Retirement Plans for the Self Employed

What Now?

So you quit the corporate rat race to start your own business.  It’s hard work, but you enjoy the freedom and the thrill of being your own boss.  There is nothing that you miss about your old job.

Except maybe your 401(k). 

Traditional and Roth IRAs are nice, but limited as to the amount you’re allowed to contribute each year.  You feel it’s not enough to fully fund your retirement needs.  And you need tax savings now.

Consider the world of small business retirement plans.  There are several plans that are specific or adaptable for small businesses or sole proprietorships.  These include the SIMPLE IRAs, SEP and SARSEP IRAs, and Keogh plans.  Keogh plans (also called HR-10 plans) are qualified plans that include Solo 401(k)s, profit sharing plans, money purchase plans and defined benefit plans.  Each plan has its advantages and disadvantages, and applicability to different business situations.  Each one is highlighted below.

SIMPLE IRA

The SIMPLE IRA (Savings Incentive Match Plan for Employees Individual Retirement Account) is a tax-deferred employer-sponsored retirement plan similar to large 401(k) and 403(b) plans, but with simpler and less costly administration.  The SIMPLE IRA is funded with pre-tax dollars. 

Contributions are currently limited to 100% of net earnings up to an $11,500 maximum ($14,000 for persons over 50).  This is lower than the current limit of $16,500 for traditional 401(k) and 403(b) plans, but more than double that of traditional IRAs. 

Only employers with less than 100 employees may establish SIMPLE IRAs.  After crossing the 100-employee threshold, the SIMPLE may continue for two more years before a different plan must be implemented. 

Employees are not required to make regular contributions, but the plan does require a certain minimum contribution from the employer.  This minimum is either a dollar for dollar match on the first 3% of employee salary, or a flat 2% of salary for each employee with at least $5000 in compensation for the year.

This type of plan would be appropriate for businesses with no employees, or with few employees if you’d like to offer them an incentive to continue to work for you.  The mandatory employer contribution is generally less for a SIMPLE than for a SEP.  If the number of employees is getting close to 100, you may want to consider a traditional corporate retirement plan to save the hassle of having to change it over.

SEP IRA

The SEP IRA (Simplified Employee Pension Individual Retirement Account) is a variation of the IRA.  It has no significant administration costs for self-employed persons with no employees.   

Contributions for the self-employed person is limited to 25% of net earnings from self-employment, or $49,000, whichever is less.  The formula for net earnings from self-employment is all revenues minus expenses minus the deduction for one half of your self-employment tax minus deductions for contributions to the SEP IRA.  (If this sounds convoluted to you, don’t worry; the IRS has a cheat sheet for this calculation.)

If the self-employed person does have employees, the employees must receive the same benefits as the owner (the same percentage rate).  For the employees, the SEP IRA is similar to a traditional IRA only with higher contributions limits and with contributions made by the employer, not the employee.  The IRS maximum restrictions on employee eligibility is be at least 21 years of age, has worked for the employer for at least three of the last five years, and received at least $500 in compensation during the year.  Your plan eligibility may be less strict than this(i.e., younger age, etc.), but not more. 

A SAR-SEP is a variation in which the employee may also contribute a portion of their pre-tax pay.  SAR SEPs are allowed only if the employer has fewer than 25 employees during the prior year.

Similar to a SIMPLE IRA, a SEP IRA would be appropriate for businesses with no employees, or with few employees if you’d like to offer them an incentive to continue to work for you.  The mandatory employer contribution would be higher for a SEP than for a SIMPLE.  Another difference in choosing between a SEP or a SIMPLE IRA is in the amount of net earnings from self-employment.  The pivot point is $46,000.  Using the SEP calculation, 25% of $46,000 is $11,500 – the maximum contribution for the SIMPLE.  At less than $46,000, a SEP actually would allow a maximum contribution that is less than what would be allowed in a SIMPLE.  So for a self-employed person with no employees, and with net earnings from self-employment above $46,000, a SEP IRA would be a wise choice; otherwise, use a SIMPLE IRA.

Keogh Plans

Also called HR-10 plans, these are considered qualified plans for tax purposes.  These include Solo 401(k)s, profit sharing plans, money purchase pension plans, and defined benefit plans

Solo 401(k)

Similar to a corporate 401(k), a Solo 401(k) offers tax-deferred savings for business owners.  The business must be very small, limited to the business owners and their spouses.  It also works for partnerships, including partners’ spouses.  You may have part-time employees who work less than 1,000 per year; they will be excluded from the plan.  If you have an employee that works more than that, you can’t do a Solo 401(k).

Got more questions? Contact Us or email Casey Smith directly at [email protected].