Participating in an employer-sponsored retirement plan is one of the best ways to save for retirement – especially if they match your contributions.
But what about for those who are their own employers? According to a recent study, the number of self-employed people in America is expected to reach 42 million by 2020. And these are all people who need to retire just like those who are employed by others.
There are some good retirement plan options available for those who are self-employed – and for their employees. Here’s a quick breakdown of three of the most common plans: SEP IRAs, Solo 401k’s, and SIMPLE IRAs.
Simplified Employee Pension (SEP) IRA
What is a SEP IRA?
This type of retirement plan allows business owners to contribute to both their employees’ retirement savings and their own by investing in a SEP IRA (Simplified Employee Pension Individual Retirement Account) for each participant. These types of accounts are very similar to traditional IRAs, and follow the same rules for investments, distributions, and rollovers. Like traditional IRAs, SEP IRAs will allow any earnings to grow tax-deferred until you withdraw them when you are retired. Keep in mind that contributions must be cash and cannot be property.
However, despite their similarities, SEP IRAs and traditional IRAs are very different when it comes to contribution limits, and who can contribute. Anyone can contribute to a traditional IRA, but SEP IRAs are meant for employees of small businesses and individuals who are self-employed. There are some eligibility requirements, though, that may be a little more restrictive than other available plans. Consult a professional for a complete list.
SEP IRA Contribution Limits
Contribution limits are the same if you are contributing to your employee’s SEP IRA or if you are self-employed and contributing to your own. As of 2018, contribution limits cannot exceed the lesser of:
- 25% of compensation, or
- $55,000 for 2018
According to the IRS, “up to $275,000 of an employee’s compensation may be considered. If you’re self-employed, use a special calculation to determine contributions for yourself.” The calculations can get more complicated if you are self-employed, so a professional advisor could be a great resource for helping to clarify your specific situation.
Benefits & Challenges of SEP IRAs
SEP IRAs were created specifically for small business owners who wanted to offer retirement plans to employees and for self-employed individuals. Many small business owners don’t employ enough people to justify a full 401(k), so the SEP IRA is a great benefit to offer in a small business setting.
A SEP is also a great vehicle if you want to actively manage investments, since all trades are made with no tax consequences. Many SEP providers offer a wide range of investment choices.
However, it’s important to note that all employees must receive the same percentage of earned income or compensation (up to 25%), so these plans can be expensive. Additionally, SEP IRAs do not allow catch-up contributions, as they are funded only by employer contributions.
Solo 401(k)/Solo Roth 401(k)
What is a Solo 401(k)/Solo Roth 401(k)?
Solos were created primarily for high net worth “owner-only businesses,” or those with only part-time employees. Examples of such business might be private practice doctors, CPAs, or small family businesses. Solo 401(k) plans allow for the same deferrals found in traditional 401(k) plans, and the employer contributions found in profit-sharing plans.
Solo 401(k) Contribution Limits
According to the IRS, contribution limits for solo 401(k) accounts are:
- Employee Contributions: For 2018, the elective deferral is $18,500, or $24,500 if age 50 or older.
- Employer Nonelective Contributions: 25% of compensation as defined by the plan.
- Self-Employed Contributions: You must make a special calculation to determine your elective deferrals and nonelective contributions. The IRS states that when you are calculating the contribution, compensation is your earned income and is defined as “net earnings from self-employment after deducting both:
- one-half of your self-employment tax, and
- contributions for yourself.”
You can use the worksheets in Chapter 5 of IRS publication 560 for determining your allowable contribution rate and tax deduction. The total contribution amount is not to exceed $55,000.00 in 2018.
Benefits & Challenges of a Solo 401(k) Plan
A solo 401(k) offers higher contribution limits than a SEP or SIMPLE plan. There are also flexible contribution options, meaning that you are able to contribute as much as legally allowed, but you are not obliged to do so.
The solo 401(k) also contains a Roth-type sub account – the solo Roth 401(k). This type of account allows contributions without any income restrictions, and tax-free withdrawals in retirement.
Solo 401(k) plans also come with relatively easy administration. There are generally no filing requirements unless your plan reaches $250,000 in assets, at which point the account holder will need to begin filing with the IRS.
These plans can be complicated to set up and maintain, so make sure you do your research before opting into one of these plans. There are several restrictions that may not be immediately obvious – for example – you can only open a solo 401(k) if you have no employees other than your spouse.
What is a SIMPLE IRA?
A SIMPLE IRA plan allows individuals to contribute to traditional IRA plans if they are small business owners, work for a small business, or are self-employed. It was created as a solution for small employers who do not currently sponsor a retirement plan.
They are available to any small business with fewer than 100 employees and are relatively easy to establish. The employer, however, cannot have any other retirement plan if they are setting up a SIMPLE IRA.
SIMPLE IRA Contribution Limits
According to the IRS, contributions to a SIMPLE IRA include:
- Salary reduction employee contributions: This type of contribution is limited to $12,500 in 2018. If you are 50 or older, you are eligible for a $3,000 catch-up contribution.
- Employer contributions: Can be either matching contributions or nonelective contributions.
- The employer is generally required to match an employee’s contribution up to 3% per year.
- Alternatively, an employer can also make non-elective contributions of 2% of each employee’s compensation per year (up to $275,000 in total compensation per eligible employee), provided they give the employee sufficient notice.
Benefits & Challenges of a SIMPLE IRA
SIMPLE IRAs do not have the start-up and administrative costs that traditional retirement savings plans often have. There are also no filing requirements associated with a SIMPLE IRA so the plan is simpler to maintain than some other traditional retirement savings vehicles.
While the SIMPLE IRA is a great option for many people, it’s important to note that the contribution limits are quite a bit lower than the alternatives. Another caveat to note: if you plan to make an early withdrawal, you can face a penalty of up to 25% within the first couple of years.
Another type of account that is gaining popularity amongst self-employed and entrepreneurial individuals is the ROBS plan (Rollover for Business Startups), which isn’t a vehicle for saving for retirement, but does bear mentioning in this conversation. It is, however, a way to invest funds from a retirement account like an IRA or 401(k) into a new business venture without incurring early withdrawal penalties and taxes.
A Rollover Business Startup or ROBS plan can be a risky and complicated option for people wanting to use their 401(k) to fund a business. In order to increase the probability of success, you would need to work with a lawyer who is familiar with this type of plan and must start with at least $50,0000. ROBS allows you to purchase stock in your startup company inside the 401(k) and use those funds for the running of the business. This can be a risky proposition if the business fails. There is also a risk of the IRS nullifying the ROBS plan if it isn’t set up or maintained correctly. If this does happen, the ROBS plan is treated as a taxable distribution and can be subject to taxes and penalties. Employing a competent CPA and tax lawyer can help avoid these potential pitfalls.
If you are self-employed or operate a small business, there are several retirement savings vehicles available to you. The SEP IRA, solo 401(k), and SIMPLE IRA plans all have benefits and drawbacks, so it’s important to thoroughly research which option works best for your unique situation before making a decision. A financial advisor can help you navigate this, and determine which account is the best fit for your overall financial life.
To learn more about which plan might be right for you, contact a financial advisor.