Talk to a business owner who has been in business for a while and he or she will tell you to make sure that you put a retirement plan in place.
When you are starting out and have modest income, the Savings Incentive Match Plan for Employees (SIMPLE) IRA can be the perfect plan.
You must have your SIMPLE IRA set up by October 1, 2020, to permit a deductible contribution for your 2020 tax year. If you are going to establish a SIMPLE IRA this year, do it now. October 1 will be here before you know it.
Here’s what you need to know about the often-underappreciated SIMPLE IRA small-business retirement plan alternative.
SIMPLE IRA Basics
For the one-person operation that generates only a modest amount of annual income, the SIMPLE IRA is often the best tax-favored retirement plan choice.
Self-employed individuals can set up SIMPLE IRAs. So can one-employee corporations and other employers with up to 100 workers. For this purpose, only employees who earned at least $5,000 during the previous year are counted.
For 2020, you can contribute up to the lesser of
- 100 percent of self-employment income or corporate salary, or
This is considered to be an elective deferral contribution made to your SIMPLE IRA account by you as a self-employed individual or by you as an employee of your own corporation.
Then the employer makes a matching contribution equal to the lesser of (1) 3 percent of your self-employment income or salary or (2) the amount of your elective deferral contribution.
When you run your business as a sole proprietorship or as a single-member LLC treated as a sole proprietorship for tax purposes, you make the employer matching contribution, as well as the elective deferral contribution, on your own behalf.
When you are employed by your own C or S corporation, the company makes the employer matching contribution to your account. The elective deferral contribution is withheld from your salary.
Example 1: Corporate Business
You are employed by your own C or S corporation (the results are the same either way). You receive a $30,000 salary for the year. You contribute the maximum $13,500 to your SIMPLE IRA as an elective deferral contribution. That reduces your taxable salary from $30,000 to $16,500 for federal income tax purposes.
You then direct your corporation to make a matching deductible employer contribution of $900 (3 percent x $30,000). So the elective deferral and employer contributions add up to a total of $14,400 of tax-saving deductions. Nice!
In contrast, if you had a simplified employee pension (SEP) arrangement or a profit-sharing plan, the maximum deductible contribution to your account would be only $7,500 (25 percent x your $30,000 salary).
Example 2: Sole Proprietorship
You run your shop as a sole proprietorship or a single-member LLC treated as a sole proprietorship for tax purposes. You have $30,000 of net self-employment income for the year. You contribute the maximum $13,500 to your SIMPLE IRA and claim a $13,500 deduction on your Form 1040.
You then make a matching employer contribution of $900 (3 percent x $30,000) and deduct another $900 on your Form 1040. The combined tax-saving deductible contributions add up to $14,400.
In contrast, the maximum deductible contribution would be only $6,000 (20 percent x $30,000) with a self-employed SEP or defined contribution Keogh plan.
Extra Catch-up Contributions if You Are Age 50 or Older
If you are age 50 or older as of December 31, 2020, you can make an additional catch-up elective deferral contribution of up to $3,000 for 2020.
So, if you are age 50 or older at year-end, the maximum 2020 elective deferral contribution, including the extra catch-up contribution, is $16,500 ($13,500 + $3,000).
SIMPLE IRA Pros
When your business produces only a modest amount of annual income, the SIMPLE IRA arrangement can permit much healthier annual deductible contributions to your account, as the preceding examples illustrate.
Also, SIMPLE IRA elective deferral contributions are completely discretionary. If you decide not to make an elective deferral contribution for the year, you need not make any employer matching contribution either. So you can limit contributions to very minimal amounts, or even nothing at all, in years when cash is tight. Flexibility is good!
Finally, with a SIMPLE IRA, there is no requirement to file any annual reports with the federal government. Yay!
SIMPLE IRA Cons
The SIMPLE IRA is not the best choice if your business produces healthy annual self-employment income or a healthy annual corporate salary for you. In that scenario, other types of plans, such as a SEP, solo 401(k) plan, or defined benefit pension plan, can permit larger annual deductible contributions to your account.
You must establish your SIMPLE IRA by no later than October 1 of the year for which the initial deductible contribution will be made. For example, you must set up your SIMPLE IRA by October 1, 2020, to make a deductible contribution for the 2020 tax year.
Keep this in mind: SIMPLE IRAs are simple, and simple is good!
We specialize in helping clients clarify their taxes so they keep more of their money. Many small business owners who come to see us in Fort Worth, TX generally do not understand the tax law enough to explain it to a fifth grader.