4 Ways the Self-Employed Can Save for Retirement

23-Sep-2010

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Advantages/Disadvantages of retirement plans for self-employed:

By Catey Hill, Published September 17, 2010

After working for years at the automotive web site Carfax, Lowell Bike struck out on his own, co-founding MyAutoTips.com. Bike knew starting a business would have its challenges, but he never thought setting up a retirement plan would be so difficult.

“It was confusing,” he says. “There are just so many requirements for each different plan.”

As if saving for retirement wasn’t hard enough already, small business owners have the extra burden of having to set up their own savings funds. Business start-ups reached their highest level in 14 years in 2009, according to the Kauffman Index of Entrepreneurial Activity, and as more Americans become their own bosses, picking the right savings plan is an important planning decision.

But with different costs, advantages, and tax consequences to sort out – on top of the business you’re trying to run – setting up a self-employed retirement account can be tricky. The rewards are well worth it, says Eric Kuniholm, a principal at Boston-based Beacon Capital Management Advisors, which focuses on retirement planning for the self-employed. On top of retirement security, opening the account often results in “a significant and sometimes huge tax deduction,” he says.

Here are some of the major retirement plans for the self-employed — and some of the advantages and disadvantages of each. Keep in mind, in some of these choices, you’ll have to consider yourself both the saver and the employer, which can mean double-paying in some cases. But those plans are also ones you could offer to current or future employees.

Individual 401(k)

The individual 401(k), also known as a solo 401(k), works similarly to a 401(k) at a large company — and you can select between a Roth or a traditional plan. But it is only available for individual business owners and their spouses. The annual contribution limit for 2010 is $16,500 — with the option of a profit-sharing add-on that is 25% of your compensation or $49,000, whichever is less. The plan also offers $5,500 annual catch-up contributions for savers 50 and older. These plans are now offered by most mutual fund and investment management companies.

Pros: This plan is flexible. There are no forced contributions, and sole proprietors can put away more money than they can with the SIMPLE IRA and often more than with the SEP IRA. Business owners can take out a loan from this plan.

Cons: The individual 401(k) is more costly – these plans usually range from about $15 to $250 per year, though some can be even more expensive, Kuniholm says. They’re also more difficult to open and administer than some other options. And because costs vary greatly, savers need to shop around, says Jan Zobel, an Oakland-based enrolled agent and author of “Minding Her Own Business: The Self-Employed Woman’s Guide to Taxes and Recordkeeping.”

Best for: A solo businessperson who wants a higher cap for saving. “For most people, this plan will allow them to put more money away than they would be able to with the SEP,” Kuniholm says. Just be sure you’re up for the hassle of opening and operating the plan.

SEP IRA

The Simplified Employee Pension is basically a pension plan funded by the employer using a simple formula for contributions: In 2010, employers can contribute up to 20% of net self-employment income (or up to 25% of employees’ compensation) or $49,000, whichever is less. Employers of any size are eligible for this plan.

Pros: The SEP is easy and inexpensive to start and administer, typically about $15-$35 per year, Kuniholm says. It also has higher contribution limits than the SIMPLE IRA, and contribution amounts can vary each year, which allows for more flexibility. The SEP can be opened as late as the extended due date for your income taxes – until Oct. 15 for sole proprietors – and requires no annual government reports.

Cons: The sole responsibility of funding the SEP IRA falls on the employer, so if you have employees, you, as the employer, must contribute the same percentage of compensation for them as you do for yourself. Most people can save more with an individual 401(k) than with a SEP IRA. There’s no allowance for catch-up contributions. And you cannot take out a loan from this plan.

Best for: Because the burden of funding the plan falls solely on the employer, this is best for a one-person business or one with very few employees, says Wes Moss, CFP and chief investment strategist at Capital Investment Advisors in Atlanta. It works well for people who want to put away a fairly significant amount of money in an inexpensive and easy-to-maintain way — and have flexibility around their contribution levels.

SIMPLE IRA

The Savings Incentive Match Plan for Employees is a tax-deferred retirement savings plan for small businesses that the employer must contribute to. Employees can if they choose. In 2010, the employer must annually either match employee salary contributions up to 3% (this can be reduced to 1% in any two out of five years) or put in 2% of compensation for all eligible employees — even those who don’t put in money for themselves. Employees can contribute up to $11,500 and an additional $2,500 if they are age 50 or older.

If you’re a solo businessperson, you act as both the employer and employee in this plan, meaning that each year you can contribute up to $11,500 or 100% of your income, (whichever is less), in addition to 2% or 3% of your income. Only employers with fewer than 100 employees and no other retirement plans are eligible. You may be able to hold both a traditional IRA and a SIMPLE IRA depending on your modified adjusted gross income.

Pros: The plan is inexpensive to open and run, typically about $15-$35 per year, and easy to start – it usually just takes one call to a financial institution and a few forms. It’s also easy to administer and requires no annual government reports.

Cons: Contribution limits are low relative to other options. Employer contribution levels are relatively inflexible. Plus participants cannot borrow against their accounts, like they can with a traditional 401(k).

Best for: Not many, says Kuniholm. It’s a simple plan for very small businesses that don’t want to contribute a lot and don’t want to take out a loan from the plan. Because employer contributions are mandatory and this plan cannot be terminated until the beginning of the next calendar year, the SIMPLE IRA is best for an employer who knows he or she will be able to pay the match.

Defined Benefit Plans

The defined benefit plan is similar to a traditional pension with benefits calculated using a formula that includes age, income, target benefit and more. Any employer is eligible, and in 2010 employers may contribute up to $195,000, though the actual contribution depends on the formula calculations. Like a SEP IRA, this plan is funded solely by the employer, but contributions to a defined benefit plan are determined by a complicated formula, which often results in much higher contribution limits than with the SEP IRA.

Pros: The defined benefit plan allows employers to save a much more money than any of the three other plans.

Cons: This plan is very complicated to open and operate, requiring an actuary, who will likely charge fees of more than $1,000, to determine contributions. (You can find an actuary through the American Academy of Actuaries) The contributions to the plan are mandatory.

Plan best for: High-income business owners with the time and resources to set up and administer this complicated plan—and who want to put away a very significant amount of money, Zobel says.

Source: smartmoney.com


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