As Americans get into their senior years, many find that they do not plan their finances as they should have. This may mean that they’ll have to retire later, if at all, leaving them ill-prepared for the hardships that may come in their older years.
There are basic steps to take when planning for retirement but if you are a small business owner, you will need to take more complicated measures to ensure your ideal lifestyle. Here are some common but avoidable mistakes small business owners make in planning for retirement.
Not Deferring Taxes
Place as much taxable income into tax-free or tax-deferred accounts. Most income is taxable, but if you have an IRA (Individual Retirement Account) taxes can be deferred. There are also tax-free investments available, such as municipal bonds, proceeds from life insurance, and education plans.
Seeking Specialist Advice
You may need to consult more than one advisor. If you are over 60, an elder-care attorney would be appropriate. A CPA would be your go-to specialist for tax avoidance plans of action. If you need to minimize estate and inheritance taxes, an estate-planning attorney would be most helpful.
Consider Long-Term Health and Housing
Modern medicine helps people live longer but also increases the likelihood of outliving your money. Older Americans often live in nursing homes or have long-term care needs, which can be very costly. Even if you are an older American, you can still and should start planning.
Having the Wrong Retirement Plan
When you are self-employed, you have several options for retirement besides a traditional or Roth IRA plan.
- Independent 401(k) (or solo)
This is ideal for a sole proprietor or a small business owner whose only employee is his/her spouse. Starting in 2016, self-employed business owners can contribute up to $18,000 in elective deferrals in concurrence with employer non-elective contributions. Up to $6,000 in catch-up contributions are allowed if you are age 50 or older.
- SEP IRA (Simplified Employee Pension)
This plan is a traditional IRA for sole proprietors or businesses with more than one worker. The 2016 contribution limit is 25% of earnings or $53,500, whichever is the least amount, however, catch-up contributions are not allowed.
- SIMPLE IRA (Savings Incentive Match Plan for Employees)
This is like a SEP in that it can be a great savings tool if you are a solo entrepreneur or if you have employees. The difference between a SEP and a SIMPLE IRA is the amount you can contribute. The maximum amount that you can give is $15,000 with a catch-up limit capped at $3,000.
Each of the three options offers a way to make tax-deferred investments and tax-deductible contributions. Each plan has a different amount that you can save. Talk with a financial advisor to maximize your savings potential.
Making Incorrect Contributions
Each plan has different limits and guidelines to follow. Make sure that you are using your net business income, subtracting the deduction for half of your total self-employment tax payments.
Consider this: A sole proprietor has a SEP IRA and grosses $100,000 annually but reports a net income of $75,000 after $25,000 in taxes. In the situation that this person used the gross income amount, he/she would likely make the mistake of contributing $25,000 to his/her IRA. Using the correct income amount of $75,000 and assuming a deduction for half of the self-employment tax, totaling $5,300, this sole proprietor’s total reportable income would be $69,700. Then, applying the 25% contribution rule, he/she would be able to contribute up to $17,425 (.25 x 69,700).
Contributing more than the allowed limit to a fund could trigger an excise tax penalty, which is currently 10% of the total over the limit. Referring back to the SEP IRA example, if $25,000 were contributed instead of the allowed $17,425, 10% of the $7,575 difference would be owed.
Premature Withdrawals from Savings
Retirement is a long-term goal, and the money you set aside is supposed to grow over time. Using this income early shrinks your potential in a couple of ways. You cannot earn interest on what has been withdrawn, and you could be penalized with taxes if it is classified as an early distribution.
Usually, the penalty for withdrawal of funds from the retirement plans listed above is 10% if done before the age of 59 ½, unless an exception is made. Income tax will also be due on the distribution taken. Some plans allow loans, but if not paid back promptly, they will be considered taxable distributions. Use your retirement money only as a last resort.
Owning a small business requires a different rule book. It is best to educate yourself and to heavily research each plan’s contribution limits and tax advantages. You can visit the sources used at http://bit.ly/1UN5yum and http://bit.ly/22Aqz1n. If you are in the market for financial advisors, seek referrals and make a list of questions and possible scenarios.
