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Planning for the success of a start-up business is an all-consuming goal for entrepreneurs. The drive to make the business succeed and prosper during the early years requires looking for sources of debt and equity in order to allow the business to grow. This often results in business profits being poured back into the business to fuel additional growth. Certainly there are merits to that strategy but it may be mindful to remember the saying, “Pigs get fat, hogs get slaughtered.”
Setting aside something for a rainy day is good planning. Many business owners anticipate their liquidity event occurring when they sell or cash out the business. They look forward to the time when they can trade the day-to-day grind for a sun-filled retirement. What happens though if a competitor or technology blindsides the original business plan? What if your liquidation decision is forced during a downturn in business or the economy? Are there steps a business owner can take early on to minimize these issues and the impact on their personal financial and retirement plan? Utilizing a retirement plan option as a part of the business plan and taking some chips off the table via retirement planning can help relieve potential financial stress in later years.
Small business owners have a number of options available for planning for their retirement. The ultimate choice often depends on the number of employees and whether employees are to be allowed to defer income along with the business owners.
An Individual or Solo 401(k) is an option only for those who are self-employed or operate through a business entity structure and have no employees other than the owner and the owner’s spouse if the spouse works as an employee. The Solo 401(k) allows for both elective deferral by the employee as well as an employer contribution. Employee deferrals are limited to 100% of compensation but not more than the current annual contribution limit of $18,000. Additionally, those age 50 or older can defer an additional $6,000.
Employer contribution limits depend on the business’ entity structure. If set up as a corporation, either C or S, or an LLC taxed as a corporation, up to 25% of compensation can be contributed. For other entity structures, up to 20% of net adjusted business profit can be contributed. Net adjusted business profit is determined by subtracting business expenses and half of the self-employment tax from the gross self-employment income. However, be aware that the maximum annual contribution for employee deferral and employer contribution cannot exceed $54,000.
A Solo 401(k) can be set up and administered very cost efficiently. Plans must be set up by the end of the taxable year. A Form 5500 is not required to be filed annually until the account reaches a value of $250,000.
For those businesses with employees, there are additional retirement planning options to consider. The SEP-IRA may be an excellent option, particularly for those with a small number of employees. A SEP-IRA must be created for each “eligible employee.” An eligible employee is one that is at least 21 years old, has worked for the employer at least three of the past five years and has received at least $600 in compensation during the year. An employer may use a less restrictive definition of eligible employee but not a more restrictive definition.
Newly created SEP-IRAs do not allow the employee to make a deferral from their compensation. All the contributions to a SEP-IRA come from the employer.The maximum deductible contribution is 25% of compensation up to a maximum of $54,000. The employer determines the percentage to contribute, however, that percentage must be applied to all eligible employees. There is no requirement to make a contribution each year, giving an employer flexibility. For flush years, they may wish to contribute a higher percentage. For lean years when other cash needs arise for the use of the business’ capital, they may wish to lower or even forego a contribution.
A SEP-IRA must be established by the due date of the employer’s tax return, including extensions. Employer contributions must also be made by the due date of the employer’s tax return, including extensions. There is no filing requirement for the employer.
A SIMPLE IRA is only available for businesses with 100 employees or less. However, only employees who received at least $5,000 in compensation from the employer during any two years prior to the current year and are reasonably expected to receive $5,000 in compensation during the current plan year are eligible to participate. The employer may choose to lower these thresholds for participating but cannot increase them.
Employees can elect to defer salary of up to 100% of their compensation but not to exceed $12,500. For those age 50 or above, there is an additional $3,000 catch-up deferral allowed as well. Employer contributions must be made each year, though as described below, the required contribution percentage may be switched from year to year.
Employers must either make a 2% nonelective contribution or a 3% matching contribution. This determination must be made during the election period for employee deferrals and cannot be changed mid-year. The 2% nonelective contribution must be made to each eligible employee’s account regardless of whether or not the employee elected deferral of salary. The 3% matching contribution choice requires a matching contribution on a dollar-for-dollar basis on the first 3% deferred by the employee. This 3% limit may be lowered to as low as 1%. However, this cannot occur more frequently than two out the last five years including the current period. One quirk is that a contribution must be made to an eligible employee’s account even if they are no longer employed at the end of the year.
A SIMPLE IRA must be established by October 1. Employer contributions must be made by the due date of the employer’s tax return, including extensions. There is no filing requirement for the employer.
There are different ways to monetize a business. Most business owners think of monetization as the sale proceeds when they are ready to exit the business. However don’t overlook the benefits of regularly taking a little bit off the table each year. Setting aside $10,000 a year and growing it at 7% annually for 25 years yields approximately $636,000. Delaying this option and waiting 15 years to start setting the same amount aside only yields approximately $180,000.
Utilizing a retirement plan for a small business allows the owner to take some chips off the table by monetizing value. It can lessen the impact of economic downturns applicable to the business. It can also be an attractive option in the retention of employees.
The above commentary represent the opinions of the author as of 8.24.17 and are subject to change at any time due to market or economic conditions or other factors.Print