Retirement Planning for the Self-Employed
If you are self-employed and do not have any employees, there are a wide variety of defined contribution and defined benefit retirement plans that you can establish and fund. In some cases, setting up multiple plans allows you to get the maximum contribution. Your tax structure may come into consideration if you are a C Corporation, which is subject to corporate taxes. However, this should not make much of a difference if you are a pass-through entity, such as a sole proprietor, Limited Liability Corporation or S Corporation.
Which retirement plan is best for you depends on several factors including cash flow, your age, and income. Cash flow is a major factor, and it's vital to know how much you will contribute to your plan annually. Also, you need to decide if you will opt for a set ongoing annual contribution or a plan that can be funded at different levels each year.
Your age and income are two other significant factors to consider when designing a plan. Some plans allow for employee deferrals based on W-2 income while others are entirely employer funded and contributions to plans, such as profit-sharing or defined benefit, can be based on age and/or income.
An SEP (Simplified Employee Pension) is an easy to setup, employer-funded plan. Contributions can vary, and the plan does not have to be funded every year. You can contribute up to 25% of compensation or a maximum of $53,000 for 2015 (this calculation is slightly different if you are a sole proprietor). The plan can be set up anytime and must be funded by the employer’s tax deadline, including extensions. Contributions are immediately vested. Additionally, No loans are allowed and withdrawals prior to age 59 and a half are taxable and subject to a 10% penalty.
A Simple IRA is an inexpensive, easy to set up plan that has no discrimination testing or filing requirements. However, the plan has lower contributions limits than an SEP or 401(k) and must be established by October 1 of the year you plan to begin making contributions.
Each year the employer has to make a matching contribution of up to 3% of W-2 compensation (that can be reduced to 1% with restrictions) or a 2% nonelective contribution for each plan participant. Under the nonelective contribution formula, even if you don’t contribute to the plan, the employer must still make a contribution equal to 2% of compensation. You can make tax-deferred contributions of up to $12,000 a year (plus a $2,500 catch up if age 50 or older) and are immediately 100% vested in all contributions. The plan does not allow loans and accounts may not be used as collateral. In-service withdrawals are allowed, but taxed as income and subject to a 10% additional tax if under age fifty-nine and a half. Also, withdrawals made within the first two years of participation are subject to an additional 25% tax.
401(k) and Profit Sharing
Many small business owners shy away from 401(k) plans because they require the administration to ensure contributions meet specific nondiscrimination requirements, known as the actual deferral percentage and actual contribution percentage tests. However, testing is not an issue for a one-person 401(k). The plan does require a plan document, which a third party administrator(TPA) helps prepare, and filing a simplified 5500 form each year. The cost for a TPA for an individual 401(k) is very reasonable. A loan of up to $50,000 or 50% of the vested account value is allowed and must be paid back within five years. You determine the loan interest rate in the plan document and can be set at prime plus 1-2%.
Contributions to a 401(k) can vary year to year. In 2015, you are allowed to defer up to $18,000 of W-2 income with an additional $5,500 catch-up contribution if you are 50 or older. Deferrals must be made during the calendar year. By including a profit sharing plan (PSP), the total annual additions to your account can increase to the lessor of 100% of W-2 compensation or $53,000 ($59,000 including catch-up a contribution) for 2015. The traditional PSP is employer funded and allows contributions of up to 25% of compensation. Employer contributions can be made in the current or following tax year, prior to filing your business return.
Defined Benefit Plans
Even if you have fully funded an SEP or 401(k)/PSP you can still add an employer funded pension plan (defined benefit) to your retirement savings program. Contributions to a defined benefit plan are based on actuarial assumptions and computations. When a participant enters the plan, an actuary determines what amount of funding is needed to provide the future benefit based on several factors, including age and interest rate assumptions. Both traditional defined benefit and cash balance plans are designed to offer a series of monthly payments for life. The difference is a traditional defined benefit plan is required to provide a series of set payments for life, beginning at retirement; while a cash balance plan defines the benefit in terms of a future account balance that can be converted into a series of lifetime payments or rolled over to an IRA. Thus, the actual future benefit in a cash balance plan can vary and depends in part on the actual investment return.
The interest rate assumptions can have a significant effect on the plan funding requirement, and there are variations on defined benefit plans, such as a 412(i) life insurance based plan, that use very low-interest rates assumptions and thus have a higher funding requirement. For 2015, the maximum annual benefit for a defined benefit plan cannot exceed the lesser of $210,000 or 100% of the participant's average compensation for their three highest consecutive calendar years.
Defined benefit plans are complex and expensive to set up and administer. The plan must file a 5500 form every year and must submit a Schedule B signed by an enrolled actuary that outlines funding levels. The plans must be fully funded each and benefits can’t be retroactively changed. There is also a tax penalty if the minimum funding requirement is not met each year or if there are excess contributions.
The Bottom Line
Many self-employed people are reluctant to put aside money for retirement, but saving for the future is important, and a qualified plan also helps reduce your taxable income. The best approach may be to set up a plan that provides the most flexibility in funding and allows loans, such as a 401(k) with PSP. That way in prosperous years you can add a lot and in bad years you can skip contributions altogether. Contributions limits for the most qualified plan are periodically increased (although once a defined benefit plan is set up the contribution limits are not adjusted) so as your earnings increase your contributions can grow as well. (Read more retirement tips, here: How to Shift From Saving to Spending in Retirement.)