Self-Employed? Assessing the Retirement-Funding Landscape
The best plan depends on how much you can invest and how much flexibility you need.
When you start at a new job at most companies, you're usually presented with a glossy packet that details your options for insurance and retirement savings. But self-employed folks don't have it so easy. Instead, they're forced to fend for themselves on both fronts.
Lucky self-employed people can piggyback on the health insurance coverage provided by a spouse's employer. But when it comes to retirement savings, everyone's on their own, and selecting the right type of plan can be a complicated business unto itself. Although the tax code includes several breaks to encourage the self-employed and small-business owners to save for their own retirements, selecting the right plan for yourself and your firm entails assessing an alphabet soup's worth of options.
Which type of plan you choose depends on how much you plan to save, how many employees you have now or may have in the future, and how much flexibility you'd like, among other factors.
Here's an overview of some of the key options, along with those types of individuals and small businesses for whom they're best. Note that I've left off a few options, such as traditional pension plans, whose popularity is ebbing away because of their lack of flexibility.
These plans aren't just for self-employed folks, obviously, but they should be a first stop for any self-employed individuals looking to save for retirement. The key benefit is simplicity. You can put almost anything you like inside an IRA wrapper, and you won't have to contend with any messy paperwork or extra fees to start one up. And if you opt for a Roth IRA, you'll be able to take tax-free withdrawals in retirement and won't have to take mandatory distributions at age 70 1/2.
The key drawback is that contribution limits are pretty paltry: $5,000 for those under 50 in 2010 and $6,000 for the over-50 set in 2010. Income limits also put a lid on who can initially contribute to a Roth, but it's possible to get in through the back door by starting a traditional IRA and immediately converting to a Roth. Roth IRA owners can withdraw their contributions at any time without taxes or penalties, offering an ideal escape hatch for those who'd like to save but fear they might need the money at a later time.
Who It's Right For
Because contribution limits are so low, conventional and Roth IRAs are ideal for those self-employed people who aren't in a position to save much for their retirements. But any self-employed individual should make an IRA the first stop on the road to retirement-funding because he can contribute to a traditional or Roth IRA in conjunction with any of the vehicles outlined below.
The solo, or individual, 401(k) is a relatively new option in the retirement-planning market, but these plans have really taken off in popularity in recent years. In part that's because they're familiar--they work much like regular 401(k)s do--and also because they allow for higher contributions than is the case with some other retirement-funding vehicles. You can put as much into a solo 401(k) as you can a conventional 401(k)--in 2010, that's $16,500 for those under 50 and $22,000 for the over-50 set.
You can also sink an additional 20% of your net profits in the plan, up to a total contribution amount of $49,000 for those under 50 and $54,500 for 50-somethings on up in 2010. An additional benefit is that you can do a Roth version of the Solo 401(k), just as you can with a regular 401(k), thereby enabling tax-free withdrawals in retirement in exchange for making aftertax contributions. There are no income limits on contributions, and Solo 401(k) participants can also take loans from their accounts.
Who It's Right For
Just as its name suggests, the solo 401(k) is geared toward individual, self-employed folks and their spouses. It's therefore a good option for those individuals and couples who are in a position to save a fair amount for retirement--not so much for those who have visions of hiring many employees down the line. And even though taking a loan from a 401(k) is never ideal, the ability to do so here is a plus for those who need to tap the money prior to retirement or simply want the flexibility to do so in a pinch. Solo 401(k) participants can contribute more in good years and less money in lean ones, offering another layer of flexibility.
Whereas Solo 401(k)s are geared toward self-employed individuals and their spouses, a savings incentive match plan for employees, or SIMPLE IRA, can accommodate businesses with up to 100 employees. The contribution limits are lower than is the case for Solo 401(k)s: $11,500 for those under 50 and $14,000 for those over 50 in 2010. Much like a regular 401(k), employees make contributions on their own behalf, and their employers can make matching contributions of up to 3% of pay. Contributions are tax-deductible, while withdrawals are taxable. Unlike regular IRAs and solo 401(k)s, SIMPLE IRAs do not allow participants to borrow from their accounts. SIMPLE IRA owners can, however, roll over their accounts into a conventional IRA, provided they've had the plan for at least two years.
Who It's Right For
Although the solo 401(k) allows for higher contributions and greater flexibility (such as loans and the Roth option), the SIMPLE IRA is a good choice for businesses with a few more employees. The costs for startup and ongoing administration are also relatively low. And in contrast with a SEP IRA, which I'll discuss in a moment, the onus of retirement savings falls on the employee, not the employer. (The employer can make matching contributions, but the heavy lifting goes to the employees.)
In contrast with a SIMPLE IRA, the employer makes the whole contribution to the simplified employee pension IRA; employees don't contribute on their own behalf. That's why most SEPs are set up for self-employed individuals or small businesses that seek to reward the owner or a few key partners with rich retirement benefits. Contribution limits are more generous than is the case with SIMPLE IRAs: In 2010, the contribution limit is up to 25% of compensation, to a maximum level of $49,000. (Note that there is no higher allowable contribution amount for those over 50, in contrast with solo 401(k)s.) Contributions can fluctuate from year to year. SEP IRA owners cannot borrow from their accounts. Contributions are tax-deductible but withdrawals are subject to ordinary income tax. Setup and maintenance costs are low.
Who It's Right For
The key appeal is to individuals who own their own businesses, have employees other than just the proprietor and his or her spouse, and would like to contribute a fair amount for their own retirements as well as for their partners or employees. Bear in mind that even though the contribution ceiling is the same for both solo 401(k)s and SEP IRAs--$49,000--the allowable contributions for a solo 401(k) may be higher for many businesses That's because the solo 401(k) contribution may be composed of two elements--the regular contribution of $16,500 (or $22,000 for those 50 and up) as well was 20% of net profits. SEP IRA contributions, in contrast, consist of 25% of compensation alone; there is no baseline contribution that isn't tied to compensation. Nor does the SEP IRA allow for a higher maximum contribution from those ages 50 and above.
I won't spend too much time on this one because if you're considering a Keogh, you'll need to get some outside help before deciding if this is the right option for you. Keogh plans are available to firms with 10 or fewer employees. They come in two main varieties: defined benefit (offers a fixed benefit, much like a pension) and profit-sharing, or defined contribution. Setting up and administering a Keogh is apt to be more costly and time-consuming than implementing the aforementioned plans. So why even consider one? Keogh plan contribution limits may be higher for some individuals, especially those who are highly compensated. Employees can contribute up to $16,500, and employers can kick in up to $49,000, for a total contribution of more than $65,000.
Who It's Right For
Keogh plans are most attractive for individuals who earn a high level of income and can take maximum advantage of the higher contribution limits. For most people, however, extra setup and administrative costs outweigh that benefit.