"With the future of social security up in the air and traditional corporate pension plans on the path towards extinction, contributing to a retirement plan provides some peace of mind that you'll be able to retire comfortably," explains Andrew Schwartz CPA, founder of CPA Niche, LLC.
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Contributing to a retirement plan is one of the best tax shelters available to people during their working years. Money contributed generally saves taxes today and also grows tax deferred. Self-employed individuals and small business owners, however, need to set up a retirement plan for their business before they can begin adding to their nest egg on a pre-tax basis.
One popular option is known as a SIMPLE IRA. This user-friendly plan makes the most sense for business owners who either consistently earn less than $50,000 per year or have employees and aren’t in a position to contribute a lot of money on their behalf.
Self-employed individuals and small business owners with no staff can contribute up to $10,000 ($12,500 if 50 or older), plus 3 percent of their W-2 wages or net self-employment income into their SIMPLE each year. On $20,000 of income, a person can sock away up to $10,600 in pre-tax dollars this year.
“When you have staff, if you contribute to your own retirement account, you're generally required to make equivalent contributions on behalf of your eligible employees as well. So it’s very important to understand when your staff becomes eligible to participate in your company’s retirement plan,” says Schwartz. “For a SIMPLE, an employee who earned at least $5,000 from you during either of the prior two years, and is reasonably expected to earn $5,000 from you in this calendar year, becomes eligible.”
Contributions into a SIMPLE IRA consist of two components. The bulk of the contribution is from “salary deferrals" equal to the lesser of $10,000 ($12,500 if 50 or older) or either W-2 wages or net self-employment income. Keep in mind that the amount an individual can contribute into a SIMPLE may be limited if that person participates in a 401(k) or 403(b) plan through another employer. For 2006, total "deferrals" through all available plans generally can't exceed $15,000 ($20,000 if 50 or older).
With a SIMPLE, an employer is also required to make contributions into their eligible employees’ accounts. Employers have the option of making a non-match of 2% of the wages paid to all eligible employees, or making a matching contribution of 3% of their participating employees’ wages, with the option of reducing the match to just 1% for two out of every five years. For example, on $30,000 of annual salary, the company match would be limited to just $900 per year.
Since the bulk of the money going into a SIMPLE comes out of each employees' pocket through salary deferrals, many small business owners with staff end up migrating towards a SIMPLE IRA or a more sophisticated and costly 401(k) plan.
The due date for establishing a SIMPLE is October 1st of the first year of the plan, which means there are only a few weeks left to set one up for 2006. With a SIMPLE, there is very little paperwork required to establish and maintain the plan, no fees except those charged by the fund company or financial advisor, and no annual filing requirements with the IRS.
“Other plans common to self-employed individuals and small business owners include SEPs and 401(k) plans,” says Schwartz. “When deciding which plan makes the most sense for your business, there are many factors that come into play, so make sure to seek the guidance from your CPA and financial advisors before deciding whether to go with a SIMPLE, SEP, 401(k) or other type of retirement savings plan.”