So you’ve finally made the leap and started your own business and you have positive cash flow. Not so much that you can retire next year but enough that you can start thinking about putting away some money for your future. Here are some easy ways to build a nest egg.
IRAs: Roth vs Traditional
One of the easiest ways to put money into a retirement plan is to open up your own Individual Retirement Account commonly known as an IRA. IRAs came into being when the Employee Retirement Income Security Act was passed in 1974. At the time, it allowed you to contribute as much as $1500 into an IRA and to make that contribution deductible, allowing the individual to reduce their taxable income. When it came time to take the money out of the account for your retirement, that was when you were taxed on your money. This type of IRA is a tax-deferred retirement account because you were not required to pay any taxes on gains and the principal until you were allowed to take the money out at age 59 ½.
A few modifications had been made through the years with the IRA in terms of an increase In contribution limits, eligibility requirements, deductibility requirements, but there were not major changes until 1997 when the Tax Payer Relief Act was passed and created the Roth IRA, which was different from the traditionally existing IRA. Unlike the traditional IRA, contributions to a Roth IRA were not deductible but they had one big advantage over the traditional IRA, any earnings that the Roth IRA gained over the years were NOT taxable. This type of IRA is a tax-free retirement account because you didn’t have to pay any taxes on the money it earned. Another big advantage to the Roth IRA was that since the contributions were not deductible, the rules allowed you access to your contributions at any time. This gave the Roth IRA account owner more flexibility than the Traditional IRA account owner. With the traditional IRA, your money was locked up until much later into the future. If you had to take the money out, you were hit with penalties for taking your money out early. With the Roth IRA, if you had an emergency you can tap into your Roth IRA contributions without any penalty or taxes since these contributions were never deductible! These two reasons alone made the Roth IRA the more popular choice for the self-employed.
Currently you are allowed to contribute up to a maximum total of $4000 annually into an IRA account whether it’s a traditional IRA or a Roth IRA or both. IRA accounts can be opened in your local bank or a brokerage firm. The money you put in your IRA can be invested in CDs, mutual funds, bonds, stocks, annuities or a combination of these.
Another type of retirement plan for self-employed businesses that was created in 1996 is the Savings Incentive Match Plan for Employees of Small Employers or SIMPLE IRA for short. If you are a one-person business, meaning that you are your own CEO, CFO and COO, then this type of IRA is worth looking into if you can put away more than $4,000 and as much as $11,500 annually. At this level, your business has grown to the point that your cash flow is consistent and you can easily contribute up to the maximum allowed in order to reduce your taxable income. Similar to the traditional IRA, your contributions to the SIMPLE IRA account was tax-deductible and if you were to take money out before age 59 ½ you will incur penalties. You can open up a SIMPLE-IRA in a bank or a brokerage firm and that money can also be invested in CDs, mutual funds, bonds, stocks, annuities or a combination of all those types of investments.
A third choice to put money away for retirement is to use a SEP-IRA. SEP is short for Simplified Employee Pension Plan and was created with the passing of the Revenue Act of 1978. With a SEP-IRA, the self-employed business owner can put away as much as 25% of eligible compensation but no more than $49,000 each year. These contributions are fully deductible and if you were to take money out before age 59 ½ you will incur penalties. To be able to comfortable contribute to a SEP-IRA, your business at this stage is not only established but continues to thrive and you are actively looking to help reduce your taxable income in a legitimate way. Also at this stage, the business owner has some full-time employees and you would be required to make contributions on their behalf, based on a calculation not a dollar-for-dollar match, into their own SEP-IRAs when you make contributions to your own. If you value your employees and want them to remain with you, it is to your benefit to offer this type of retirement plan to them. As with the other IRAs, a bank or brokerage firm can help set up these accounts for you and your employees and as previously mentioned, the moneys can be invested in CDs, mutual funds, stocks, bonds, annuities or a combination.
As always, before you open any kind of IRA account, discuss your choices with your accountant so that you can choose the type of retirement plan that is appropriate for you at your given stage of the business. You want to be informed of the eligibility rules, maximum contribution limits, distribution rules, the deductibility of your contributions and so forth. Most important, if you are using investments other than a Certificate of Deposit you will want to discuss the risk involved with the type of investment that you use in you IRA.