The number of self-employed Americans has steadily climbed when compared to historical levels. According to this data from the Pew Research Center, approximately 30% of jobs in the United States are held by those who are self-employed, or by the workers that they have hired.
Considering the steady increase in the number of self-employed Americans, a question that immediately comes to mind for these folks are their retirement plans (or lack thereof). With the continuing uncertainty about the future of the Social Security program, this issue of self-employed retirement plans deserves a closer look.
Simplified Employee Pension (SEP IRA)
As the name alludes to, one of the most attractive features of this plan is how easy it is to set up and maintain. Essentially all that is requiredis some basic paperwork, and annual reporting to the IRS is not mandatory.
Another reason to opt for a SEP IRA is the higher level of contribution limits allowed. You have the latitude of socking away up to 25% of the W-2 income that you earn as self-employment compensation, or approximately 20% of the Schedule C net income from the business portion of your return. The total allowed contributions are $53,000 for the current 2016 tax year. This flexibility enables you to increase how much you are saving for your retirement as the profits from your self-employment work go up.
A final benefit of SEP IRA plans is their tax-deferred status. This tax deferment lasts until you start pulling from your plan. In most cases, you are permitted to start withdrawing money when you reach 59 and 1/2 years old, but you aren’t forced to start withdrawals until you reach 70 and 1/2 years of age.
The primary drawback to a SEP IRA is that contributions can only be made by the employer (you). If you do have employees, by law they must be included in the retirement plan. And, you are not allowed to contribute any more toward your own account than for your workers.
Detailed Benefit Plan
These type of plans are more traditional, and similar to pension plans that used to be the norm. Somewhat surprisingly, these plans have great upside for you if you’re self-employed:
Exceptionally high contribution limits – Although the amount is tied to your age, you can realistically squirrel away around $100,000 per year for your retirement.
Lower tax rate – The contributions that you make to this type of plan can be written off as a business expense. This has the net effect of lowering your taxable income.
Flexibility to use with other plans – While you contribute to a defined benefit plan, the regulations will allow you to simultaneously contribute to a SEP IRA or 401(k).
Tax deferral. As is the case with most plans, contributions to a detailed benefit plan are tax-deferred.
The following are the most notable drawbacks to a detailed benefit plan:
Cost – These type of plans are somewhat complex to initially set up and also relatively expensive to maintain.
Lack of flexibility – You must commit to funding these types of plans at a set level — and even is business falls off for the year, your contributions have to remain the same.
This plan has to be offered to all employees – Just as with a SEP IRA plan, you must make contributions for any employees that you have. This can end up being quite expensive.
Using one of these plans reduces your taxable income and in some cases can place you in a lower tax bracket. This will have the net effect of saving you a lot of money in the short term, while at the same time setting you up nicely for your golden years.
Savings Incentive Match Plan for Employees (SIMPLE IRA)
SIMPLE plans are similar to a SEP IRA in that only a minimal amount of paperwork is needed to set the plan up, and then maintain it going forward. As far as contribution limits, SIMPLE IRA’s rank toward the bottom of the pack — the amount can be a maximum of $12,500 per year, plus another $3,000 annually if you are 50 years of age or older.
Other benefits of a SIMPLE IRA plan include tax-deferred growth, and the feature of matching contributions being deductible as a business expense.
A SIMPLE IRA offers significantly lower contribution limits when compared to a SEP IRA, Solo 401(k), or detailed benefit plan. In addition, there are more regulations to be aware of and abide by compared to the other plans. For example, for the first two years after your beginning funding of your plan, you are not allowed to transfer those funds into any other retirement plan. Further, if you are under 59 and 1/2 years old and take a distribution from this plan in the first two years after creating it, Uncle Sam will impose a 25% penalty on this withdrawal.
One final drawback to a SIMPLE IRA is that any money you contribute toward this plan counts against the maximum allowed $18,000 you can defer to your 401(k).
This type of plan allows for very high contribution limits, given that you are both the employer and the employee. As the employee, $18,000 per year is allowed to be put away toward a solo 401(k) — plus an additional $6,000 annually in “catch-up” funding if you are above the age of 50. A traditional 401(k) allows for contributions to be made pre-tax — a solo 401(k) follows the same parameters.
As the employer, you are allowed to put in 25% of the total revenue from your business (20% if the business is a sole proprietorship or 1 member LLC). This amount is above and beyond the “employee” contribution. The annual allowed maximum for both employer and employee contributions is $54,000 ($60,000 if you include catch-up funding). Finally, 401(k) funding is deductible as a business expense.
The two major downsides to a solo 401(k) are the prohibitive amount of paperwork that is required to be filed with the IRS, and the fact that you are allowed to create one only if the only employees of your company are you and your spouse.
With the number of self-employed Americans currently at 30% and sure to grow over the coming years, the issue of planning and saving for retirement is one that deserves the attention of any self-employed person.
If you have any questions about self-employment retirement plans, please feel free to contact us today!