The government gives you lots of choices if your self employed to save for retirement. Not only do you have the typical options—a traditional IRA, a Roth IRA but you can also choose from a SEP, an individual 401k, a keogh (pension or money purchase) or a defined benefit plan for your self employed retirement plan. These plans allow larger contributions and don’t have phase out limits based on your income. Let’s take a look at each and a comparison.
SEPs — Simplified Employee Pension
Often referred to as SEP-IRAs — this type of self employed retirement plan allows you to contribute and deduct up to 20% of self-employment income (25% of salary if you're an employee of your own corporation).You may vary the percentage contribution each year from 0% to the maximum. The maximum dollar contribution for 2008 is $46,000.
Unlike traditional IRA or Roth IRA accounts which must be opened by December 31, SEPs can be opened as late as the extended due date of your income tax return. SEPs are much simpler to establish and administer than Keogh profit-sharing and pension plans as you don’t need to file form 5500. SEPs are just as easy as deductible IRAs, but they allow much bigger contributions.
Self Employed Retirement Plan Options*
|SEP||20%*/$46,000||None||Simple to establish and administer|
|Keogh||20%*/$46,000 (or more)||None||Can be designated a profit-sharing plan, pension plan or both|
|Individual 401(k)||$46,000/$51,000 if age 50 or older at year end||None||High contribution limits mean you can lower your tax bills and generate more tax-deferred earnings for your retirement stash.|
|Defined Benefit||$185,000, limited by age||None|| Annual
contributions mandatory—allows people age 50+ to sock away a lot of money
Based on 2008 limits.
* 20% of self-employment income or 25% of compensation for employees.
Keogh plans are the self-employed equivalent of corporate pension and profit sharing plans. Like their corporate cousins, this type of self employed retired plan comes in two basic flavors: profit-sharing plans and pension plans. To get a deduction for the current tax year, the plan must be established before year's end. Once that's done, actual contributions can be deferred until the extended due date for that year's return.
Annual contributions to Keogh profit-sharing plans are based on a percentage of self-employment income or compensation and subject to a $46,000 ceiling or 13% of self employment income. If you establish a pension plan, you can do so in conjunction with a profit sharing keogh so that your full contribution can get up to 20% of self employment income. But the pension plan contribution is fixed and mandatory each year whereas the profit sharing plan may vary each year from 1% to 13% of self employment income.
Defined Benefit Plan
Defined benefit pension plans are designed to deliver a targeted annual retirement benefit, which can be as high as $185,000. Each year's contribution must be calculated by an actuary — the exact amount depends on your income, the target benefit, years until retirement and anticipated investment returns. Annual actuarial fees and the required IRS report may be $2,000 annually so it general, your earnings should be $250,000 or more to make this type of self employed retirement plan a viable choice. Another negative: You're locked into making the actuarially determined contribution each year. However, if you are over 50, a defined benefit plan may a great choice because it permits much bigger contributions than any other type of program. The annual contribution is mandatory so your cash flow should be such that you can fund the plan each year. This type of self employed retirement plan is a bad choice if you will have employees unless they are very young (contributions are small for young employees).
With an individual 401(k) you can contribute up to 100% of the first $15,500 of your 2008 compensation or self-employment income ($20,500 if you'll be 50 or older at year-end). On top of that, you can contribute and deduct an additional amount of up to 25% of your compensation income, or 20% of your self-employment income, not to exceed $46,000 for 2008. In other words, you get to contribute as if you are the employer and then additional contribution as if you are the employee. So you could get a total of $66,500 into your individual 401k if you have sufficiently high income and are age 50 or older making this a very good self employed retirement plan. You must establish your plan by Dec. 31.
The problem with employees
If your business has employees, a SEP, Solo 401(k) or Keogh generally must cover them as well — meaning you'll probably have to make contributions that don't just benefit yourself. All employee SEP contributions are immediately 100% vested. With both Keogh profit-sharing and pension plans as well as 401(k) plans, employees cause lots of complications (i.e. you need to take your money and contribute to their accounts). But, if the employees tend to be young and turnover high or if they work part time, keogh plans allow you to eliminate those who do not have 2 years of tenure with your company or those that work less than 1000 hours annually. In addition, with Keogh and 401k self employment retirement plans, you can vest the contributions so that if your employees leave say after 3 years, most of the money you have contributed into their accounts is reallocated to the remaining employees (i.e. mostly you). The tax guidelines may require you to pay in money on their behalf while limiting contributions for yourself.
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