Updated: Mar 18, 2024

How to Turn Your Small Business Retirement Account into a Money Machine

Small business retirement accounts have contribution limits far higher than traditional retirement accounts and savings can be applied to investments.
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Like most people, I have a regular job that I go to every day. I submit a time card and at the end of the week, I get a paycheck.

My company offers a retirement plan, so I have the option to have some of the money from my paycheck taken out every week and put into a retirement account.

If I take that option, I don’t have to pay taxes on the amount I put in the account until years down the road, making it less financially painful to save for the future.

The rules and regulations on similar tax-deferred accounts are arcane for the providers, but they’re simple for the people who work and deposit money into them on a regular basis.

Outside of my day job, I have work to bring in some extra money. I referee soccer on the weekends for local leagues and I write articles.

Like any income I earn, I have to pay taxes on this money, but I have been able to take advantage of small business retirement accounts to reduce the tax bill for my side income.

Tax regulations for people who are not regular employees of a company are highly complex.

Things like the self-employment tax mean that freelancers and small business owners can pay more in tax than they would have if they had earned their money as a regular wage.

These complicated tax codes also affect people who have a side business or money making hobby.

Most sole proprietors, small business owners, and freelancers are willing to pay that bit of extra tax because they enjoy their business, lifestyle or retirement options.

What surprises many people is that this freedom extends into the realm of saving.  Small business retirement accounts, such as the SEP-IRA, SIMPLE IRA, and the Solo 401(k) have contribution limits far higher than traditional retirement accounts.

To make things better, you get to select the provider, and the investment vehicles of your choice, since you are the one administering the account.

Traditional vs. Small Business Retirement Accounts

People who are standard employees of a company have a few options for funding their retirement. Their company will most likely offer a 401(k) or rarely, a pension plan.

They can elect to have a flat amount or percentage of each paycheck automatically deposited into that account each pay period.

The employer selects which company the 401(k) is held with and the company that provides the 401(k) selects the investments that are available.

In general, 401(k) providers vary widely in terms of the fees they charge and the investments they make available. Some accounts have low fees and allow you to invest in individual stocks or from a wide selection of mutual funds.

Other providers charge high fees and restrict you to a small selection of their own funds.

If your 401(k) provider charges high fees or doesn’t provide investment choices that match your needs it can have a major effect on your retirement saving.

Despite this, the high limit on 401(k) contributions, $19,500 for most savers today, and the fact that many companies encourage saving by matching funds you contribute cause people to put most of their savings in these accounts.

IRAs are how people who earn a regular wage can find some freedom with their retirement savings. Individuals can select their own IRA provider and whatever investments they would like.

This means that you can avoid the high fees that some 401(k) providers charge. The major downside of IRAs is that the contribution limit for 2020 and 2021 is $6,000, less than one-third that of a 401(k).

While this will result in no small sum of money at retirement for someone who starts young maxes out the limit each year it makes it difficult to adjust your contributions for lean years, or years where you make more than you expect.

Small business retirement accounts, like the SEP-IRA, allow you to shop around for a provider, and save more money than a normal IRA or a 401(k).

If you own a small business or make any money for freelance or contract work, you can open an SEP-IRA for yourself and, if you have any, all of your employees.

Like a normal IRA, you may contribute up to $6,000 as an individual. The real benefit comes from the ability to contribute to the account as an employer, even if you only employ yourself.

As an employer, you can contribute up to $58,000 to the account for 2021, so long as you contribute no more than 25 percent of the employee’s salary (or roughly 20 percent if you are contributing on your own behalf).

This is more than double the combined limit of a 401(k) and IRA for regular wage earners.

Each type of account has its own rules and requirements that you must follow.

Sole Proprietors and SEP-IRAs

SEP-IRAs are ideal for freelancers or sole proprietors because they can be set up online in a matter of minutes at providers like Vanguard or Fidelity.

You can invest in any number of mutual funds or individual stocks in the account, and you can elect to contribute, or not contribute funds at any time, so long as you remain within the contribution limits.

You can deduct the employer contributions you make on your behalf as a business expense, making this a great way to save come tax time. Beyond that, there are no tax reporting requirements.

If you have employees you can still open an SEP-IRA but you must also open one for each of your employees.

It also requires that if you make a contribution for one employee, you must make an equal contribution, as a percentage of salary, for all your other employees.

SEP-IRAs are flexible because they can be converted into a Solo 401(k) if you don’t have any employees. This will let you take advantage of a 401(k) loan or the higher employee contribution limit.

Limits of  Simple IRAs

SIMPLE IRAs are designed for small businesses that have less than 100 employees. These function much like 401(k)s for larger businesses in that they can be funded via payroll deductions and employer contributions.

If you make employer contributions in a year, you must contribute either 2 percent of each employee’s annual pay to their account each year, or match their contributions dollar for dollar up to 3 percent of their salary.

You may also elect to not make contributions in any given year. Again, employer contributions are tax deductible and there are no tax reporting requirements for the employer.

The limit for SIMPLE IRAs is lower, $13,500, so opening one may not be the best choice for a freelancer.

Complications of Solo 401(k)s

A Solo 401(k) is the most paperwork intensive of the accounts and can only be opened by people with no employees. This tradeoff is compensated by the increased flexibility of the account.

You can contribute up to the standard 401(k) maximum ($19,500 in 2021) as an employee. As an employer. you can contribute up to 100 percent of your compensation up to a total maximum or $58,000 in 2021 though not all employer contributions are tax deductible.

Like standard 401(k)s, you can take loans against the balance or withdraw from it early under certain circumstances, making it a solid choice for people who value flexibility and the higher employee contribution limit.

Retirement Accounts for a Side Business

Many people have a hobby, for fun or for profit, which they find can make them some extra spending money.

Whether you do woodworking, website design, referee sports, drive for Uber or Lyft, article writing, or anything else that people are willing to pay for, you are considered to be running your own small business.

While this means you have to pay taxes on that income, it also means you can open a small business retirement account.

This is a major boon for people whose employers offer retirement accounts with high fees or poor investment choices.

By reducing contributions to your employer-sponsored account and increasing contributions to your small business account, you can get the same amount of money in low-fee, tax-deferred retirement accounts.

It’s also a benefit for hobbyists who make money from something they do for fun and pay all their bills out of their regular job. Investing even small amounts can result in large nest eggs given enough time.

If you make $5,000 from your hobby each year and max out the employer contributions for an SEP-IRA by saving $1,000 a year you will sock away $30,000 over the course of 30 years.

If you earn an average of 7 percent returns by investing that money in stock and bonds, you’ll more than triple the money, winding up with an end balance of more than $100,000.

You’ll also save $7,500 in taxes, assuming you are in the 25 percent tax bracket.

Small business retirement accounts are a great way to save for retirement and to minimize the taxes you have to pay for your freelance work or hobby businesses.

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