Hey Self-Employed, Are You Making The Most Of Your Retirement Options?
Saving enough for retirement is a big deal, and retirement is just as real and important for self-employed workers as it is for more conventional employees. Unfortunately, the retirement savings options for the self-employed aren't quite as obvious or automatic as they are for regular employees - whenever someone starts a new job, HR often tells them about any company-sponsored plans that are available, but there's no similar mechanism for the entrepreneur.
Luckily, there is a wide range of options available to those who run their own business. While some approaches are compelling in their simplicity, others allow an owner or operator to squirrel away truly considerable amounts of money for retirement. Although readers should be aware that the details and requirements of these plans can change with the tax laws, here are some of the best options available to the self-employed.
The Simplified Employee Pension Individual Retirement Account (more commonly known as SEP IRA) is modeled after the IRA account and is the simplest account to establish. There are minimal Internal Revenue Service (IRS) reporting requirements and there are typically minimal restrictions on the types of investments that someone can own through a SEP IRA plan. To set up a SEP IRA, entrepreneurs need to fill out a very basic amount of paperwork with a brokerage that offers this account type.
While SEP IRAs are simple, they are not necessarily the most effective means of saving for retirement. Contributions are limited to 25% of employee wages or 20% of net earnings (before self-employment tax) of owner or operators, which works out to about 18.6% of profits. These contributions are also capped at $49,000 per year, but any contribution can be made in a lump sum at the end of the year. Employers should also note that under most circumstances they will have to contribute the same amount for employees (on a percentage basis) as for themselves, but there is no annual funding requirement.
While investors can usually roll 401(k) distributions into a SEP IRA, it is not possible to borrow against these funds and early withdrawals come with a 10% penalty in addition to regular taxes.
An individual 401(k) is more or less like what it might sound – a plan for self-run businesses that closely mirrors the 401(k) plans offered by many larger companies. What is different, though, is that an individual 401(k) combines the features of a "regular" 401(k) with a profit-sharing plan. A 401(k) is relatively simple to start and there are only minimal filing requirements with the IRS until plan assets reach over $250,000 (even at which point the paperwork required is pretty simple).
To establish an individual 401(k), a business owner has to work with a financial institution, and that institution may impose fees and certain limits as to what investments are available in the plan. Some plans, for instance, may limit you to a fixed list of mutual funds (typically sponsored by that institution), but a little bit of shopping will turn up many reputable and well-known firms that offer low-cost plans with a great deal of flexibility.
The principal appeal of an individual 401(k) is that a self-employed worker can contribute more. Although the same $49,000 cap applies as with the SEP IRA, the contributions can take the form of salary deferral (up to $16,500) and "profit sharing" (up to 25% of compensation, less if the business is not incorporated) - making it much more likely that a worker can contribute the full amount.
While tax-free loans from plan assets are possible, only the self-employed and his or her spouse are eligible for such a plan.
The misleadingly-named SIMPLE IRA is another good option for relatively small employers. The good news is that almost any small business can establish such a plan (as long as there are no other plans in place) and there is only a minimal filing requirement (typically just the initial plan document).
Where SIMPLE IRA plans become a little less simple is in the contribution rules. Employers choose between one of two options - either matching employee contributions up to 3% or a 2% non-elective mandatory contribution (meaning that even if the employee chooses not to contribute, the employer must kick in 2% of compensation). In either case, the employee can contribute whatever percentage of their pay they wish, but cannot contribute more than $11,500 in a year.
Like other IRAs, these accounts or plans must be opened with a financial institution, and that institution will have rules as to what sorts of investments can be bought under the plan, and may charge fees for plan administration and participation.
SIMPLE IRA plans only make a lot of sense in certain specific cases. Because they represent much less potential retirement savings for the proprietor, they really only make sense in cases where the number of employees involved would make other plans too expensive.
The Keogh plan is arguably the most complex of the plans intended for self-employed workers, but it is also the option that allows for the most potential retirement savings.
Keogh plans can take the form of a defined contribution plan where a fixed sum or percentage is contributed every pay period. These plans cap total contributions in a year at $49,000, just as the SEP IRA and 401(k). Another option, though, allows these to be structured as defined benefit plans. These plans rely on IRA contribution formulas that can be rather complex, but the upshot is that certain eligible proprietors can contribute nearly $200,000 to the plan in a year.
A business must typically be incorporated to use a Keogh and they are only permitted for businesses with 10 or fewer workers. Although all contributions are made on a pre-tax basis, there can be a vesting requirement. There are federal filing requirements for these plans and the paperwork and complexity often means that professional help (be it from an accountant, investment advisor or financial institution) is necessary
As you might imagine, these plans are typically only beneficial to high earners. Because of the defined benefit structure, though, it can offer a convenient and legal work-around for situations where there is a single high-earning boss and several lower-earning employees (as in the case of a medical or legal practice).
Strictly speaking, these are not the only options that a self-employed or owner or operator worker has. Businesses can elect to offer more traditional 401(k) or defined benefit plans. Unfortunately, these plans are often undesirable, as the administrative costs can be unacceptably high for smaller businesses with relatively few employees.
The Bottom Line
Before deciding on a retirement plan for your small business, it's imperative to shop around. Many financial institutions offer low-cost (or even no-cost) plans and a great deal of free assistance. At the same time, be sure to ask questions and thoroughly understand the offerings, costs and limitations of any plan.
It is also important to be realistic about the state of your business and your growth plans. The proper plan for a single owner or operator may be different than for a business with three to 10 employees or a business with more than 50 workers. It is likewise important to realistically assess your commitment to the enterprise - although it is relatively easy to set up many of these plans, other plans may be impractical if the business is too small or if you are uncertain it will continue for several years.
Last and not least, make sure to make the most of whatever options you select. The self-employed can often make non-deductible IRA contributions in addition to participating in these plans, and that is certainly worth exploring further with your tax advisor so as to maximize the money available for retirement.
Above all, though, it is vital to do something - retirement is just as real for the self-employed and it is every bit as important to make the most of existing tax laws to maximizing your earning and savings potential.