by Eric Schaefer, CFP®, Financial Advisor, Evermay Wealth Management
In my last post, I gave an overview of common retirement plans available to businesses with two or more employees. Self-employed professionals can also benefit from the current year tax savings, future employee attraction and the diversification benefits of an employer sponsored retirement plan. While most account types available to groups are also available to self-employed business owners, there are a few beneficial differences. Below, I touch on a few popular choices and why they might make sense for your business:
SEP IRA:
Simplified Employee Pension (SEP) IRA’s are a variation of individual retirement accounts set up by an employer for its employees. These are particularly popular with self-employed individuals with sporadic cash flow. For 2015, the maximum contribution is $53,000. Contributions are typically limited to about 20% of business income, adjusted for self-employment tax. SEP IRA’s are different than many other plan types in that contributions are not mandatory and can take place at any time before the filing of the tax return (even if you extend to October 15th). The ease of setup, low administration cost and limited reporting requirements make SEP IRAs a popular choice for solopreneurs.
Individual 401(k) Plan:
Also referred to as a Solo-K plan, an individual 401(k) plan is exactly what it sounds like. Contributions are made by both the employee and employer, allowing for higher contribution limits than an employee could otherwise contribute. Employee contributions are limited to $18,000 per year ($24,000 if you’re over 50). If cash flow and profit permits, a non-elective employer contribution can be made to up to $35,000; a combined total of $53,000 ($59,000 if 50+). The non-elective contribution is based on self-employment income or W-2 if the business is incorporated and paying a salary. An important note: Individual 401(k) accounts MUST be set up before December 31 of the year in which the contribution will count; but the contributions need not be made at that time.
One reason individual 401(k) plans have gained popularity in recent years is because of a planning strategy used by many contractors and consultants who are also employed elsewhere. If they have consulting income and also set up an individual 401(k), they may have the opportunity to contribute an additional “non-elective” contribution of up to $35,000. For a Virginia taxpayer in the 35% tax bracket, that’s an immediate tax savings of $21,597! There are limitations based on business ownership and control, make sure to get an expert’s opinion if this applies to you.
Defined Benefit Pension:
As I mentioned in my first blog entry, pensions may have higher contribution limits, leading to more tax savings for a business owner. In most qualified accounts, the IRS sets blanket limitations annually. With a defined benefit pension, the IRS punts this responsibility to actuaries. The actuaries make their calculations based on your age, income, term of service and intended annual benefit. As you can imagine, a high income earning 63 year old with a starting plan balance of $0 may be able to make contributions well into the six figure range. While these plans cost a few thousand dollars to set up, a client of mine recently saved over $90,000 in 2014 taxes by setting up defined benefit plan. Funding a pension in does not obligate you to take the balance as an annuity at retirement, as you have the option of rolling it into an IRA.
Other Plans:
In the past, retirement plans for individuals were referred to as “Keogh Plans”. These plans aren’t as common anymore as they are less flexible and more costly to administer than SEP IRA’s but are subject to the same contribution limitations. Keogh plans with a defined contribution percentage are required to meet this contribution each year or be subject to a penalty; SEP IRA’s do not have this requirement.
SIMPLE IRA plans were also popular in the past but are still present in many businesses. As the name suggests, they’re simpler to set up than a traditional 401(k) but are limited to lower contribution limits of $12,500 ($15,500 if 50+). In addition to the employee contribution, the business can provide a match of up to 3%. These plans are not popular for self-employed savers as they have lower contribution limits and a small but rigid matching amount.
Conclusion:
While I have only touched on a few of the available options, each saver has a unique financial picture that will determine which plan type is most appropriate. Many business owners and self-employed professionals struggle with saving and planning for retirement, but it’s never too late to start.
Eric Schaefer, CFP® is a Financial Advisor with Evermay Wealth Management, an independent fee-only investment advisory firm in Arlington, VA. Eric can be reached by e-mail at [email protected] or by phone at (703) 822-5696.
