Saving for retirement is a hot topic. Financial pressures can keep young people from starting their retirement savings early in their careers, and most Americans don’t put enough away over the course of their working years. The problem is particularly acute for the self-employed, who miss out on the convenience and contributions of employer-sponsored plans. Fortunately, there are excellent options for self-employed workers to set aside funds for retirement in tax-advantaged accounts. These are the top three plans to consider:
SEP IRA: The Retirement Solution for Small-Business Owners
The Simplified Employee Pension Individual Retirement Account (SEP IRA) is a popular choice for those who are self-employed or own small businesses that have few employees. They are quite similar to traditional IRAs in terms of structure and tax benefits, and they work well for individuals who are looking for flexibility in how much and how often to contribute.
The primary tax advantage to an SEP IRA is that taxes on contributions are deferred. Those who participate in an SEP IRA program pay no taxes on their savings until distributions are taken – usually after retirement. It’s important to note that if distributions are taken before the age of 59 ½, you may be liable for taxes and tax penalties.
The business may also realize tax advantages on contributions made for employees. IRS Publication 4333 provides additional detail on SEP IRA tax benefits for businesses.
The reason that SEP IRAs are popular with individuals who are self-employed or have a small number of employees is that all contributions to these accounts are made by the employer. If employees want to make contributions, it’s necessary to open a separate account under a different type of retirement savings plan. There are IRS requirements with regard to who can participate in a SEP IRA, and employers must ensure the following criteria are met:
- Participants must be 21 years old or older.
- Participants must have worked for the company at least three out of the past five years.
- Participants must have received a minimum of $600 in compensation from the business.
Employers can make plan eligibility less restrictive, but they cannot make eligibility criteria more restrictive.
Total contributions to an SEP IRA cannot exceed certain IRS limits. In 2017, the maximum SEP IRA contribution is 25% of compensation or $54,000 – whichever is lower. This figure is adjusted annually based on cost-of-living changes. The primary issue to consider when deciding whether an SEP IRA is right for you is this: Businesses that offer an SEP IRA to any employee – including the business owner – must offer the SEP IRA to every eligible employee. This isn’t an issue for individuals who are self-employed, but it can be expensive as small businesses expand.
Setting up an SEP IRA for yourself and your employees is simple and inexpensive. You can use the basic IRS template (Form 5305-SEP), or you can work with your financial services provider to customize the program. If you are offering SEP IRA benefits to employees, each eligible participant must be given a copy of the plan.
SIMPLE IRA: Retirement Savings for Business Owners with Employees
Self-employed people who own small businesses that have fewer than 100 employees often find that the SEP IRA is not quite suited for their needs. Instead, they prefer the Savings Incentive Match Plan for Employees (SIMPLE IRA). This program is better suited to individuals who want to save for their own retirement and encourage their employees to do the same.
Each employee owns their own account, and they can add to employer contributions using their own funds. Employee contributions are made with pre-tax dollars, and no taxes are assessed until distributions are taken. The IRS places a limit on the amount employees can contribute to their accounts. In 2017, that figure is $12,500, and it is reviewed each year.
Employers have two options for contributing to employees’ SIMPLE IRA accounts. They can either match employee contributions up to 3% of total compensation, or they can make across-the-board contributions of 2% of total compensation for all employees.
Business owners must allow all eligible employees to participate in the plan. The IRS defines eligible employees as those who have earned $5,000 or more from the business in two preceding years and are expected to earn at least that amount in the current year.
Establishing a SIMPLE IRA is fairly straightforward. The first step is to choose a financial institution to handle the accounts. You can then use IRS templates to set up the program. Form 5304-SIMPLE is for plans that permit employees to choose their own financial institutions for their individual accounts, and Form 5305-SIMPLE is for plans that will keep all employee accounts together in the same financial institution.
Once you have committed to the SIMPLE IRA plan, you must stick with it for at least two years. If you decide to move funds out of your SIMPLE IRA to another type of plan before the two-year mark, you may be charged a 25% IRS penalty. As with any IRA, taxes and penalties may be assessed for any distributions taken before the age of 59 ½.
Solo 401(k): Individual Accounts for the Self-Employed
If you are self-employed and have no employees, the Solo 401(k) may be the right choice. This program is specifically designed for individuals (and their spouses) to take advantage of some of the tax benefits that employees of larger organizations enjoy. Your personal contributions to the Solo 401(k) are tax-deferred, so your deposits are made with pre-tax dollars, and you have no tax liability until you take a distribution. You can increase the amount of your savings by making additional contributions from the business, which may offer additional tax benefits for the business.
Your Solo 401(k) contribution limits are the same as those of standard 401(k) plans. You can contribute up to 100% of your earned income, up to the IRS limit – in 2017, that limit is $18,000. The limits are reviewed each year to determine whether they need to be adjusted due to changes in the cost of living.
The rules for withdrawing from your Solo 401(k) are the same as the rules that apply to standard 401(k) plans. If any distributions are taken before you reach the age of 59 ½, a 10% tax penalty may be assessed in addition to any taxes you owe.
Visit your financial service provider to establish your Solo 401(k) account. These experts have the forms you need to get the ball rolling. Note that the Solo 401(k) is known by a variety of other names, so don’t be alarmed if your financial services provider calls your account any of these: Self-Employed 401(k), Individual 401(k), One-Participant 401(k), Solo-k or Uni(k). All of these terms refer to the same retirement savings program.
Setting funds aside now ensures you can live the lifestyle you want once you have retired. However, when you’re self-employed, you don’t always have the same opportunities that are available to employees of large organizations. By establishing one of the tax-advantaged retirement plans for self-employed individuals, you can enjoy tax-deferred status on your contributions. This allows your savings to grow even quicker.
Are you self-employed? What is your preferred retirement savings plan? Let us know in the comments below.
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