When you're starting a business, retirement may be the last thing on your to-do list.
Yet even the most dedicated entrepreneurs hope their business someday will reach the stage that they can afford to retire and enjoy the rewards of their hard work.
Taking advantage of IRAs (individual retirement accounts) that offer tax breaks in exchange for retirement savings can help entrepreneurs reach that goal for themselves and, in some cases, for employees as well.
You make contributions to both of these plans with before-tax dollars, as long as the contributions meet specific guidelines for each type of account. The IRS describes SEP and SIMPLE plans in Publication 560, Retirement Plans for Small Businesses.
Duick, a certified public accountant, says the SEP is designed to allow anyone engaged in business to save for retirement, whether the business stays small or grows to more than 100 employees.
In a SEP plan, the employer is responsible for setting up the plan and making all the contributions. If an employer makes a contribution for one employee, he or she must make it for every qualified employee who meets the eligibility requirements set by the employer. For example, an employer could limit the plan to employees who are at least 21, have worked for the company in three previous years, and earn at least $500 during the year. The employer would be required to make contributions on behalf of anyone meeting these three tests.
Business owners can make contributions equivalent to as much as 25% of an individual's pay, not to exceed $45,000 in 2007. A self-employed owner can contribute 20% of his or her profit from the business, minus half the self-employment tax, up to the same limit. Only compensation up to $225,000 can be considered in computing contributions.
Duick, a certified public accountant, points out that businesses often establish a level of SEP contributions, such as 5% of employee compensation, and then try to make it an annual practice. But annual contributions are not required, which provides flexibility when earnings drop.
Each employee is always fully vested in a SEP plan, which means employees get to "roll over" the amounts placed in their IRAs into similar retirement accounts if they leave the business.
In comparison, SIMPLE plans are limited to businesses with fewer than 100 employees.
Employees who choose to participate in a SIMPLE plan defer up to $10,500 of pretax earnings each year to be deposited by their employer in an IRA held in the employee's name. Employees age 50 or older may make additional "catch up" contributions of $2,500 in 2007.
The employer has the option to contribute an additional amount to the SIMPLE, capped under the IRS formula at roughly 3% of compensation.
Self-employed entrepreneurs who earn less than $60,000 a year often choose the SIMPLE option, since they always have the option to save the full $10,500 plus the employer's share.
Duick says that once a self-employed worker's net income exceeds $60,000, a SEP may be a better choice because it allows him or her to save more for retirement.
"They're both [SEP and SIMPLE] very easy to document," Duick adds. "The SIMPLE has a little more work to it because you're responsible for depositing those employee deferrals."
The employee is the owner of all his or her SIMPLE contributions. Under the terms of the SIMPLE plan set up by the employer, workers can be required to work a number of years--usually less than five--before they can claim the business owner's contribution if a worker retires or seeks other employment.
In the most common version of the SIMPLE, employers only make their share of the contribution if the employee already has chosen to participate in the plan in a specific tax year.
An alternate version of the SIMPLE allows the employer to make a contribution equivalent to 2% of compensation for every employee whether or not employees defer a share of their earnings into the plan.
The benefits of using a SIMPLE IRA to save for retirement are illustrated by the plan that Duick helped set up for Tom, a self-employed photographer who works from his home and has no other employees (name and profession changed to protect privacy).
Tom contributed the maximum, $10,000, to his SIMPLE as an employee in 2006. Because Tom is self-employed, he also can contribute to his SIMPLE IRA as an employer.
Tom's employer contribution is based on 2006 net earnings of $40,255. One-half of his self-employment tax, or $2,844, is subtracted from that amount to leave $37,411. (An alternative method for computing Tom's income for SIMPLE purposes is to multiply net earnings before the self-employment tax by 0.9235.)
When that figure is entered into the IRS' formula for the SIMPLE, that allows Tom to contribute another $1,115, or just under 3% of his earnings, to his SIMPLE IRA.
Contributions to the SIMPLE IRA are made with pretax earnings, which means that Tom's contributions significantly reduce his income tax. Combined earnings for Tom and his wife place them in the 25% tax bracket, meaning that Tom's IRA contributions of $11,115 saved $2,778 in federal income tax and $722 in state income tax (based on Wisconsin rates) in 2006.
Whether you select a SIMPLE or a SEP, Duick says it's important to begin contributing as early as possible to take advantage of compound interest.
"The more you put away at a younger age, the bigger it grows," Duick notes.
SEP and SIMPLE participants get to choose the type of investment account used to hold their IRA, which allows them to adjust their investment risk as retirement nears.
Duick says offering a SIMPLE or a SEP also reminds entrepreneurs that it's unwise to rely on selling the business when they reach retirement age to generate enough money to fund their retirement. That's because the value of the business can disappear if new technology makes the business obsolete, global competitors emerge to offer the same product at a lower price, or the economy hits a downturn.
"If [business owners] don't have anything other than their business assets to sell, they may not be looking at a good future," Duick notes.
Instead, she advises entrepreneurs to begin putting SEP and SIMPLE funds away as soon as possible.
That's the best way to ensure that your retirement fund will be ready when you reach the stage--and the age--when retirement is part of your business plan.
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