How to pick the right retirement plan for your business

Author: Shannon Lynch, CFP®, Principal & Senior Wealth Advisor

When you own your own business, you’re in charge of every financial decision. This includes your own financial future — like planning for retirement. Unlike traditional employees who might have access to a 401(k), you’re responsible for managing your own retirement plan.

Many business owners rely on funding their retirement with the proceeds from selling their business. While selling your business may provide a substantial nest egg, it’s crucial to consider other strategies to ensure a successful retirement, especially if those plans change. Establishing a retirement plan not only offers a financial safety net, but can provide tax advantages that can help you save money during high-earning years.

Understanding your retirement plan options

Each business is unique, and what might be the right plan for one business might not work for another. Furthermore, some retirement plans offer tax advantages that have the potential to save you significant amounts of money, both now and in the future. 

Some plans allow pre-tax contributions, which can reduce your taxable income and lower your tax liability. Other options only allow post-tax contributions, which can reduce your taxable income in retirement.

Choosing the right retirement plan isn’t simple. It requires understanding complex tax laws, considering long-term business goals, and estimating the amount of money you'll need to live comfortably post-retirement. 

Two popular options for small business owners and self-employed individuals are the SEP IRA and the Solo 401(k). Both offer tax advantages, but they differ in terms of flexibility, contribution limits, and other requirements. Let’s take a look at each. 

Solo 401(k)

A Solo 401(k), known as an Individual 401(k), is designed for self-employed individuals without employees, with the exception of a spouse working for the business. This retirement plan offers greater flexibility by allowing you to contribute as both an employee and employer, which can significantly boost your annual retirement savings.

There are two versions of the Solo 401(k) plan: the traditional version and the Roth version. In the traditional Solo 401(k), contributions are made pre-tax, and distributions taken after age 59 ½ are taxed as ordinary income. With a Roth Solo 401(k), contributions are made post-tax, and distributions made after age 59 ½ are tax-free. 

In 2024, you can contribute up to $69,000 to a solo 401(k). If you are 50 or older, you can make an extra catch-up contribution of $7,500, bringing your total annual contribution to $76,500. 

Some Solo 401(k) administrators allow for contributions of both pre-tax and post-tax funds. You can convert the post-tax portion into a Roth 401(k) or Roth IRA through a strategy known as a “mega backdoor Roth.” This approach generally has minimal tax implications, and the earnings grow tax-free.

SEP IRA

A SEP IRA, or Simplified Employee Pension Individual Retirement Account, is designed for small business owners with few or no employees. Contributions to a SEP IRA are made pre-tax, which reduces your taxable income for the year. 

When you withdraw the funds during retirement, the money is taxed as ordinary income, similar to a traditional 401k or IRA. 

The main advantage of a SEP IRA is that it’s simple and straightforward to set up and use. It also offers high contribution limits, making it a great option for business owners.

In 2024, you can contribute up to $69,000 or 25% of your net self-employment compensation, whichever is lower. For self-employed individuals, the limit is 20% of net self-employment income, or $69,000, whichever is less.

When calculating how much you can contribute to a SEP IRA, it’s important to note the difference between net self-employment compensation and gross compensation. Net self-employment income refers to the net profit after deducting half of your self-employment taxes and your SEP contribution.

If you have employees, you must contribute an equal percentage of their compensation as you do for yourself. This requirement can be costly if you have multiple employees and you want to make large contributions to your own account. 

Choosing the Right Plan for Your Business

When deciding between a solo 401(k) and a SEP IRA, you’ll want to consider each plan’s contribution limits, plan flexibility, and tax benefits. The right choice largely depends on your financial situation and retirement goals. 

If you’re a high earner with no employees who is looking to maximize your retirement savings, a Solo 401(k) might be the better option. Its dual contribution structure allows for both pre-tax and post-tax contributions, offering greater tax advantages and flexibility. It also has a higher contribution limit, enabling you to save more. 

On the other hand, if you prioritize simplicity and lower administrative costs, a SEP IRA could be ideal. While it doesn't require annual contributions, you must contribute to your employees' accounts if you do the same for yourself.

To illustrate the differences between these two retirement plans, let's consider two scenarios:

Scenario 1: Solo 401(k) over the SEP IRA

Let’s consider Sam, a 55-year-old LLC owner who earns $300,000 annually, which places him in the 35% tax bracket.

With a SEP IRA, Sam can contribute up to 20% of his net self-employment earnings, which amounts to $57,210. This reduces his taxable income to $242,790, resulting in a tax savings of $20,024.

With a Solo 401k, Sam can contribute up to $76,500 of his net self-employment earnings  ($57,210 as an employer contribution, $23,000 as an employee contribution, and a $7,500 catch-up contribution). This reduces his taxable income to $223,500, resulting in a tax savings of $26,775. 

Despite the higher administrative costs and paperwork, the Solo 401(k) might offer Sam the opportunity to save more for his retirement and increase his tax savings.

Scenario 2: SEP IRA over the Solo 401(k)

Jane is under 50 years old and owns an LLC. She earns $750,000 annually and falls into the 37% tax bracket. 

With both a SEP IRA and Solo 401(k), Jane can contribute up to $69,000, reducing her taxable income to $681,000 and resulting in tax savings of $25,530.

Jane can contribute the same amount to each plan — however, she may consider the SEP IRA due to its lower administration costs while achieving the same tax savings.

How Compound Planning Can Help

At Compound Planning, we understand the challenges small business owners face when planning for retirement. Our team of financial advisors and tax experts are committed to making the process as smooth and beneficial as possible.

We work closely with you to understand your financial situation, business, and retirement goals, helping you select and set up the right plan as part of a comprehensive financial plan. 

We’ll also work with you to tailor your investment allocations to your goals, project future cash flows, and track your net worth.

To learn more about how our advisors can support you from start to finish, sign up for a dashboard and schedule a free consultation today.

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