Have you procrastinated in setting up a tax-advantaged retirement plan for your small business? If so, you are paying income taxes that could easily be avoided and putting your retirement financial situation at risk. However, you can set things right by taking action. That way, you’ll be positioned for tax savings in the future.
This article explains the SIMPLE IRA, which is a tax-advantaged retirement arrangement well suited to the one-person business that generates modest income. If you set up a SIMPLE IRA, your account balance at retirement age will depend on factors such as how soon contributions start, how much you contribute annually and the rate of return earned on investments held in your account.
Earnings on your SIMPLE IRA balance are allowed to accumulate tax-free until withdrawals commence. There’s no limit on how much can be accumulated in your account. Bottom line: The sooner contributions start, the sooner you can start collecting annual tax savings. The more you can put into an account, the better. You can use the tax savings to finance part of your annual contributions.
SIMPLE IRA Basics
Self-employed individuals can set up SIMPLE IRAs. So can one-employee corporations and other employers with up to 100 workers.
For 2017, the maximum contribution to your account is the lesser of:
- 100% of your self-employment income or 100% of the salary from your corporation.
- $12,500 (unchanged from 2016).
This is considered an elective deferral contribution made by the self-employed individual or employee to his or her SIMPLE IRA.
In addition, the employer generally must make a matching contribution equal to the lesser of:
- 3% of your self-employment income or 3% of the salary from your corporation.
- 100% of your elective deferral contribution.
When your business is run as a sole proprietorship (or as a single-member LLC that is treated as a proprietorship for federal tax purposes), you’re considered self-employed. Therefore, you make the employer matching contribution, as well as the elective deferral contribution, on your behalf. You then claim deductions for both contributions on your Form 1040.
What if you are employed by your own S or C corporation? In that case, the company makes the employer matching contribution to your account. The elective deferral contribution is withheld from your salary. Your corporation claims a deduction on its tax return for the employer matching contribution. The taxable salary shown on your W-2 from the corporation is reduced by your elective deferral contribution, which amounts to a personal deduction for you.
Example 1: Let’s say you run your shop as a sole proprietorship (or single-member LLC). You have $20,000 of self-employment income as well as income from other sources. You contribute the maximum $12,500 to your SIMPLE IRA and claim a $12,500 deduction. You then make a matching employer contribution of $600 (3% times $20,000) and deduct another $600 on your Form 1040. The two contributions add up to $13,100. In contrast, if you set up a simplified employee pension (SEP) or defined contribution Keogh plan, your maximum deductible contribution could only be $4,000 (20% times $20,000).
Example 2: This time, let’s say you are employed by your own S or C corporation. You receive a $20,000 salary. You contribute the maximum $12,500 to your SIMPLE IRA as an elective deferral contribution. This reduces your taxable salary from $20,000 to $7,500 for federal tax purposes. (However, your salary is not reduced for Social Security or Medicare tax purposes.) Your corporation then makes a matching deductible employer contribution of $600 (3% times $20,000). So the elective deferral and employer contributions add up to $13,100. In contrast, if you establish a corporate SEP or profit-sharing plan, the maximum deductible contribution can only be $5,000 (25% times $20,000).
Larger “Catch-Up” Contributions
If you are age 50 or older as of December 31 of the year, you can also make additional “catch-up” elective deferral contributions of $3,000 for 2017 (unchanged from 2016) and beyond. So the maximum elective deferral contribution, including the “catch-up” amount, is $15,500 for 2017 (and 2016).
Example 3: Let’s say you earn $20,000 of self-employment income or salary in 2017 and you are 50 or older at the end of that year. Up to $16,100 can be contributed to your SIMPLE IRA ($12,500 elective deferral contribution plus $3,000 “catch-up” contribution plus $600 employer matching contribution). In contrast, the maximum 2017 deductible contribution to a self-employed SEP or defined contribution Keogh plan is only $4,000 (20% times $20,000). The maximum deductible contribution to a corporate SEP or profit-sharing plan for 2017 is only $5,000 (25% times $20,000).
Key point: When your business generates a modest amount of self-employment income or salary and there are no other employees who must be covered, the SIMPLE IRA is often the best retirement plan choice. It doesn’t matter if you have additional income from other sources. This is especially true if you are 50 or older, because you can make additional “catch-up” contributions that further sweeten the deal.
You must establish your SIMPLE IRA by no later than October 1 of the year for which you want to make your initial deductible contribution.
|If your small business produces a modest amount of income, a SIMPLE IRA can permit much larger annual deductible contributions to your account.||The SIMPLE IRA is probably not the best choice if your business produces more than a modest amount of self-employment income or corporate salary for you. Other plans, such as SEPs, defined contribution plans, and 401(k)s, may permit much larger annual deductible contributions.|
|SIMPLE IRA elective deferral contributions are completely discretionary. If you don’t make an elective deferral contribution for a particular year, there is no required employer matching contribution. So you can limit contributions to very minimal amounts — or nothing in years when cash is tight.||If your business has other employees, you may have to make SIMPLE IRA employer matching contributions* for them. Matching contributions are 100 percent vested immediately. You must allow all employees to participate in a SIMPLE IRA plan if they earned $5,000 or more during any two previous years (consecutive or not), and are reasonably expected to earn at least $5,000 in the current year.|
|You can establish a SIMPLE IRA by filling out a fairly simple document available at most brokerages and financial institutions. There’s no requirement to file an annual report with the federal government.||Borrowing from a SIMPLE IRA is prohibited. In contrast, most other plans allow borrowing, assuming the plan document permits it. (However, you cannot borrow from a SEP.)|
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