Retirement PlansDefinition: An arrangement to provide people with an income during retirement when they're no longer earning a steady income from employment
There's more to being your own boss than not having to answer to anybody: You can also set up your own tax-advantaged retirement program--and probably put aside more each year than you could working for somebody else. Here are some details on the best self-employed retirement plan options out there based on the 2005 tax rules:
SEPs--Simple and Good
Simplified employee pensions--referred to as SEPs or SEP-IRAs--are generic retirement plans that allow you to contribute and deduct up to 20 percent of self-employment income (25 percent of salary if you're an employee of your own corporation). However, the percentage can be varied each year, so lower amounts (or nothing at all) can be contributed when you turn out to be starved for cash. The maximum dollar contribution is $42,000.
SEPs are great for procrastinators because they can be opened up as late as the extended due date of your income tax return. Finally, SEPs are much simpler to establish and administer than Keogh profit-sharing and pension plans. It literally takes only minutes to get one started--usually with no charge--with a bank, brokerage firm or insurance company. No annual government reports are required, and ongoing administrative expenses are nil. The bottom line is SEPs are just as easy as deductible IRAs, but they allow much bigger contributions.
Keogh plans are the self-employed equivalent of corporate retirement programs. They come in two basic flavors: profit-sharing plans and defined benefit 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 $42,000 ceiling. A plan document must be drafted in Year One (this may cost a couple hundred bucks), and the IRS demands an annual report (you can probably do this yourself).
Keogh defined benefit pension plans are designed to deliver a targeted annual retirement benefit, which can be as high as $170,000. 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 can run up to a couple grand. Another negative: You're locked into making the actuarially determined contribution each year. However, if you make good bucks and are over 50, a defined benefit plan may be worth all the trouble--because it permits much bigger contributions than any other type of program. If you're younger, go with a SEP, profit-sharing Keogh or Solo 401(k).
With a Solo 401(k) you can contribute up to 100% of the first $14,000 of your 2005 compensation or self-employment income ($18,000 if you'll be 50 or older at year-end). (This figure rises in 2006 and beyond.) On top of that, you can contribute and deduct an additional amount of up to 25 percent of your compensation income, or 20 percent of your self-employment income.
Roth IRAs--Retirement Plan Dessert
OK, you've now decided to set up a SEP, Solo 401(k) or Keogh plan. But in the true American tradition of greed you still want more, more, more retirement tax breaks. Fine. Take a good look at the Roth IRA. Contributions are nondeductible, but earnings build up tax-free and you can eventually take out all your money--including earnings--without owing Uncle Sam a dime.
For 2005, contributions up to $4,000 are allowed ($8,000 for couples), subject to phaseout between adjusted gross income of $95,000 and $110,000 for singles ($150,000 and $160,000 for joint filers). Fortunately, the phaseouts are high enough to leave most people untouched. The same relatively generous thresholds apply even if you have a SEP, 401(k)or Keogh plan (and even if your spouse is covered by a retirement plan through work of self-employment). So you can contribute the max to your SEP, 401(k) or Keogh and then pop an additional $4,000 (or $8,000) into a Roth IRA to boot. One more thing: You can contribute an additional $500 if you will be 50 or older at year-end. So can your spouse if he or she passes the age test.
Spousal Deductible IRA
While the deductible IRA is a poor stepchild to other self-employed retirement-plan choices, you should know one thing: If your spouse contributes to a retirement plan at work but you do not, you can contribute $4,000 for 2005 ($4,500 if you will be age 50 or older at year-end) to a spousal deductible IRA, as long as your joint AGI is below $150,000. (The deduction is phased out between AGI of $150,000 and $160,000.) While this is all well and good, contributing to a Roth IRA will usually save more taxes in the long run.
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 percent vested. With both Keogh profit-sharing and pension plans as well as 410(k) plans, employees cause lots of complications. The tax guidelines may require you to pay in money on their behalf while limiting contributions for yourself. The existence of employees means you should consult a good employee benefits pro before initiating any type of retirement program (other than contributing to a traditional or Roth IRA for yourself).