Retirement Plan Basics

Why Have a Retirement Plan?

As a self-employed, small business owner, there are two good reasons for setting up your own retirement plan:

  1. Building Wealth
  2. Slashing Taxes

Building Wealth

If you're a self-employed small business owner, you can stash much larger amounts of money into a tax-favored retirement plan than you could in a non-business type savings account, such as a traditional or Roth IRA.

For example, for tax years 2016 and 2015, if you set up your own personal, non-business, traditional IRA, the most you can contribute is $5,500 or $6,500 if you're 50 years of age or over (called the catch-up contribution).

However, if you set up a SEP-IRA you can contribute the lesser of:

  1. 25% of compensation, or
  2. $53,000 (for 2015 and 2016)

Note: If you're self-employed, you must perform a special computation to figure your own contribution.

The same limits apply to contributions you make for your employees to all defined contribution plans, which include SEPs.

Compensation Limits:

You may consider compensation up to $265,000 in 2016 and 2015 (subject to cost-of-living adjustments for later years). Contributions must be made in cash; you cannot contribute property.

Slashing Taxes

Here are some of the tax breaks you get by having a business retirement plan:

  • If your self-employed, contributions for yourself are deductible (on Form 1040, line 28.
  • If you have employees, contributions you make for them are deducted directly from the income of the business that provides the retirement plan.
    • For example, sole proprietors deduct contributions made on behalf of employees on Schedule C.
  • Plan assets grow tax free.
  • Plan assets are not taxed until distributed.

Retirement Plans Startup Costs Tax Credit:

You may be able to claim a tax credit for some of the ordinary and necessary costs of starting a SEP, SIMPLE IRA or qualified plan. A tax credit reduces the amount of taxes you may owe on a dollar-for-dollar basis. If you qualify, you may claim the credit using Form 8881, Credit for Small Employer Pension Plan Startup Costs.

You qualify to claim this credit if:

  • You had 100 or fewer employees who received at least $5,000 in compensation from you for the preceding year;
  • You had at least one plan participant who was a non-highly compensated employee; and
  • In the 3 tax years before the first year you’re eligible for the credit, your employees weren’t substantially the same employees who received contributions or accrued benefits in another plan sponsored by you, a member of a controlled group that includes you, or a predecessor of either.

Amount of the credit:

The credit is 50% of your ordinary and necessary eligible startup costs up to a maximum of $500 per year.

Eligible Startup Costs:

You may claim the credit for ordinary and necessary costs to:

  • Set up and administer the plan, and
  • Educate your employees about the plan.

Eligible Tax Years:

You can claim the credit for each of the first 3 years of the plan and may choose to start claiming the credit in the tax year before the tax year in which the plan becomes effective.

The credit is part of the general business credit and you may carry it back or forward to other tax years if you can’t use it in the current year. However, you can’t carry it back to a tax year beginning before January 1, 2002.

Keep in mind, you can’t deduct both the startup costs and claim the credit for the same startup costs. You aren’t required to claim the credit.

Saver's Credit

Certain low and moderate income individuals (including self-employed) who make contributions to their plan, including a traditional IRA and Roth IRA, may be eligible claim the retirement savings constrbutions credit (saver's credit).

Eligibility for the credit is based on your Adjusted Gross Income (AGI). Depending on your AGI, you may be eligible for a credit percentage of 50%, 20%, or 10%. The applicable percentage applies to the first $2,000 of your contributions. However, regardless of your income, you cannot claim the credit for tax year 2015 if any of the following apply:

  • Your were born after January 1, 1998
  • Are claimed as a dependent on another taxpayer's 2015 return, or
  • You were a full-time student during five or more months in 2015

Other limitations apply. Use Form 8880, Credit for Qualified Retirement Savings constributions to compute the credit.

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