The self-employed are in a unique position when it comes to saving for retirement. While they won't get the benefit of employer-matching 401k contributions, they do have access to a variety of tax-advantaged retirement accounts. And the self-employed may be able to sock away more into these retirement accounts.
As with all things related to retirement savings, self-employed retirement options are complex and varied. So figuring out what options you can use and which is the best fit for you can be a bit confusing. To help clear up the confusion, let's look at three of the more popular options.
A SEP (Simplified Employee Pension) IRA
plan is available to employers and self-employed individuals alike. The SEP-IRA, like a traditional IRA, operates with pre-tax contributions. The main advantage to these plans is that they're simple and streamlined, which usually translates into lower costs. This is true even if you add employees to the plan down the road.
A SEP-IRA is essentially a traditional IRA with a different name. You can open a SEP-IRA at many financial institutions (here is a list of brokers
with low costs).
You can set up an SEP-IRA at any point during the year, up to the due date (including extensions) of your income tax return for that year. So you can set up and contribute to an SEP-IRA for 2013 all the way up to your filing deadline for 2014.
One huge advantage of an SEP-IRA over a traditional IRA for the high-earning self-employed is its contribution limits. Right now, you can contribute up to $5,500 per year
(plus a $1,000 50-and-older catch-up contribution) to a traditional IRA. A SEP-IRA has much higher limits
, up to as much as $52,000 in 2014.
With a SEP-IRA, you also have the option of flexible contributions. If you don't earn a lot in a year, you don't have to contribute a lot. If you earn more, you can contribute more. You can make that decision on an annual basis based on your business performance for the year.
A SIMPLE (Savings Incentive Match Plan) IRA is another type of IRA set up for small-business owners and the self-employed. You can open this account if you have 0 to 99 employees making more than $5,000 each.
You can't have another retirement plan for your business besides the SIMPLE IRA. So you can't open it up alongside an SEP-IRA plan that would be effective for your employees, but you can contribute to both a SIMPLE IRA and a personal retirement account, like a Roth IRA.
Like the SEP-IRA, SIMPLE IRAs have much higher contribution limits than either traditional or Roth IRAs. Also like the SEP-IRA, they're relatively simple (no pun intended) to set up and affordable to run.
Unlike the SEP-IRA, you can put 100 percent of your net earnings from self-employment into the account, up to the $12,000 limit (for 2014). Plus, you'll add additional contributions of either a 2 percent of salary nonelective contribution or 3 percent matching contribution.
The SIMPLE IRA has lower contribution limits than the SEP-IRA, but its limits may be easier for some self-employed individuals to reach. If you're earning $50,000 a year or less, you'll probably be able to save more in a SIMPLE IRA than you would in an SEP-IRA plan. That's because the SIMPLE IRA doesn't have a percentage-of-income contribution limit.
Solo 401k's are also called one-participant 401k plans, the IRS terminology for these plans. A Solo 401k covers a business owner with no employees. While it can cover a spouse, it cannot cover employees.
The overall annual limit for a Solo 401k is the same as the annual limit for an SEP-IRA, $52,000 for 2014. However, with the Solo 401k, you can get to the limit more easily by making both employee elective deferrals and employer nonelective contributions.
With a Solo 401k, you can contribute up to the annual limit of $17,500 ($23,000 for those 50 and older) as an employee and add an employer nonelective contribution of up to 25 percent of your total self-employment income.
Since you can first max out your employee contribution of $17,500 and then add 25 percent of your remaining compensation, you could potentially save more money with the Solo 401, than with the SEP-IRA. (Even though the SEP-IRA is a little simpler to figure.)
If you're likely to benefit more from tax-free withdrawals down the road than from tax savings now, you might consider a Roth Solo 401k. Not all financial institutions offer them, but many do.
Although it's usually not a good idea to take a personal loan from your retirement account, with a Solo 401k, you have that option. The loan program
works similarly to how it would if your 401(k) was with an employer.
If you're leaving an employer with a 401k plan to become self-employed, it's pretty simple to roll your old 401k over to your Solo 401k. You can also roll over a traditional IRA plan into your new 40k).
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