In my last post, I gave an overview of common retirement plans available to businesses with two or more employees. Self-employed professionals can also benefit from the current year tax savings, future employee attraction and the diversification benefits of an employer sponsored retirement plan. While most account types available to groups are also available to self-employed business owners, there are a few beneficial differences. Below, I touch on a few popular choices and why they might make sense for your business:
SEP IRA:
Simplified Employee Pension (SEP) IRA’s are a variation of individual retirement accounts set up by an employer for its employees. These are particularly popular with self-employed individuals with sporadic cash flow. For 2015, the maximum contribution is $53,000. Contributions are typically limited to about 20% of business income, adjusted for self-employment tax. SEP IRA’s are different than many other plan types in that contributions are not mandatory and can take place at any time before the filing of the tax return (even if you extend to October 15th). The ease of setup, low administration cost and limited reporting requirements make SEP IRAs a popular choice for solopreneurs.
Individual 401(k) Plan:
Also referred to as a Solo-K plan, an individual 401(k) plan is exactly what it sounds like. Contributions are made by both the employee and employer, allowing for higher contribution limits than an employee could otherwise contribute. Employee contributions are limited to $18,000 per year ($24,000 if you’re over 50). If cash flow and profit permits, a non-elective employer contribution can be made to up to $35,000; a combined total of $53,000 ($59,000 if 50+). The non-elective contribution is based on self-employment income or W-2 if the business is incorporated and paying a salary. An important note: Individual 401(k) accounts MUST be set up before December 31 of the year in which the contribution will count; but the contributions need not be made at that time.
One reason individual 401(k) plans have gained popularity in recent years is because of a planning strategy used by many contractors and consultants who are also employed elsewhere. If they have consulting income and also set up an individual 401(k), they may have the opportunity to contribute an additional “non-elective” contribution of up to $35,000. For a Virginia taxpayer in the 35% tax bracket, that’s an immediate tax savings of $21,597! There are limitations based on business ownership and control, make sure to get an expert’s opinion if this applies to you.
Defined Benefit Pension:
As I mentioned in my first blog entry, pensions may have higher contribution limits, leading to more tax savings for a business owner. In most qualified accounts, the IRS sets blanket limitations annually. With a defined benefit pension, the IRS punts this responsibility to actuaries. The actuaries make their calculations based on your age, income, term of service and intended annual benefit. As you can imagine, a high income earning 63 year old with a starting plan balance of $0 may be able to make contributions well into the six figure range. While these plans cost a few thousand dollars to set up, a client of mine recently saved over $90,000 in 2014 taxes by setting up defined benefit plan. Funding a pension in does not obligate you to take the balance as an annuity at retirement, as you have the option of rolling it into an IRA.
Other Plans:
In the past, retirement plans for individuals were referred to as “Keogh Plans”. These plans aren’t as common anymore as they are less flexible and more costly to administer than SEP IRA’s but are subject to the same contribution limitations. Keogh plans with a defined contribution percentage are required to meet this contribution each year or be subject to a penalty; SEP IRA’s do not have this requirement.
SIMPLE IRA plans were also popular in the past but are still present in many businesses. As the name suggests, they’re simpler to set up than a traditional 401(k) but are limited to lower contribution limits of $12,500 ($15,500 if 50+). In addition to the employee contribution, the business can provide a match of up to 3%. These plans are not popular for self-employed savers as they have lower contribution limits and a small but rigid matching amount.
Conclusion:
While I have only touched on a few of the available options, each saver has a unique financial picture that will determine which plan type is most appropriate. Many business owners and self-employed professionals struggle with saving and planning for retirement, but it’s never too late to start.
Eric Schaefer, CFP® is a Financial Advisor with Evermay Wealth Management, an independent fee-only investment advisory firm in Arlington, VA. Eric can be reached by e-mail at [email protected] or by phone at (703) 822-5696.
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