Business IRAs are a valuable retirement plan option no matter the market. How can they help your business-owner clients in the current crisis?
During lean economic times, everyone, it seems, must work longer and harder merely to maintain the status quo. That predicament certainly rings true for many small business owners, particularly when it comes to the issue of how to handle individual retirement plans for themselves and their employees. It's often difficult for small businesses to stay the IRA course when resources and time are short.
That's why small business owners and their advisors are especially appreciative of the flexibility and lower administrative costs afforded them by SEP and SIMPLE IRA plans.
These stripped-down plans still deliver enough substance to appeal to a broad range of small business owners, according to advisor H. Brian Adcock, executive vice president at Adcock Financial Group in Tampa, Fla. In the right situations, they are "a tremendous vehicle for small business," he asserts. "If you look at their administrative costs and how few handcuffs they put on you, they are pretty friendly types of plans."
"A SEP or a SIMPLE IRA can be a very good solution, we find, for start-up situations, sole proprietors and real small employers," echoes Jim O'Shaughnessy, managing partner at Sheridan Road Financial Services, an advisory firm in Northbrook, Ill., that serves businesses and individual clients. "And ultimately, as they begin to grow and add employees, that's when it can be worthwhile for them to explore other plan designs, such as a 401(k)."
SEP IRAs (simplified employee pension individual retirement accounts) and SIMPLE (savings incentive match plan for employees) IRAs tend to be best suited to sole proprietors and small companies with up to five employees, O'Shaughnessy says. Once a company surpasses that threshold and has a larger critical mass of employee retirement assets to handle, 401(k)-types of plans often become more appealing because they come with a much broader range of competitively priced investment options. What's more, he notes, the responsibility for administering SEP IRAs for more than a handful of employees can become too burdensome for many small business owners.
"It gets more complicated as you add more employees to the mix, which is why many companies grow into 401(k) plans, where they get access to fund managers and third-party administrators."
Still, SEP IRAs and SIMPLE IRAs more than fit the bill for many smaller-proportioned but growth-minded companies. Flexibility is a major reason.
For baby boomers who own small businesses, SEP IRAs serve as a "building block for a defined benefit plan down the road," says O'Shaughnessy's colleague, Chris Karam, a managing director at Sheridan Road.
They also provide much-needed liquidity to fund retirement income vehicles, observes O'Shaughnessy.
"A lot of baby boomers nearing retirement have their net worth tied up in their homes and their small businesses, which for the most part are illiquid assets. In those situations, the SEP can be a great vehicle for the small business owner or sole proprietor who's looking for an efficient way to set a decent amount of money aside, pre-tax."
As the economic downturn underscored, SEPs can also provide important flexibility to small businesses and sole proprietors in the area of contributions. The absence of a minimum annual contribution requirement with a SEP gives business owners a reprieve when cash flow is tight or uncertain, says Karam. SEPs also tend to carry relatively low administrative costs, he adds, which "really makes it a viable solution," especially when cash flow is tight.
As a key source of liquidity for the retirement plans of many baby boomer small business owners, SEPs also can be used as a reserve to fund the health care needs of an individual or a couple during retirement, Karam points out. "A couple retiring at age 65 on average is going to need something like a quarter-million dollars just to cover their health care requirements. We often recommend using [a SEP] as a place to set that money aside."
A SEP, according to Adcock, also can be a tax-friendly tool for business owners (or one of their employees) who have an income source separate from their main business, such as from speaking engagements. In such a scenario, it can be worthwhile to use a SEP in tandem with a 401(k) or other type of retirement plan, where income from the outside source is funneled into the SEP. "It can only really be used when the stars align," he explains, "but in a world that is becoming more tax-toxic, having an opportunity like this to put aside as much [money] as possible in a tax-deferred or tax-free environment makes a lot of sense."
It's best, Adcock says, to consult with a CPA to determine whether such a set-up might apply to a particular client, and if so, how best to structure contributions.
These kinds of narrower applications for a SEP are dwarfed by the potentially huge opportunities that loom for the IRA-holding populace as a result of federal tax provisions enacted as part of the Pension Protection Act of 2006 (PPA). Not only did it open the door to allow direct, penalty-free conversion of traditional IRAs to Roth IRAs, it also lifted the $100,000 income limit on penalty-free conversions to Roth IRAs, at least for 2010. Under the law, the income cap that limits eligibility for conversions from traditional IRAs to Roth IRAs is set to disappear next year, so anyone can convert a non-qualified SEP or other kind of traditional IRA to a Roth IRA, regardless of income level. That provision also comes with a one-time opportunity to spread payment of conversion taxes over the 2011 and 2012 tax years. After taxes are paid, and if the conversion is executed correctly, amounts in the Roth IRA grow tax-free and should not be subject to income tax upon withdrawal.
The cap-free Roth conversion opportunity has become a major point of discussion among advisors and their IRA-owning clients, including those invested in a SEP or SIMPLE. Conversion can make sense for the vast majority of IRA holders whose accounts lost significant value during the market downturn, since they will be paying conversion taxes on a lower asset level, notes O'Shaughnessy. Conversion also makes sense for qualifying IRA owners who expect federal tax levels and/or the value of their IRA assets to increase in years to come. Given current conditions, the likelihood of each is strong, says Adcock. So why not pay now, when both tax rates and asset value are lower?
What's more, he adds, SEP and SIMPLE owners who take the conversion route get what amounts to a "free look" window with their Roth conversion, as tax rules allow them to rescind a conversion. That window opens Jan. 1, 2010, when the cap-free conversion provision takes hold, and can last until Oct. 15 of 2011, provided the IRA holder gets an extension to file 2010 taxes.
During that time, he says, "you can wait and see how your [converted IRAs] have done. If they have taken off, you made the right decision. If not, you can choose to rescind the conversion."
In the end, Adcock explains, converting more funds into Roth plans can help counterbalance looming tax liabilities in a retirement portfolio from sources such as annuities, 401(k)s, pension plans and traditional IRAs.
For advisors, "the challenging task is going to be determining case-by-case how best, and at what level, to take advantage of this tremendous tool."
When to Keep It SIMPLE
When it comes to retirement plans for small businesses and the self-employed, bare-bones is certainly better than nothing. That's where a SIMPLE IRA can be a viable option, says advisor H. Brian Adcock of Adcock Financial.
"A lot of times this is absolutely the best solution, especially for much smaller companies that are really limited in their HR departments. SIMPLE plans are easy to implement and are a little more automated, so administrative costs are lower and you don't have to worry about ADP or ACP testing requirements, Form 5500s and those kinds of things."
A few factors to weigh with SIMPLE IRAs:
- SEP IRAs generally allow for larger contributions.
- SIMPLE IRAs accommodate both employer and employee contributions; SEPs generally do not.
- SIMPLE IRAs require some form of employer contribution; SEPs generally do not.
- Unlike with a SEP, the SIMPLE plan must be the employer's sole retirement plan, although employees can also contribute to their own traditional or Roth IRAs.
- Under current tax rules, a self-employed person earning less than $46,000 from his or her business could make a greater contribution to a SIMPLE IRA than to a SEP IRA. This threshold in many cases makes a SIMPLE IRA attractive to early-stage start-ups and part-time businesses.
- Penalties for early withdrawal (within two years of plan inception) are higher with a SIMPLE IRA than with a SEP IRA (25 percent and 10 percent, respectively).