Albert Einstein is attributed the famous quote describing compound interest as the eighth wonder of the world. Unfortunately, he was not around long enough to benefit from the proliferation of retirement vehicles allowed to invest in marketable securities, which enabled that compounding to occur in a tax-deferred, or even tax-free, environment. Through the early 1960s, employees were mostly covered by the defined benefit pensions of large corporations, many of which were famously underfunded, Studebaker being the prime example and legislative tipping point. Change arrived in 1962, when the Keogh Act made qualified pension plans available to self-employed persons, unincorporated small businesses, farmers, professionals and their employees. Twelve years later, the Employee Retirement Income Security Act of 1974 (ERISA) established individual retirement accounts (IRAs). As thankful as we all are for the creation of this ninth wonder – tax-free compound interest – the increase in retirement account types has led to an abundance of options, creating confusion for small companies and self-employed individuals who lack the resources and time required to identify the best option. We have you covered.
Defined benefit plans, most often known as a pension, and defined contribution plans, such as a 401(k) or 403(b), are well known because of media coverage and the sheer number of participants in each. Pensions, usually preceded by an adjective describing how adequately funded they are, are often the subject of news stories, and 401(k) plans are common at larger firms that have abandoned pensions. However, outside of those two plan types exists an oft-overlooked subset of the retirement investment spectrum offering benefits that are uniquely advantageous to sole proprietors and small-business owners. These plans are often much easier to create and administer and can have large contribution limits, which can be attractive to a small, under-resourced organization or retired executive who has some consulting income and wants to contribute a significantly larger amount to a retirement vehicle than the $5,500 ($6,500 for those over 50) allowed for traditional IRAs.Whether it is a small-business owner, a retired professional receiving consulting income or an employed individual with a small side business, many successful professionals generate self-employed 1099 income, requiring them to pay both the employer and employee tax portion. These taxes include Social Security, Medicare and federal income tax. Three retirement plan types that are most suitable to these professionals exist: the Savings Incentive Match Plan for Employees (SIMPLE), the Solo 401(k), often referred to as an Individual 401(k), and the Simplified Employee Pension (SEP) plan. All three plans offer certain tax advantages – namely, tax-deferred growth and the corporate tax deduction of employer contributions. That is where the similarities end, though, as they differ in how they are set up and how much they can be funded with. Understanding these differences is important, as each small-business owner or self-employed professional may have different needs when it comes to funding his or her retirement.