Maximum SEP-IRA contribution limit for 2017:
Lesser of $54,000 or 25% of your compensation.
IRS Definition of Compensation:
If your business entity is S-Corp/C-Corp, compensation is defined as gross compensation reported on W-2. The IRS does not permit the use of K-1 income as an acceptable definition of compensation.
If your business entity is Sole-prop, determining compensation is a circular calculation and cannot be done online. You should reach out to your service provider or email us at firstname.lastname@example.org and we shall be happy to do it for you.
If you have employees who have worked with you for more than 3 years, you have to contribute a similar percentage to the employee accounts as well.
One of the best kept secrets of the pension industry is a type of a pension plan that provides much larger contributions to the business owners than a SEP-IRA.
If you have employees, please scroll below to the section titled, Small Business with Employees.
If you do not have employees, please keep reading:
The pension plan with the potential to generate contributions larger than a SEP-IRA is a defined benefit plan.
There are a lot of myths surrounding a defined benefit plan, many of which are just myths. Since you are self-employed, the defined benefit plan works very similar to a SEP-IRA, except that the contribution limit is higher.
If we have your attention till here, you are in for some serious tax savings!
A defined benefit plan is capable of generating a tax deduction of up to $200,000 and higher in some scenarios, making it an ideal choice for a self employed individual looking for a large tax deduction.
If you want to get an estimate of what you can contribute to a defined benefit plan, please use our defined benefit calculator on the right.
Defined benefit plan example
Case Study: Retirement Plan for self employed individual
Employment status: Self employed
Three year average income: 100,000 as W-2 compensation/Schedule C income/K-1 Income
Participant’s age: 50
A participant with the above mentioned parameters can accumulate $ 1,248,535.08 till s/he reaches an assumed retirement age of 62. In the first year, a maximum contribution of $ 82,788.00 can be made to the defined benefit plan.
Employment status: Self employed
Three year average income: More than $265,000 as W-2 compensation/Schedule C income/K-1 Income
Participant’s age: 50
A participant with the above mentioned parameters can accumulate $ 2,621,923.68 till s/he reaches an assumed retirement age of 62. In the first year, a maximum contribution of $ 166,267.00 can be made to the plan.
You can use our online defined benefit calculator to find out how much you can contribute to a defined benefit plan. You can reach out to us at email@example.com if you have specific questions about setting up the plan.
How to set up a defined benefit plan?
Setting up a defined benefit plan involves one additional step than required to set up a SEP-IRA.
A final calculation needs to be performed about how much you can actually contribute to a defined benefit plan. These amounts vary from person to person and are typically based on the age of the individual, type of business entity and the compensation history.
You can then decide the amount that you want to contribute to the plan for a particular year.
For examples, your actuary may calculate that you can contribute $200,000 in the defined benefit plan in the first year. However, you might want a lower contribution amount and your actuary needs to be informed of that. Once you and your actuary agree on a contribution amount, you are all set to go ahead with the next steps.
Every defined benefit plan requires a plan document which will list all assumptions of the pension plan and ensure compliance with all IRS rules and regulations. This document has to be drafted by an actuary before you can set up the investment accounts for the plan. The actuary will customize a plan document based on the contributions you need. Make sure your actuary provides you a plan document that is pre-approved by the IRS so you don’t need to go through the hassle yourself. You can read more about a pension plan document here.
After the plan document has been drafted, you are all set to open the investment account for the plan. You can open the account with any firm and we can guide you in filling up the forms for this.
You can start making contributions to the plan as and when free cash flow is available once the investment accounts are open. For the first year, the contribution will be what was decided between you and the actuary. The actuary will calculate a range for each subsequent year along with a recommended contribution amount. The deposits can be made until you file the tax returns for your business.
All qualified plans are required to file annual returns with the IRS. Note that these returns are different from the company tax returns and your personal tax returns. Also note that the CPA or financial advisor cannot file these returns since these are required to be certified by an actuary.
The actuary will fill up a form called the Form 5500SF and certify another form called the Schedule SB. You will need to sign the form as the plan sponsor and the actuary will file it electronically. The penalties for not filing these forms run in to hundreds of dollars and the pension plan could end up getting disqualified.
If you are a self employed individual and interested in exploring the idea of a defined benefit plan for yourself feel free to email us at firstname.lastname@example.org and we can guide you in this. We specialize in this area and can provide you with valuable advice and services that could end up saving thousands of dollars and getting a boost to your retirement planning.
