Self Employed? Know Your Retirement Options
If you're self-employed, then you know you've socked away many a dollar into your self-employment tax (SE) over the years. This money is intended to pay for your social security and Medicare upon retirement; but you might have wondered whether this money is enough, or if it will be available when you need it most. Have you planned for retirement? Do you know your options?
The bad news is that most self-employed individuals don't take time to learn about their retirement options, even though they may know exactly how they want their businesses to grow. The good news is that you can set up and - in most instances - control your own tax-advantaged retirement program and put aside more each year than the average wage earner. The following list details the best self-employed retirement plans based upon 2007 tax rules.
SEPs - Simplified Employee Pensions
SEPs or SEP IRAs can represent a significant source of retirement income for self-employed employers and their employees. You can contribute and deduct up to 20% of your self-employment income (25% if you're an employee of your own corporation) into a traditional individual retirement account (IRA) if you're self-employed, a sole proprietor, an independent contractor, or if you're involved in a partnership or corporation. The bonus to this plan is that you can vary the contribution percentage depending upon whether you experienced a "feast or famine" tax year. During the good years you can contribute more, during the lean years you can avoid payment totally. While this plan doesn't set a limit on minimum contributions, the maximum dollar contribution is $45,000.
This plan can be set up as late as April (or the extended due date) in the year that you file your income tax return for the previous year. This plan is fairly DIY, as you can open a SEP at your local bank, insurance agent, a mutual fund company, or even through an online brokerage firm with a form 5305-SEP [PDF]. A SEP can be opened in minutes and with little to no charge in most situations. You don't need to file annual government reports, and ongoing administrative costs are no more than those levied on traditional IRAs. If you're worried about start-up fees, you might like to know that you can deduct up to $500 per year for the first three years for those charges.
You can contribute more to your SEP than the wage earner can contribute to a traditional IRA; otherwise, the SEP IRA works just like a traditional IRA. Contributions to a SEP are tax deductible, and you don't pay taxes on the earnings on the investments. You cannot take loans from your contributions, but you can make withdrawals. If you make withdrawals without a rollover before age 59½, you will pay taxes and - at this time - a ten-percent penalty on monies withdrawn. You also must begin to withdraw a specific minimum amount from your SEP account by April 1 of the year following the year you reach age 70½. You also must withdraw an additional required minimum distribution amount by 31 December in that year and annually thereafter.
You can terminate a SEP at any time with notification to your financial institution about your intent. You can roll those funds over into another SEP IRA, to a traditional IRA, or to an employer’s qualified retirement plan - provided the other plan allows rollovers - without penalty. If you have employees who are involved in this plan, you might notify them that you intend to discontinue the plan. You do not, however, need to give notice to the IRA about your SEP termination. You can maintain a SEP and another retirement plan as well - a bonus for individuals who want as many tax-deferred options as possible, even if it's just for one year (the feast year).
If you seek the equivalent to a corporate retirement plan, you can find your answer in either a profit-sharing or defined benefit Keogh plan. Unlike a SEP, sole proprietors or partnerships must open a Keogh plan before the end of a given year. But, once you've accomplished this goal, you can wait to contribute to the plan when you file your income tax return the following year.
If you want the corporate aspect to your retirement, you'll get it with a Keogh. This plan incorporates all the costs and complexities associated with qualified plan setups, it incurs the same withdrawal penalties as a corporate pension plan, and you may encounter more paperwork than you want - including annual reports to the IRS. You will encounter the same $45,000 ceiling for contributions to a Keogh profit-sharing plan as you will with the SEP, but you can set a ceiling as high as $180,000 for a defined benefit Keogh plan. The latter option requires an actuary to calculate your contribution based upon your income, the target benefit, years until retirement, and anticipated investment returns.
Keogh setup and ongoing fees for paperwork and for professional guidance are more suited to self-employed individuals with established businesses and consistent incomes. One reason behind this limited parameter is that once you open a determined benefit contribution plan, you're locked into that contribution every year. But, Keogh plans might make an ideal rollover option for individuals who currently contribute to a SEP that no longer fulfills required retirement goals. A sit-down with a financial advisor might eliminate any guesswork about whether to go with a Keogh and whether to invest in a profit-sharing or defined benefit choice.
On the plus side, Keogh plan contributions are deducted from gross income and contributions and interest income are tax deferred until withdrawal. Additionally, certain lump sum benefits might be eligible for special 10-year averaging in some instances, a great benefit for those who experience a disproportionate "feast" year among several famine years. Additionally, if you receive an eligible rollover distribution from a Keogh plan, you can roll over all or part of the distribution, including a lump-sum distribution, into a traditional IRA.
There's little information about Keogh plans on the Web, as this option usually requires individual attention by a financial advisor. Ask your banker, insurance agent, or brokerage about solutions for your questions, and shop around to compare rates and fees before you make a decision.
From personal experience, I can tell you that you cannot expect your local bank to know about this retirement option, known as the Solo 401(k) or the Individual 401(k). But, since this plan is gaining in popularity, you can probably teach your local banker or broker about your options. This retirement plan is geared specifically for individuals who work solo as freelancers, contractors, partnerships, or corporations, and who make inconsistent incomes. It's ideal for the freelance creative who fears socking away money for retirement, especially when that individual understands that "famine" years often outnumber "feast" years.
