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Retirement Plans for the Self-Employed

The self-employed person generally enjoys the freedom and flexibility that comes with being their own boss. We prefer to make our own rules, make our own schedule, and make our own money.

And with that freedom and flexibility that self-employment offers, we also have a few choices in how to go about planning for retirement - the SEP Plan, Solo 401(k), and the Keogh Plan. Here's a quick rundown of retirement plans available to those who make it on their own:

SEP (Simplified Employee Pension) Plan
The SEP Plan is the most commonly used retirement plan for the self-employed individual or the small business with only a few employees. It's easy to set-up, and because this is a simplified plan, the administrative costs are generally lower than for other, more complex plans.

This plan is also known as a SEP IRA - under a SEP, employers make contributions to traditional Individual Retirement Arrangements (IRAs) that are set up for employees and self-employed individuals.

To be eligible for SEP IRA contributions, employees must be at least 21 years of age, must have worked for the employer for at least three of the previous years, and received at least $450 in compensation for the tax year.

The withdrawal guidelines and tax rules apply just as they do for a traditional IRA - the contributions are 100% tax deductible and earnings grow tax-deferred. Withdrawals after the age of 59 1/2 are taxed as ordinary income. Withdrawals made before 59 1/2 are subject to a 10% penalty in addition to income taxes. And you must begin taking distributions by age 70 1/2.

Simply, the SEP IRA is a great choice for self-employed individuals or owner and spouse businesses. The owner-employee of a corporation may contribute up to 25% of their W-2 earnings, and the sole proprietor may contribute 20% of net self employment income, up to the maximum contribution limit of $49,000 for 2009.
The SEP IRA can be set up and funded as late as the tax deadline for the year you file your taxes. For example, to take a contribution deduction for the tax year 2009, your SEP IRA must be set up and funded by April 15, 2010, or by October 15, 2010 if you filed an extension. This can work to your benefit by allowing you to reduce your taxable income even if waited until the tax year had ended before assessing your tax situation.

Remember, you cannot make withdrawals from your SEP IRA before age 59 1/2 without incurring penalties. So keep that in mind, as you may prefer the Solo 401(k) if you anticipate the need to borrow from it. On the other hand, if you plan to use your plan strictly as it was meant to be - to save and invest for retirement - going with the SEP IRA is easier at a lower cost. And if something comes up where you absolutely need the funds in the future, or you just decide that a Solo 401(k) works better for your needs, you may convert your SEP IRA to a Solo 401(k) at a later time with some minor administrative paperwork.

Solo 401(k)
The Solo 401(k) may be the best option for those who plan to sock away a lot of their self-employment earnings for retirement. This plan is available to the self-employed and small business owners who have no employees, and your spouse also qualifies for the plan if they contribute to your business. The Solo 401(k) is really no different than any other kind of 401(k) except that the rules are a little more relaxed when there are no employees.

The Solo 401(k) has the same maximum contribution limit as the SEP IRA and other self-employed retirement plans, but some may find that they are able to contribute more tax-deferred dollars to a Solo 401(k) because of the way the allowable contributions are calculated.

For 2009, you can contribute up to 100% of the first $16,500 ($22,000 if age 50+) of W-2 compensation or net self employment income for a sole proprietorship. In addition, a profit-sharing contribution can be made up to 25% of W-2 wages, or 20% of net self employment income. With the Solo 401(k), you can make contributions as both an employee and an employer - up to the maximum contribution limit of $49,000.

So the big benefit comes for those who earn a relatively small amount from self employment but want to put away most or all of it. For example, say you have a day job that covers your living expenses, and you earn an additional $15,000 annually from self-employment. With a Solo 401(k), you can sock away all $15,000 of your self-employment earnings. But with a SEP IRA, a sole proprietor could only put away 20% of net self-employment income, which comes to $3000.

And if you have a second job and your employer offers a 401(k), you may contribute to both as long as you don't exceed the maximum allowable contribution between the two retirement accounts.

As mentioned in the earlier section, you can take a loan from your 401(k) - as long as the managing company permits them - making this the plan of choice for the self-employed who want the flexibility to tap into their retirement funds before the age of 59 1/2. The loan will have to be paid back within five years, with interest, but it will all go right back into your Solo 401(k) account.

Your Solo 401(k) plan must be set up by December 31st of the tax year, but you can make a tax-deductible contribution up through the tax deadline, April 15th, or October 15th if you file an extension.

Keogh Plan
Keogh plans are the self-employed equivalent of corporate retirement programs, and may be set up as either a profit-sharing plan or a defined benefit pension plan. Keogh plans are generally known for their higher upkeep costs and more paperwork than other types of plans.

The Keogh Plan is subject to the same restrictions as an IRA - you are penalized for early withdrawal before the age of 59 1/2 and you must begin to take mandatory distributions by age 70 1/2.

To get a deduction for the current tax year, the plan must be established before December 31st of the tax year. After the plan is established, the actual contributions can be deferred until the tax deadline for that year's return. Annual contributions to Keogh profit-sharing plans are based on 25% of self-employment income or compensation and subject to the maximum contribution limit of $49,000 for 2009.

A plan document must be drafted in the first year, and can cost a couple hundred dollars. You will also need to file an annual report with the IRS. Keogh profit-sharing contributions are flexible dependant on the business' profits each year.

Keogh defined benefit pension plans are designed to deliver a targeted annual retirement benefit, which can be as high as $195,000. Each year's contribution must be calculated by an actuary — the exact amount depends on your income, the target benefit, years until retirement and anticipated investment returns. Annual actuarial fees and the required IRS report can run up to a couple thousand.

The Keogh defined benefit plan locks you into making the determined contribution each year, so it may cause problems if your business has a bad year. This type of plan is usually the most beneficial to high earners over the age of 50 due to their larger allowable contributions. Younger self-employed individuals are usually better off with a SEP IRA, Solo 401(k), or a profit-sharing Keogh plan.

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Saturday, 13 April 2024

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