Self-employment offers both advantages and disadvantages for retirement savings. The primary disadvantage from self-employment is that the self-employed person must personally fund his retirement savings without contributions from his employer. A major advange for self-employed individuals is that usually able to invest a greater percentage of their income into tax deferred retirement accounts than their employed counterparts. The self-employed can save for their retirement through the use of a simplified employee pension (SEP), or a savings incentive match plan for employees (SIMPLE plan), or a self-employed 401k plan.
SEP IRA: A great retirement savings option for the self-employed
A SEP is a retirement plan that allows the self-employed to make retirement contributions to a SEP IRA on behalf of themselves and their employees. A SEP makes use of special type of traditional IRA called a SEP IRA. A SEP plan must be in writing, however, a SEP plan is not required to meet the complex requirements for a qualified retirement plan (such as a 401k plan).
If a self-employed person elects to set up a SEP, the self-employed person must create a SEP IRA for himself and for each eligible employee of the self-employed person. An eligible employee is any employee who is age 21 or older, has worked for the self-employed person 3 out the last 5 years, and earned at least $550 in compensation from the self-employed person.
A self-employed person may contribute up to the lesser of (i) 25 percent of total compensation from self-employment or (ii) $49,000 to his SEP-IRA. If the self-employed person has eligible employees, then the employer must contribute the same percentage of income to the employee’s SEP-IRA as the employer did to his own SEP-IRA. For example, John is a self-employed attorney who earned $100,000 from self-employment. John has 2 eligible employees, a legal assistant who earned $50,000 from employment and a receptionist who earned $25,000 from employment. John may contribute up to a maximum of 25 percent of his compensation from self-employment ($25,000) to his SEP-IRA. If John elects to contribute $25,000 to his SEP-IRA, then John must also contribute $12,500 to his legal assistant’s SEP-IRA (25 percent of $50,000) and $6,250 to his receptionist’s SEP-IRA (25 percent of $25,000).
The advantages of a SEP for a self-employed person are (i) the ease of setting up a SEP and the minimal record keeping requirements to maintain a SEP and (ii) the high maximum contribution limits which allow the self-employed person to maximize his retirement contributions. The major disadvantage of a SEP is the requirement that the self-employed person must make the same percentage contribution to each eligible employee as he makes to himself. If a self-employed person has eligible employees, then making contributions to a SEP can become quite expensive for the self-employed person, effectively limiting the amount that the self-employed person is able to contribute to his retirement account.
SIMPLE Plan: A good retirement savings option for self-employed persons with employees
Under a SIMPLE plan, the employer sets up a SIMPLE IRA for each eligible employee. An eligible employee is anyone who received at least $5,000 in compensation during either of the 2 calendar years before the current calendar year and who is expected to earn at least $5,000 in compensation during the current calendar year. An employer must have 100 or fewer eligible employees in order to set up and maintain a SIMPLE plan.
Under a SIMPLE plan, a participant may make a salary reduction contribution of up to $11,500 to the participant’s retirement account. The employer must make either (i) a matching contribution equal to 3 percent of the participant’s total compensation (not to exceed $11,500) or (i) a non-elective contribution equal to 2 percent of the participant’s total compensation. The employer must make the same percentage contribution to each plan participant.
The maximum amount that a self-employed person may contribute to his retirement account under a SIMPLE plan each year is $23,500 ($11,500 in salary reduction plus $11,500 in matching contribution).
The advantages of a SIMPLE plan for a self-employed person are the ease of administration and the smaller amount of required contributions that must be made on behalf of employees. The major disadvantage of a SIMPLE plan is that the self-employed person may not be able to contribute as much to a SIMPLE plan as to a SEP-IRA.
Self-employed 401k plans
A self-employed person with no employees may be able to maximize his retirement contributions through the use of a self-employed 401k plan. Under a self-employed 401k plan, a self-employed person may contribute the lesser of 25 percent of his eligible income from self-employment or $49,000 to his retirement plan. Additionally, the self-employed person may elect to make an additional salary reduction contribution of up to $16,500 to his retirement plan.
By comparing the self-employed 401k with a SEP-IRA, it is easy to see how the self-employed 401k can allow the self-employed person to maximize his retirement contribution. If we assume the self-employed individual has eligible self-employment income of $100,000, then he could contribute a maximum of $41,500 ($25,000 (25 percent of $100,000) plus $16,500 elective salary reduction contribution). The same self-employed person earning an eligible self-employment income of $100,000 could only contribute a maximum of $25,000 to a SEP-IRA.
The advantage of the self-employed 401k is that it allows a self-employed person to contribute the maximum amount to their retirement account. The disadvantages are that it is only available to self-employed persons with no employees (those with employees could choose to adopt a regular 401k plan) and that a 401k plan has greater record keeping and governmental filing requirements which can add to the expense of maintaining the plan.
Which plan is the best retirement option for a self-employed person?
For a self-employed individual with no employees, the best retirement savings option will be either a self-employed 401k or a SEP-IRA. Both of these plans allow a self-employed person to make greater contributions to their retirement account than does a SIMPLE plan. If a self-employed person has only a few relatively lowly paid employees, then a SEP-IRA is probably the best retirement option. If a self-employed person has a number of employees (but fewer than 100), then a SIMPLE plan is probably the best option as a SIMPLE plan does not require the employer to make as large contributions to employee retirement accounts as would be required under a SEP plan.