Before I tell you how to find this retirement plan, I want to fire you up with the benefits that Solo 401(k) plans contain for self-employed individuals. First, you can contribute up to 100% of the first $15,500 of your 2007 compensation or self-employment income ($20,500 if you'll be age 50 or older at year-end). Then, you can contribute and deduct an additional amount of up to 25% of your compensation income or 20% of your self employment income over that initial amount. These amounts mean a lot to a self-employed person on a limited budget, as you can max out a substantial tax-deferred retirement balance quickly while you cut your annual income tax bills dramatically.
One example from Smart Money shows that a sole proprietor could save $31,500 from an $80,000 income [$15,500 + (20% of $80,000)] in the Solo(k) as opposed to a "mere" $16,000 with a traditional 401K. And, if you will be over age 50 by year-end, your maximum contributions for 2007 "would be $40,500 [$20,500 + (25% x $80,000)] and $36,500 [$20,500 + (20% x $80,000)], respectively."
The Solo (k) dollar cap for 2007 equals $45,000 or $50,000 if you're over age 50. When you approach the annual $225,000 per year income, the Solo (k) begins to lose its advantage because those dollar caps will prevent you from accruing any substantial tax-deferred retirement savings out of a larger income. But, you can open another retirement plan or roll this plan over into a Keogh once you've gained footing on your retirement and business goals.
Another sweet plus to this plan is that you can contribute zero dollars during lean years. Plus, if you need money during extra-lean years in the future, you can borrow from your Solo (k). A loan is different from a withdrawal - you still must make tax payments on withdrawals outside rollovers and pay penalties for early distributions through withdrawals.
The only drawback with this plan is that it doesn't allow you to grow your business, unless you plan to hire a spouse or an immediate relative. If you plan to hire outside employees in the future, you'll need to find another retirement savings option before you go that route. On the other hand, if you plan to reduce your business you can reduce administrative costs in your retirement plans as well. Money from tax-deferred retirement plans such as traditional IRAs, SEP, 401(k), SIMPLE IRAs, and Keogh plans can be consolidated in a Solo 401(k).
Finally, despite the fact that this option seems simple enough to be a DIY operation, you'll need to contact a brokerage or bank to set up the Solo (k). Setup fees run anywhere from $150-$300 depending upon the services you purchase, and annual fees may apply as well. But, if you can handle the paperwork for simple investments, you can cut that annual cost greatly.
Take a look at this Solo 401(k) vendor list to see if you can recognize your bank or brokerage firm. If you don't recognize any businesses listed here, you still have a little time to call around. While you must establish your plan by 31 December this year if you want to claim a 2007 tax deduction, you can make contributions as late as the date you file your taxes in 2008.
Roth and Spousal IRAs
If you're a normal red-blooded tax-paying American, you want to find as many tax breaks as possible. Now that you've decided upon a SEP, a Keogh, or a Solo 401(k), you can add to your retirement funds with a Roth IRA or a Spouse Deductible IRA.
While tax contributions to the Roth IRA aren't deductible, your earnings are tax-free. When you're ready to take out your money, you don't owe the IRS a penny. Contributions up to $4,000 are allowed for 2007 ($8,000 for couples), subject to phaseout between adjusted gross incomes of $99,000 and $114,000 for singles and $156,000 and $166,000 for joint filers. The same relative thresholds apply even if you maintain a SEP, 401(k) or Keogh, and even if your spouse is covered by a self-employment or work-related retirement plan. So contribute as much as you can to your SEP, Solo, or Keogh, and then boot another lump sum into a Roth for maximum tax benefits for now and later.
The spousal deductible plan is your last resort, but one that may benefit if your spouse contributes to a retirement plan at work but you don't. You can contribute $4,000 for 2007, $5,000 if you're over age 50 by year-end to a spousal deductible IRA as long as your joint adjusted gross income is below $156,000. The Roth may look good to you after you consider this option, as you have more control over your funds with the Roth.
What to do if your business grows?
If you hire employees now or if you plan to hire them in the future, a SEP, Solo, or Keogh must be used to cover them. This means that you'll need to make contributions that don't benefit you, but that benefit your investments in your business. While the IRS information about SEP is fairly straightforward about how to handle this plan, you'll probably need financial advice to learn how to cover your employees' retirements with a Keogh or Solo 401(k). As I mentioned previously, the Solo plan is strict about hiring and covering employees. Furthermore, tax guidelines may require you to pay money for employees before you pay yourself with the Keogh.
Look for help in the form of a tax benefits professional before you contribute any money into any retirement plan for your employees. You might discover other options that will benefit everyone concerned. But, before you plan for a long sit-down with a financial expert, read through IRS materials for the self-employed individual. Even if you don't understand everything listed within this IRS section, you can build a list of questions that can be answered during your financial planning session.
Finally, learn how to use your income and your loans or credit lines wisely. The IRS draws definite lines between business and personal deductions, so you may end up spending more in one camp and not enough in the other before the year ends. Small details can make a big difference in how much you pay Uncle Sam, especially when your income straddles a tax bracket.
Use Advisor Now to find a financial advisor near you, or pick up your phone book and call around to find someone who seems knowledgeable about your needs and goals. Some advisors don't charge for an initial visit, and other advisors may offer all the tools you need to save money on your taxes and for your retirement. Shop around, be selective, and find someone you feel comfortable with, as this person could become a business 'partner' as your business grows.