Tax-Savvy Retirement Plan Options for the Self Employed
John Chichester, Jr. CFP, CPA, PFS
With all the negative news on the so-called demise of our Social Security System, many small business owners are unsure where to turn when it comes to installing a qualified retirement plan. Most self-employed business owners cannot afford the costs nor need the complexity of the traditional 401(k) plan. So where do they turn?
Fortunately, there are other types of retirement accounts that are easy to set up and inexpensive to maintain, namely the Simple IRA, SEP-IRA, and Solo 401(k). What they all have in common is up-front tax deductibility and tax-deferred growth: Contributions are usually tax-deductible, and the account owner doesn’t pay taxes on the potential earnings until they withdraw the money.* There are, however, key differences among these major plans, most significantly how much can be contributed and what happens when the business owners add staff. Because they can’t fully fund more than one in a single year, the business owner needs to make a choice.
Option #1 Solo 401(k)
Typical Customer: If their business is doing well or they need to catch up with their savings. The generous contribution formula of this self-employed version of the corporate benefit staple lets them put aside more money at a lower income level than they can with a SEP. (In the event that they can save even more, they’ll need a profit-sharing plan, an option that can be expensive and complicated.)
It is also possible to take out a loan against a Solo 401(k), a great feature if they’re running a business and worry that any money in a retirement plan will be out of reach for years to come. What if they need funds during a business crunch? They can borrow half the account’s balance, up to $50,000, and typically take up to five years to pay it back (provider rules vary).
Unfortunately, once their balance exceeds $100,000, the IRS requires an annual filing of Form 5500, which could cost a few hundred dollars.
2006 Limit: 100 percentof first $15,000 in income, plus 25 percentof total net income, up to $44,000; $49,000 if they are 50 or older
Pros: High contribution limit; they can borrow against the balance
Cons: More paperwork; with full-time help, they must switch to a traditional 401(k) or stop funding the plan
*Ordinary income taxes are due upon withdrawal. Penalties usually apply for non-qualified withdrawals. Speak to a professional for guidance.
Option #2: Simplified Employee Pension IRA (SEP-IRA)
Typical Customer: If they run a one-person show and plan to keep it that way. They can open one at virtually any bank, mutual fund company, or brokerage firm, and pay low or no annual account fees. Their contribution limit is based on a simple formula: they can put away as much as 25 percentof their net income, up to a cap that is periodically raised to keep pace with inflation. But what’s especially appealing is a SEP’s funding flexibility. They can wait to fund the plan until they file their taxes. So if their income turns out to be higher than expected, they can make a large contribution and cut their tax bill. Ordinary income taxes are due upon withdrawal. Penalties usually apply for non-qualified withdrawals. Speak with a tax professional for professional guidance.
2006 Limit: 25 percent of net income, up to $44,000
Pros: Flexible funding rules; easy to open; low or no fees
Cons: If they hire help, the funding rules can make the plan costly; no loans allowed
Option #3: Simple IRA
Typical Customer: If they work alone but aspire to run a bigger business. What if they are having such a great year that they decide to hire even one full-time employee? With a SEP-IRA or Solo 401(k), they can face hassles. SEP rules can lock them into expensive employee contributions. With a Solo 401(k), unless that helper is married to them, they’ll have to stop funding their plan or convert it to a traditional 401(k). For that, most rely on professional help, and they may even have to hire a third-party plan administrator, often at considerable expense. With a Simple IRA, they can keep investing in the same plan. Note: simple stands for “savings incentive match plan for employees,” so they have to match their employees’ contributions, up to three percentof pay. One of the restrictions with a Simple IRA is that they can contribute no more than $10,000 a year ($12,500 if they’re 50 or over), which may not be enough to fund a comfortable retirement.
2006 Limit: $10,000; $12,500 if they are 50 or older
Pros: Easy and inexpensive to open
Cons: The lower contribution limits may not be enough to fund a comfortable retirement
So, as tax season has ended, now may be a perfect time for self-employed business owners to figure out which of these three major sole-owner plans best suits their business and personal needs.
John J. Chichester, Jr. CFP, CPA*, PFS, is a registered representative of
AZ CPA – June 2006
This content has not yet been Rated.
To Rate content, please Login.
