There are plenty of advantages to self-employment, but there are also a lot of additional responsibilities that aren’t part of the picture when you’re an employee. One of the biggest advantages and drawbacks is the lack of structure for benefit plans. As a self-employed person (with no other employees), you have the freedom to set your own policies, schedule and so forth. But, many of the structures that we take for granted, such as health insurance, taxes, and retirement plans, are solely up to you to set up and maintain. So, you may be wondering where to start when it comes to selecting a retirement plan. We’re here to help.
The two most popular retirement savings plan options for self-employed individuals with no employees are the SEP (Simplified Employee Pension) IRA and the Individual (or Solo) 401(k). As with most things in the financial realm, there’s no such thing as a one-size-fits-all solution, so it’s important to understand which option is best for you. Below we outline both options for self-employed persons (with no employees) at a high level, with a focus on the different benefits to each.
SEP IRA: The Best Choice for Flexibility and Ease of Use
Contributions: The main advantages to a SEP IRA are ease of use, minimal responsibilities for the account owner and flexible timing of contributions. With this plan, you only make contributions from your business as an employer, not as an employee, which is deductible against your adjusted gross income (AGI) on your individual 1040. This plan allows you to open and fund an account right up until you file your tax return. So it’s great for procrastinators or if you need to have flexibility around contributions based on cash flow.
Contribution Limit: The contribution limit for the SEP IRA is 20% of your net income (minus the self-employment tax), up to a maximum of $54k per year. Your contributions are pre-tax, so they will be taxed upon withdrawal.
Roth Options: The SEP IRA does not have a Roth option. Since your income tax bracket could be much higher at retirement than it is currently, you’ll need to weigh the risk of paying more taxes on withdrawal against the simplicity of the SEP.
Loans: Loans against IRAs including the SEP IRA are not permitted under current IRS code.
Individual (or Solo) 401(k) : The Best Choice for Maximizing Contributions from Multiple Sources
Contributions: The Individual 401(k) allows you to contribute from two sources: as an employee and an employer. The contribution rules are stricter than the SEP IRA, and the administrative demands are higher. The deadline for establishing the plan is by the fiscal year end of the business year (typically December 31). Your employee contributions can be made throughout the year, but no later than the fiscal year end of the business year. The employer portion of your contributions can be made up to the filing deadline (or the extension deadline), and there’s a 5500 Form filing requirement.
Contribution Limits: An Individual 401(k) with a profit sharing component allows you to contribute up to $18k as an employee, and then an additional 20% of your net income as an employer annually. If you’re over 50, you can contribute up to an additional $6k of income via a ‘catch-up’ provision, making this an excellent option for someone who’s a little behind the curve on saving for retirement. Regardless of the source, the total contribution limit is $54k ($60K with the ‘catch-up’ provision). The total contribution is deductible against your AGI on your individual 1040.
Roth Options: The employee portion of the contribution can be counted as a Roth contribution, which means it’s after tax. This is ideal if you’re anticipating being in a higher tax bracket upon withdrawal.
Loans: Another advantage to the Individual 401(k) is that you can take loans against your plan. You can take up to 50% of the vested value or $50K, whichever is smaller. This gives you more options for obtaining funds for some of life’s other needs or unexpected surprises without the tax or penalties of withdrawing from your retirement account.
Consider This Example:
Margaret is 60 years old and self-employed (with no employees) and her business earned $100k in net income (after self-employment taxes). If Margaret has a SEP IRA, she would be able to defer $20k (20%) of her business income. If she has an Individual 401(k) with a profit sharing component, she can defer $44k of her business income from her employee deferral ($18K), employer contribution ($20K), and by using the ‘catch-up’ provision ($6K). Ultimately, it’s up to Margaret to weigh the pros and cons of using a SEP IRA or an Individual 401(k). The Individual 401(k) allows her to defer a higher amount, but she may prefer the flexibility of the SEP IRA.
Selecting, setting up and maintaining your retirement plan is a complex process, and it’s easy to overlook the details when you’re doing it alone. Saving for retirement is a critical step in securing your future, and Cray Kaiser can assist you with understanding which plan is right for your specific needs. Contact us today to get started or to make sure you’re on the right track!
Please Note: Policies and percentages are all reflective as of 2017. We will make updates as needed to reflect any changes. Should you have questions in the meantime, please contact us.