focus today is on small business owners and the retirement plans which are available to them.
If you are self-employed, own a small business, or receive any other form of 1099 income, you can set up your own retirement plan. It will offer you an excellent way of sheltering a portion of your income from taxes. It will also allow you to put money aside for your future which will grow tax-deferred until retirement. Having a plan at your workplace can also help build your brand, improve your employee loyalty, and make those around you a bit wealthier in the process. While there are many retirement plans available to small business owners, I’d like to focus on three: the SEP IRA, profit-sharing plan, and self-employed (solo) 401k. None of these plans demand heavy costs to establish and, typically, they don’t demand too much in the way of paperwork or headache.
•SEP IRA – This is an excellent plan if you’re self-employed or in a family business. Contributions are made by the employer on behalf of the employees. In practice, this could be Dad contributing for Mom, Uncle Paul, and Aunt Linda. Also, note that Dad, as employer, qualifies as an employee as well. SEP plans are quite flexible in that the employer can choose the investment plan, the level of contribution (up to certain limits) and how frequently contributions are made. If the business doesn’t have a great year, Dad can elect not to make any contributions to the plan. This feature is sometimes viewed as a drawback because contributions must cover all employees. So, even if Dad is mad at Aunt Linda, he can’t skip over her in terms of making a contribution. He must contribute the same percentage of her salary as he does for himself and everybody else. Also, once a contribution is made, it immediately vests and belongs to the employee. If Aunt Linda quits one day after getting her 2006 contribution, she’s free to take that money with her upon leaving. Note: the maximum contribution in 2006 is $44,000, or up to 25% of compensation, whichever is less. The plan is easy to set up and doesn’t involve much in the way of complicated paperwork.
•Profit-Sharing Plan – These are similar to SEP plans in that contributions must be made by the employer rather than the employee. They provide a decent level of control to the business owner in that plan eligibility and vesting schedules are flexible and at the discretion of the employer. These plans are often used as incentives to retain employees and improve their performance. If the plan vests every five years, and the employee is getting a contribution equal to 20% of their salary, you can believe the employee, if they have a genuine interest in their financial lives, will work hard to maximize profits for the business and stay employed until the vesting period comes around. The key protective clause which exists for the employee is that a uniform percentage must be given to everybody. That doesn’t mean the amount has to be the same, just the percentage. If Dad is earning $200,000 and Mom is earning $100,000 and a 20% contribution level is determined for 2006, Dad must set aside $40,000 for himself and $20,000 for Mom. The other small detail about this plan is that the application is often comprehensive and generally has stricter regulatory requirements than a SEP IRA. This is ultimately to protect both the employees and the employer but can be a drag if you do all the administration yourself.
•The self-employed (solo) 401k – This plan is generally for business owners and their immediate family members only. It’s typically not for businesses that have non-family employees. Your business can be unincorporated, such as a sole proprietorship, or it can be an entity such as an LLC, partnership, or S-corporation. The employer (which is in many cases the employee as well) can make a tax-deductible contribution of up to 25% of compensation, capping out at $44,000. The employee can make a pre-tax contribution of up to $15,000/year as well in which the investment earnings will grow tax-deferred until retirement. With the profit sharing component, the solo 401k is often recognized for allowing the largest contributions when compared to other defined contribution plans.
Yes, there are other retirement plans which may be options for your business as well. You’ll want to seek more information about the specifics of each plan and how they fit into your business model prior to selecting a plan. The above choices are fairly easy to manage and could help many small businesses save money that don’t currently offer a plan. If you’d like more information about any of the above plans or wish to discuss your business model, feel free to send me an e-mail.*
Russell Bailyn
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Wealth Management
Premier Financial Advisors
14 E. 60th Street, #402
New York, NY 10022
212-752-4343 *31
*Keep in mind that distributions taken prior to age 59.5 are generally subject to ordinary income tax and a 10% federal tax penalty.
Securities and certain investment advisory services offered through: FIrst Allied Securities, Inc., a registered Broker/Dealer. Member: NASD & SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.