Making retirement plans for a small business

Q. I have a small business and I’m finally ready to start a retirement plan. I’m the only employee. What’s the difference between a 401(k) and SEP-IRA?
— Small biz

A. It’s great to hear you’re ready for a retirement plan.

You do have several choices, and the best plan for you depends on how many employees you have, how much money you’re able to save each year and how much the plan will cost to administer.

First, let’s talk about the benefits of 401(k) plans and SEP-IRAs.

Contributions to both of these retirement plans are tax deductible by the business and neither has a minimum amount that you must contribute each year, said Laurie Wolfe, a certified public accountant with Lassus Wherley in New Providence.

“Both of these plans offer flexibility with regards to timing of contributions, which makes sense for a business with profits that tend to fluctuate from year to year,” Wolfe said. “Both plans need to be set up by Dec. 31 of the year you wish to make contributions, but deposits can be made all the way up to the filing deadline of the tax return — including extensions.”

This helps create post year-end tax planning opportunities, she said.

Most small businesses use a SEP-IRA for its ease of set-up and comparatively low administration costs, she said.

She said SEP-IRAs may be ideal for a one-person business or a business with just a few employees.

In this type of plan, the employer or the self-employed person contributes the money. The annual contribution amount can be as much as 25 percent of the net earnings of the business with a $53,000 cap in 2016, Wolfe said.

“Because net earnings of a self-employed person is defined as the net income of the business less the deduction for half of the Social Security and Medicare taxes less the contribution itself, the contribution amount ends up being 20 percent of the net income of the business,” she said.

SEP-IRAs enable you to save more than traditional IRAs which have a $5,500 maximum ($6,500 for those 50 years of age and older).

You must keep in mind that if you ever take on an employee, the plan must cover anyone over 21 years of age, earning $600 or more and who has worked for you during three of the past five years at the same contribution percentage as you contribute for yourself, she said.

401(k) plans, on the other hand, are qualified plans and are more complex than SEP-IRAs, and they have more governmental reporting requirements.

You said you’re the only employee, so let’s discuss Solo or Individual 401(k)s, which are for a self-employed individual with no employees.

Wolfe said it allows you to contribute as both employee and employer. In 2016 employees can contribute up to $18,000 ($24,000 if 50 years old and above) and the employer can contribute up to 20 percent of total earnings with a maximum overall contribution of $53,000 ($59,000 if 50 or older).

“The advantage here over the SEP-IRA is that there is no percentage of total earnings limitation on the employee portion,” she said. “So if you only make $18,000, you could put it all in the 401(k). The plan will also cover a spouse that works for you.”

The big con of the Solo 401(k) is that they are more complicated. You will need a plan administrator to set it up and you will have to pay set up and on-going administration fees.

“If the plan balance exceeds $250,000, you will have to file a Form 5500 annually and pay those tax preparation costs,” she said. “You will not be able to use this type of plan if you hire someone other than your spouse.”

Consider speaking to a tax pro who knows your tax situation and your business for more help in choosing the best plan for you.

Karin Price Mueller writes the Bamboozled column for The Star-Ledger and she’s the founder of NJMoneyHelp.com. Click here to sign up for the NJMoneyHelp.com weekly e-newsletter. Like NJMoneyHelp.com on Facebook and follow it on Twitter.