Self-employed individuals are notoriously busy, but that does not mean that planning for retirement should be put on the back burner. A recent survey indicated that 70% of America’s 10 million self-employed individuals are not saving regularly for retirement and 28% aren’t saving at all. It is well worth the time to explore the tax-advantaged options to fund your retirement years.
For self-employed individuals, the plan options are IRA-based, defined contribution and defined benefit plans. It is important to review the benefits and detriments of each in order to choose the one that is most advantageous for your future, as well as considers the structure of your business and, if applicable, any employees. It is also important to understand any additional tax or regulatory compliance associated with certain plans.
With an IRA-based plan, the benefits upon retirement depend on the funding of the IRA and the related gains and losses over the years. Similarly, a defined contribution plan does not state a specific benefit upon retirement; the benefits are dependent on the contributions plus the earnings on the investment. A defined benefit plan promises a specified benefit at retirement, such as $1,000 per month. The annual contributions must be sufficient to fund the promised benefits.
The most common types of retirement accounts for self-employed individuals include solo 401(k)s, SEP IRAs, profit sharing plans, and defined benefit plans. An overview of each is below and a more detailed summary can be found in this excerpt from the joint Department of Labor/IRS brochure, Choosing a Retirement Solution for Your Small Business.
- A solo 401(k) is best for someone who has no other employees, other than a spouse, which makes it exempt from discrimination testing. Benefits include higher contribution limits. Contributions can come from annual salary deferrals of up to $18,000 plus an additional $6,000 if you are older than age 50 as well an additional 25% of net earnings from self-employment for total annual contributions of up to $53,000. A spouse can also participate with these same limitations. An additional bonus to this plan is that the employer contributions are deductible as a business expense. One logistical drawback is filing an annual report with the IRS if you have at least $250,000 in the account.
- A Simplified Employee Pension IRA, or SEP IRA, is best for individuals who have few or no employees and want flexibility with contributions to the fund. These plans are simple to create and no annual reporting with the IRS is required. Contributions of up to 25% of compensation or just under 20% of your Schedule C net income are permitted, with a max of $53,000 for the year. This plan can get expensive if you have employees because contributions to this plan can only come from you, as the employer, and contribution percentages must be equal among everyone.
- A profit sharing plan works well with individuals who have a slightly larger number of employees because of the flexibility afforded to the employer regarding contributions. Individuals can have a business of any size and this plan can coincide with other retirement plans. Contributions to the plan are strictly discretionary; so during low performance years, no contribution is necessary. If contributions are made, a formula is needed to determine how contributions are divided among employees. The contribution limit is the lesser of 100% of compensation or $53,000 in 2016. Two requirements of this plan are annually filing a Form 5500 and discriminatory testing to ensure the plan does not unfairly benefit higher-compensated employees.
- A defined benefit plan is great for individuals who have high, stable incomes and the ability to defer a substantial amount for retirement. Contributions are based on total desired benefit in retirement and requires an actuarial calculation. The maximum annual benefit can be up to $215,000 for 2016. This plan can also work in conjunction with other plans, such as a 401(k) and/or a profit sharing plan. Like a 401(k), the contributions can be written off as business expenses, thus reducing taxable income. However, when you commit to funding the plan at a certain level, you must maintain that level of contribution. This is also not the most ideal plan if you have employees since this must be offered to everyone and it can become very expensive. An entrepreneur without any employees and the ability to shift a significant amount of current income to retirement savings is a great fit for this strategy. In this scenario, benefits typically exceed the compliance costs.
There are several strategies for self-employed retirement planning that can make your financial future more secure while capitalizing on current and future tax benefits. To explore your options, please contact me at firstname.lastname@example.org or 609-689-9700. As a full-service accounting and financial firm, our advisors can help guide you or your business through complex tax planning.