Run your own business? Here’s help choosing the right retirement saving strategy for you.
Whether out of choice or necessity, the ranks of the self-employed are growing.
No matter what you call them—independent consultants, contract employees, entrepreneurs or just plain freelancers—self-employed people account for more than a quarter of those working in the U.S., according to a 2010 survey by Kelly Services, a human resources consulting firm, up from 19% three years earlier. While the trend was fueled by the recession, workplace experts say it's here to stay.
Working for yourself can mean more flexibility, greater job satisfaction and the potential for a bigger paycheck. What it doesn't offer is a neatly packaged bundle of benefits. That means the burden for saving for retirement falls solely on you.
There are plenty of options
The good news: There are ample opportunities for self-employed savers to sock away tax-deferred money. In fact, you have the potential to save even more on your own than you would working for someone else, says Brian Hogan, director of retirement product management for Fidelity Investments.
Before you dive headfirst into choosing a retirement account, though, make sure you've addressed such things as lining up health insurance and building your cash reserves. “You don't want to lock money in a retirement plan only to have to pull it out,” says Bill Losey, a certified financial planner in Wilton, N.Y.
Next, give some thought to your business. Do you have employees? Will you have some next year? And what sort of retirement benefits, if any, do you plan to offer? Some plans put the burden of saving for your employees’ retirement on you, the business owner, says Hogan.
The issue is complex, and can add a layer of administrative headaches. So it’s a good idea to talk with your tax adviser. The primer below outlines the key advantages and caveats of the various options for self-employed savers. Don't drag your feet though. Just because you don't punch in doesn't mean the retirement clock has stopped ticking.
SEP IRA
Available to self-employed workers and small businesses, the Simplified Employee Pension plan, or SEP, is essentially an IRA with bigger contribution limits. How big? For the 2010 and 2011 tax years, you can contribute up to 25% of your compensation up to a maximum of $49,000.
That limit is significantly higher than the $16,500 you could sock away in a company 401(k). “For ease of use, this is my favorite plan,” says Losey. “It's easy to open, there are no annual reporting requirements and you can adjust your contributions as you see fit.”
Advantage: You have until your tax-filing deadline to establish the account and make contributions, and you aren't obligated to make regular contributions to your account or your employees' accounts. For 2010, that means you can still set up a plan and make a deductible contribution by April 18; if you file an extension you may have until Oct. 15.
Caveat: If employees are in the picture, they can't make contributions to the plan, but you can contribute money on their behalf.
Solo 401(k)
A relative newcomer, the solo or self-employed 401(k) became available in 2002 and resembles the employer 401(k) plans most people know and love.
“Because of its familiarity, more people are leaning toward these plans,” says Cheryl Costa, a certified financial planner with AFW Advisors in Natick, Mass. You can contribute 100% of your compensation up to $16,500 ($22,000 if you're over 50) plus 25% of your compensation through profit-sharing for a maximum grand total of $49,000 a year.
Moreover, some plans allow participants to opt for Roth contributions, in which case they pay taxes now for the potential to save taxes later. Whether or not you go this route depends on many factors but it's worth a look. “Chances are you already have plenty of deductions as a self-employed person or business owner,” says Jerry Cannizzaro with Retirement Planning Services Inc. in Oakton, Va.
Advantage: The maximum allowed is the same as a SEP. But if your adjusted earned income is $82,500 or less, you'll be able to save more in a solo 401(k) than in a SEP, where contribution limits are tied to income and don't include profit-sharing. “If you have excess cash flow a solo 401(k) may be the way to go,” says Losey.
Caveat: If you have full-time employees you need not apply; plans are only available to self-employed individuals or companies with no employees other than spouses. Unlike the SEP, the plans do have annual reporting requirements.
Simple IRA
Available to self-employed workers and businesses with 100 employees or fewer, the plans are as easy to set up as the name suggests. The differences between a SEP and Simple IRA show up if you have employees. Unlike a SEP, where only employers can make contributions on behalf of their employees, these plans let employees save up to $11,500 ($14,000 if 50 and older) toward their retirement.
They also allow employers to make matching contributions of up to 3% of compensation or contribute up to 2% of each employee's salary, up to $4,900. If you are a self-employed individual or owner of the company you can effectively match your own savings. But if you match your own savings you'll be required to do the same for your employees. And once you start making contributions, says Costa, you may be required by law to continue with that match.
Advantage: If you have employees, a Simple IRA allows them to make their own contributions to the plan.
Caveat: Contribution limits are significantly lower than those for the SEP or the solo 401(k).
Keogh
Introduced in the 1960s as the original self-employed retirement plan, Keoghs went out of vogue with the introduction of the three plans mentioned earlier. These days the term Keogh generally is used to describe two other types of individual retirement plans, profit-sharing plans and defined-benefit plans. Both can be a hassle to set up and to maintain, requiring a plan document and annual report.
With profit-sharing plans, which are based on a percentage of income and capped at $49,000, it's probably not worth it. But if you're looking to play catch-up for retirement and have the cash to invest, a defined-benefit plan may be worth checking out, says Costa. The reason: You can put up to $195,000 a year in a defined-benefit plan — but your actual contribution is based on an annual actuarial calculation that takes into account things like your income, years to retirement and projected returns.
Advantage: Potentially huge — up to $195,000 — in contribution limits.
Caveat: They're expensive and present an administrative headache.
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