There are a plethora of things that seems to constantly be on the mind of a business owner or self employed individual and quite often retirement planning is not one of them. After all, who can think about retirement planning that affects 40 years down the road when there is next weeks payroll, next month’s tax bill, and next years business insurance to think about?
In the United States it is quite common for individuals to leave it up to their employers to kick start the retirement planning efforts of the individual by automatically enrolling them in a 401(k) or other employer provided retirement plan. Those who are self employed do not have the luxury of enlisting the help of an HR department for retirement plan help as quite often the small business owner is their own HR department!
Those who are self employed and neglect the education needed to plan for their own retirement properly do so at their own peril. A properly designed self employed retirement plan will not only make one’s financial future in retirement that much more secure but also is an important element of tax savings that you just do not want to miss. Here is a guide to some of the various retirement plans available to those who are self employed.
The 401(k) plan is by far the most widely known type of retirement plan. A 401(k) plan is very flexible in that participants can invest in stocks, bonds, CD’s, company stock, etc. Contributions made into a 401(k) receives tax privileged treatment as an above the line deduction, the money invested into a 401(k) grows tax deferred, and taxed are not paid on money in a 401(k) until the money is withdrawn for retirement.
Self employed individuals can set up a single 401(k) (solo 401(k)) for just themselves or if they have employees then they can set up a traditional 401(k) plan to cover themselves and their employees.
The advantage to setting up a 401(k) plan as a business owner is that offering a 401(k) plan is a great method of boosting employee retention because 401(k) plans are so well known that they are almost synonymous with retirement planning in the mind of many.
The disadvantage to setting up a 401(k) plan as a self employed individual is that the administrative costs of 401(k) plans are somewhat higher than many other self employed retirement plan options like IRA’s and SIMPLE IRA’s.
Individual Retirement Accounts (IRA’s)
After the 401(k) the IRA is quite possible the most well known type of retirement plan as the IRA is available to both self employed and non self employed individuals. Even though the IRA is not designed only for the self employed it is still a great self employed retirement plan option because of the great tax advantages.
There are two main types of IRA’s: traditional and Roth. The major difference between the two is that contributions into a traditional IRA are deductible in the year the contribution is made as an above the line deduction while the money in the account grows tax deferred as taxes are paid when the money is distributed from the account as opposed to the Roth IRA which does not enjoy a tax deduction for contributions made but does offer tax free growth within the account with no taxes due when distributions are made.
There are many different rules and regulations that affect both traditional and Roth IRA’s but if you are stuck and can’t decide whether to choose a Roth or a traditional IRA then here is a good rule of thumb (everything else being equal): if you anticipate being in a higher tax bracket when you retire and begin to take distributions then choose a Roth. If you anticipate being in a lower tax bracket when you retire and begin to take distributions then choose a traditional IRA.
A SIMPLE plan is technically also an IRA but it is designed specifically for small businesses. SIMPLE stands for Savings Incentive Match Plan for Employees of Small Employers) and is a great way for small business owners to save for their own retirement while also providing a way for their employees to save for their retirement as well.
Some of the advantages to SIMPLE plans is that much like a regular IRA a SIMPLE IRA is very easy to establish, has low administrative costs, and many different financial institutions offer SIMPLE IRA plan setup.
The disadvantages to to SIMPLE plans is that compared to some of the other retirement plan options available for the self employed a SIMPLE plan has relatively low contribution limits.
The SIMPLE is ideal for sole proprietors or those who are self employed with few employees and in businesses with relatively high employee turnover rates.
SEP stands for Simplified Employee Pension and is also a type of IRA like the SIMPLE. SEP plans are ideal for many self employed individuals because:
- They allow substantial contributions to the plan (much higher than SIMPLE IRA’s),
- They allow contributions (and even formation) all the way up to the due date of the tax return. Tthis means you can wait until the last second to set up a SEP plan for the prior calendar year as long as the plan is set up and SEP contributions are made before the tax return filing deadline
- The contribution requirements for SEP’s are very flexible, meaning that you don’t have to contribute a huge amount every year to a SEP and is therefor ideal for self employed individuals with fluctuating incomes who one year might be flush with cash but the next year might have difficulty paying off the business credit card every month
- The administration and setup for SEP’s is very low cost (like SIMPLE IRA’s)
- Contributions to a SEP receive an above the line tax deduction.
From an employer’s perspective the one disadvantage to a SEP plan is that every single employee that meets the SEP eligibility guidelines must have a SEP established in their name and receive a contribution from the employer. This could be relatively onerous for the self employed individual with many employees since the SIMPLE plan has much stricter employee eligibility requirements.
An additional type of SEP plan that is also used by some small businesses is the SAR-SEP. The SAR-SEP stands for Salary Reduction SEP plan and is designed for companies with 25 or fewer employees as a low cost way of letting employees defer part of their salary into a retirement plan.
Keogh plans (also called HR 10 plans) are retirement plans designed specifically for the self employed (and are available only to the self employed) that can be structured as a defined contribution plan (like a 401(k) plan) or a defined benefit plan (like a pension plan). Keogh plans are used by some but not as popular as SIMPLE plans, SEP plans, or Solo 401(k) plans because Keogh plans are somewhat difficult to set up, are relatively expensive to administer, and can be an all around hassle to properly design and maintain.
Which Self Employed Retirement Plan is Best?
The important thing to remember is that there is no “one size fits all” retirement plan that is best for everyone that is self employed. How much money your business makes, how many employees you have, how much money you would like to contribute to a plan, and many other factors will help you to determine which option is best for you. The important thing to do is what any future value calculator will tell you: “It’s better to start saving for retirement sooner rather than later!” What other self employed retirement plan options have YOU considered?
Contributor’s articles are written by members of the personal finance community. Each article was reviewed Moolanomy’s editorial team before its publication.