Small Business Retirement Plan Options and Cautions

With the end of the year approaching, the IRS recently reminded self-employed small business owners that they can deduct contributions they make to retirement plans for themselves and …

With the end of the year approaching, the IRS recently reminded self-employed small business owners that they can deduct contributions they make to retirement plans for themselves and their employees. This includes not only contributions you make to your own plan as a sole proprietor but also any trustee fees not covered by the plan. The notice went on to “provide a quick look at preventing incorrect deductions for retirement plans.” This article offers some additional information and insight that will help business owners avoid disallowed deductions.

Kinds of plans 

Self-employed small business owners have a few choices for what kind of retirement plan to set up.

SEP-IRA: A simplified employee pension (SEP) plan can be set up as an individual retirement account or annuity. For many years this was the first choice of retirement plans for most small business owners because the fees are relatively low and the contribution limits are higher than those for some other types of plans—up to $46,000 or 25 percent of compensation (20 percent of net business income for Schedule C filers) in 2008. The employer must make contributions on behalf of all employees who are at least 21 years old and have worked for the company for at least three of the last five years. The contribution formula can’t discriminate in favor of highly compensated employees.

Individual 401(k): The newest kind of retirement plan for self-employed business owners is sometimes referred to as a “ solo 401(k).” It is favored by self-employed people without any employees (including leased employees) because it allows the company to make a contribution of up to $15,500 as an “elective deferral.” This contribution is in addition to the profit-sharing contribution of up to the $46,000 or 20 percent of net business income (25 percent of compensation) allowed in a SEP-IRA. Solo 401(k) plans can also cover the spouse of the business owner.

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SIMPLE IRA or 401(k): Some companies with at least one and not more than 100 employees choose a SIMPLE plan because these plans allow employees to make elective contributions. The employer can choose either to contribute 2 percent of the employee’s compensation or to match employees’ contributions up to 3 percent of compensation. These plans have lower contribution limits ($10,500 per employee in 2008) and must be set up between January 1 and October 1, except for new businesses. While they limit employers’ financial obligations, they also limit owner-employees’ contributions to their own retirement plans.

For all three kinds of plans, participants age 50 or older can make a “catch-up contribution” of an additional $5,000 in 2008 and $5,500 in 2009.

Cautions from the IRS

In a fact sheet issued in July, the IRS cautioned self-employed business owners that they can “avoid examinations and additional assessments” by making sure they qualify for the amount of deduction they are claiming. Specifically, the fact sheet said:

  • The amount contributed to the retirement plan, and deducted in calculating adjusted gross income (AGI), can’t be more than the amount used to calculate self-employment tax on Schedule SE (self-employment tax form). If your business is incorporated, the amount contributed can’t be more than the amount of taxable wages reported on your W-2.
  • The amount of income used to calculate your maximum contribution is your net self-employment earnings minus half your self-employment tax. That part’s easy. But the amount of your maximum contribution comes from a more complicated calculation that accounts for the contribution itself. The IRS suggests that you use the tables and/or worksheets provided in Publication 560, “Retirement Plans for Small Business,” for figuring your allowable contribution rate and tax deduction to make sure you get it right. (Note: this link is to the 2007 form. Check the IRS Web site for updates for future years’ returns.)
  • If your business is on a fiscal year but your retirement plan is on a calendar year, don’t try to split the retirement plan contribution into two parts to mesh with your business’s fiscal year. Deduct the entire contribution on the business tax return that covers the end of the calendar year.

Note that the maximum “elective deferral” amount is figured on an individual rather than a plan basis. This means you can take up to $15,500 in 2008 for all plans you participate in. If you contribute to another 401(k) plan, the maximum you can elective deferral you can make into your business plan is reduced by the amount you contribute to the other plan.

If you have at least one employee who is not highly compensated, you may be able to get a tax credit of up to 50 percent of the cost of setting up a new plan and educating employees about it, up to a maximum of $500 per year for the first three years of the plan.

The IRS also notes in Publication 560 that some retirement plan participants may qualify for the retirement savings contribution credit. However, it can be taken only on returns reporting maximum adjusted gross income of $26,500 for individuals and $53,000 for joint returns.

Although it’s too late to set up a SIMPLE plan this year (unless yours is a new business), there’s still time to set up one of the other two types of retirement plans discussed above. If you’re thinking about starting an individual 401(k), note that the plan must be established by the end of the tax year even though you don’t have to fund it until your return is due. SEP-IRAs can be set up any time before the tax return is due (including extensions).

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