The sole proprietorship is the most common and simple form of business organization in the United States. The sole proprietorship is formed very easily and inexpensively. In fact a person going into business for them self automatically creates a sole proprietorship by default. No formalities are necessary.
Successful sole proprietorships are often looking for ways to increase their tax deductions. One of the most significant tax deductions for a sole proprietorship is to make a contribution to a retirement plan. Contributions into a retirement plan are generally 100% tax deductible and in 2020 can be up to $57,000 for a SEP IRA and potentially more in an Individual 401k or Defined Benefit Plan. Sole proprietors have an important decision to make when selecting the appropriate retirement plan and this information will help with your due diligence process.
The various retirement plans can be broken down into two main groups for sole proprietors who would like to make a retirement contribution in excess of the $6,000 limit and $7,000 if age 50 or older of the Traditional IRA and Roth IRA.
1) Are you a sole proprietorship consisting of only yourself or have a spouse as the only W-2 employee?
Most sole proprietorships fit this profile and they usually establish either the Individual 401k, SEP IRA, Defined Benefit Plan or SIMPLE IRA. These retirement plans are popular because they offer high annual contribution limits and some plans permit loans. Below are some of the defining features of retirement plans that are available to sole proprietorships with no W-2 employees.
- 2020 SEP IRA contribution limit is $57,000.
- Easy to set up and minimal administrative responsibilities.
- The Individual 401k may provide a larger contribution compared to a SEP IRA at the same income level.
- For those age 50 or older there isn't an additional catch-up provision like there is with the Individual 401k.
- 401k loans are not permitted.
What are the advantages of a SEP IRA?
The SEP IRA has broad appeal due to its high maximum contribution limits and its administrative ease to set up and maintain. The 2020 SEP IRA contribution limit maximum is $57,000. The annual contribution into a SEP IRA is based on net income if you are a sole proprietorship. Annual contributions up to 20% of your net adjusted self employment income (or net adjusted business profits) can be contributed into a SEP IRA. The SEP IRA is a great choice for a sole proprietor who would like to contribute up to 20% of net self employment income.
Learn more about the SEP IRA.
- 2020 Individual 401k contribution limit is $57,000 and $63,500 if age 50 or older due to a "catch-up" provision.
- 401k loans are permitted with an Individual 401k plan. 401k loans are permitted up to 50% of the total value of the Individual 401k up to a maximum of $50,000.
- Roth 401k - There is an option to make Roth 401k contributions with the salary deferral portion of the Individual 401k. Contributions into a Roth 401k are not tax deductible, but withdrawals are tax free after age 59 ½.
- Potentially greater administrative responsibilities and administrative fees compared to a SEP IRA.
What are the advantages of the Individual 401k?
The Individual 401k and SEP IRA are popular because both plans have high contribution limits and have completely discretionary annual funding requirements. In 2020 a SEP IRA has a maximum contribution limit of $57,000 and an Individual 401k has a contribution limit of $57,000 and $63,500 if age 50 or older.
A SEP IRA is easier to setup and has less administrative costs than an Individual 401k, however an Individual 401k may allow a greater contribution at the same income level due to the way the contribution is calculated.
After tax Roth contributions can be made into an Individual 401k. Roth 401k contributions are not tax deductible, but are received tax free when withdrawn after age 59 ½. SEP IRA contributions can only be made pre-tax and does not have a Roth option.
Another important distinction between these retirement plans is an Individual 401k has a loan provision. IRS rules do not allow loans with a SEP IRA. Individual 401k loans are permitted up to 50% of the total 401k value with a $50,000 maximum.
Learn more about the Individual 401k.
Defined Benefit Plan
- Depending on the age and income of the business owner, annual contributions can exceed $100,000 or more.
- Loans may be permitted, however this may increase annual funding requirements.
- More expensive to set up and to maintain.
- Rigid annual funding requirements.
What are the advantages of a Defined Benefit Plan?
The Defined Benefit Plan is appropriate for those who want to make tax deductible contributions in excess of the maximum limits of the Individual 401k or SEP IRA. Defined Benefit Plans offer substantial tax deductible retirement contributions and significant future retirement income. Depending on your age and income the annual contribution to a Defined Benefit Plan can be $100,000 to $200,000 or more.
Defined Benefit Plans have greater administrative fees and more rigid annual funding requirements, but may be ideal for sole proprietors who wish to shelter the largest percentage of their income permitted by IRS rules.
Learn more about the Defined Benefit Plan.
- A SIMPLE IRA is easy to set up and has low administrative responsibilities.
- 2020 SIMPLE IRA contribution limit is $13,500 or $16,500 if age 50 or older. In addition there is a maximum 3% employer contribution.
- Relatively low maximum annual contribution limits.
- Loans are not permitted.
What are the advantages of a SIMPLE IRA?
Sole proprietors who have a SIMPLE IRA are able to contribute up to 100% of their income up to the maximum contribution limits of $13,500 or $16,500 if age 50 or older. As a result, significant contributions can be made into a SIMPLE IRA even at lower income levels. A good candidate for this plan doesn't mind the relatively low maximum contribution limits. Sole proprietors who would like to contribute in excess of the limits of a SIMPLE IRA should consider an Individual 401k since it has higher contribution limits.
Learn more about the SIMPLE IRA.
2) Are you a sole proprietorship with full time employees?
Sole proprietorships with full time employees generally select from retirement plans that fall into 3 categories.
- Retirement plans that are exclusively funded by the employer.
- Retirement plans that are employer and employee funded.
- Retirement plans that are exclusively employee funded.
Learn more about the small business retirement plans available for sole proprietorships with employees.