Small Business with Employees
If you are a small business with employees, the IRS requires you to contribute for them if they have:
It takes a very generous person to set up a SEP-IRA if you have eligible employees.
For example, if you contribute 20% of your W-2 wages to your SEP-IRA, you have to contribute 20% of the employee’s W-2 wages as a contribution to their SEP-IRA accounts. This 20% has to be entirely employer contribution and you cannot withhold any portion of it from the employee wages.
There are two ways in which this situation can be turned in your favor:
Option 1: You can limit contribution to employees at 5% of their W-2 compensation while you contribute the maximum of $54,000 in a profit sharing plan. This design is called as a New-Comparability profit sharing plan. Please read more about it below.
Option 2: You can contribute more than $54,000 for yourself by setting up a defined benefit plan while contributing between 5% to 7.5% of employee wages in a profit sharing plan set up for the employees. This design is called as a floor offset defined benefit plan design. Please scroll down to read more about it.
Option 1: New Comparability Profit Sharing Plan
A new comparability profit sharing plan is an IRS approved pension plan design which allows skewing of benefits in favor of owners and key employees within certain limits. A third party administrator like us will perform Non-discrimination testing in order to ensure compliance with all IRS rules. Of course, such a plan design will incur administrative costs, but the savings on employee contributions will be much larger making the administrative costs look insignificant.
A typical new comparability allocation will look as below:
Floor offset defined benefit plan design
A floor offset plan is one of the most advanced pension plan design and involves a defined benefit plan and a profit sharing plan working together.
Who is it ideal for?
The floor offset is ideal if:
- Your business has a lot of free cash flow and you are looking to put aside a large sum of money for your own retirement.
- You are a small to medium sized business (less than 10 employees)
- There is only a single owner of the business or at least a small number (2-3) partners.
A typical floor offset allocation:
So what exactly is this plan design?
Let’s set up the background first with the help of an example. Let’s assume you are the owner of a small business with five employees and have decent amount of free cash flow. You just turned 50 this year and are appalled by the fact that in spite of a successful decade in business, you have managed to accumulate only $500,000 towards your retirement goals. You want higher contributions each year while keeping the allocations to your employees low.
Someone just mentioned about a defined benefit plan to you. However, since you have employees, you will have to provide a retirement plan option to them as well. If you include your employees in the defined benefit plan, you end up contributing a large amount of money to them, so large that it does not make sense to sponsor a retirement plan.
This is where a floor offset comes in to rescue.
The IRS permits segmentation in a defined benefit plan, which basically means assigning different people to different classes based on job title, location etc. As the owner, you are a part of class 1, while all other non-owner employees are a part of class 2. The IRS also permits different allocation formulas for each class. The allocation formula is typically a certain percentage of compensation that will be earned in retirement. This formula determines how much money you can accumulate as the owner and how much money you have to contribute towards your employees.
As the owner, you can choose to receive 100% of your compensation, subject to a cap of $210,000 each year after retirement. You can also design the plan such that employees receive 5% of their compensation as retirement benefits. This is the first step in reducing the costs. However, the floor offset goes one step further in this regards. A profit sharing plan is designed to work in accordance with the defined benefit plan. Everyone is allocated a minimum of 5% of pay in the profit sharing plan. These allocations in the profit sharing plan are then used to ‘offset’ the benefits the employees receive in the defined benefit plan. In most cases, the entire benefits of the employees in the defined benefit plan are offset and they receive only the 5% contribution in the profit sharing plan.
When we say ‘offset’, it does not mean we take the benefits in the defined benefit plan and subtract the allocation in the profit sharing plan. Complex financial mathematics is involved in this as everyone’s benefits are projected to an assumed retirement age of 62/65 and offset at that point.
There is also the added complexity of cross-testing of benefits and contributions. As your third party administrator, we will mask all this complexity and do the math for you. We use high end software and the expertise of actuaries to achieve the optimal allocations for our clients.
If you have employees who are older than you, then their benefits may not be offset completely. Such employees will receive the allocation in the profit sharing plan and the residual benefits which were not offset from the defined benefit plan.
The floor offset plan is probably the only plan design that allows you to contribute a large amount of money for yourself while keeping employees contributions in the 5 – 7.5% range. Below is a real example of a floor offset plan in action. This was designed for one of our clients who is relatively young.
Feel free to email us at email@example.com if you have any specific questions about any of the points above.
You can also generate a quick estimate of how much you can contribute in the defined benefit plan by using our defined benefit calculator here.