Best Retirement Plan for Small Business Owners?

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Salaried employees generally have an employer-sponsored 401(k) retirement account administered by the company’s HR department. Failing that, many use Individual Retirement Accounts (IRAs) from local banks, credit unions, or brokerages. Some especially conscientious employees use both.

Small business owners tend to likewise be big fans of the IRA, either in Traditional or Roth form. And while these are certainly better than having no retirement plan at all, an IRA is rarely the ideal plan. The self-employed have several retirement options which are both exclusive to them and, often times, more lucrative than the more traditional plans above.

Simple IRA

Simple IRAs are ideal for small business owners who wish to set up retirement accounts for their employees. As Bankrate explains, these accounts were established with businesses of “no more than 100 employees who earned $5,000 or more on the payroll for the previous calendar year” in mind.

Over time, Simple IRAs have become most commonly used by employers with seven or fewer employees. Fortunately, the Simple IRA is extremely easy to set up, requiring just four pages of paperwork and about ten minutes of one’s time. Employers are limited to contributing 3% of an employees pay, up to an $11,500 yearly contribution limit.

The Solo 401(k)

One rarely discussed advantage of self-employment is the existence of retirement accounts with much higher yearly contribution limits. The Solo 401(k) account is a prime example. SmartMoney explores how Solo 401(k) plans work, explaining that they’re essentially regular 401(k) accounts with much higher contribution limits: up to $49,000 per year in 2010, depending on age, income and other circumstances.

Putting things in perspective, regular 401(k) and IRA contribution limits top out at $16,500 and $5,000 per year (not counting catchup contributions), respectively. It should be noted that Solo 401(k) plans are generally restricted to business owners, rather than employees of the business in question.

The Solo Roth 401(k)

Solo Roth 401(k) plans are similar to regular Solo 401(k) plans, but offer the tax advantages of a Roth IRA. As you may know, Roth IRAs are accounts for which contributions get taxed, but withdrawals (which contain the accumulated savings, interest and investment returns of decades) do not. Moreover, InvestorGuide reveals several key advantages the Solo Roth 401(k) holds over a regular Roth IRA:

High income earners can contribute to Solo Roth 401(k) accounts even if they’re not eligible for a Roth IRAYou can contribute much more per year to a Solo Roth 401(k) as compared to a Roth IRAYou can borrow from your Solo Roth 401(k)You can avoid (if you wish) the required minimum distributions of a Roth 401(k) by rolling its funds over to a Roth IRA prior to age 70-1/2, so long as you set up the Roth IRA account five years priorYou can also maintain a Roth IRA in conjunction with a Solo Roth 401(k), which expands your potential annual contributions even furtherThe Simplified Employee Pension (SEP) IRA

The Simplified Employee Pension IRA (SEP-IRA) is in many ways similar to a Solo 401(k). While both have the same maximum annual contribution limit, it takes a higher level of income to max out the SEP-IRA. In 2009 and 2010, self-employed individuals and business owners can contribute 20% of net self-employment income or 25% of W-2 wages up to $49,000 per year. Contributions are tax deductible.

Withdrawals prior to turning 59-1/2 are subject to a 10% penalty (plus income taxes), while withdrawals after 59-1/2 are just taxed as ordinary income. Unlike defined contribution plans, there are no restrictions on whether or how much money you can contribute to a SEP-IRA in a given year. SEP-IRAs are also designed for one person businesses or business owners with employees, rather than for the company’s employees themselves.

Keogh Plans

Keogh plans are a type of defined contribution retirement plan. Established by Congressional legislation in 1962, Keoghs allow tax deductible contributions of up to 25% of annual income up to $49,000. Keogh funds can be withdrawn by 59-1/2 and must begin by 70-1/2.

A Keogh (also known as an HR10 plan) can be invested into the same broad range of securities – stocks, bonds, CDs and annuities – as can traditional accounts like 401(k)s and IRAs. Investopedia cautions, however, that their high contribution limits are accompanied by greater paperwork burdens and upkeep costs.

Defined Benefit Plans

Described by Bankrate as “the most expensive and complicated retirement plan for the self-employed,” defined benefit plans are nevertheless an option for self-employed individuals with “mountains of money” to put toward retirement. Employers can save an eye-popping maximum of $195,000 per year, but there’s a catch: an actuary is needed to determine the exact amount that can be contributed (a rather costly expense).

In contrast to the flexibility offered by Solo 401(k) accounts and Simple IRAs, a defined benefit plan is an extremely structured arrangement that must be operated in accordance with strict rules. Largely because of these expenses and complications, Bankrate finds that there are roughly 38,000 defined benefit plans today, down from 114,000 in 1985. Nevertheless, they remain a worthwhile tax-deferral possibility for wealthy business owners.