RETIREMENT PLANS FOR THE SELF-EMPLOYED

As a self-employed person, I wonder: what is the absolute maximum I can put into my retirement plan?

So you've paid into Social Security for years, but you fear that the benefits will not keep you afloat when you retire. You realize that you need to start planning for retirement. But where to begin?

You may want to look into various retirement plans that allow you to defer taxes on money you put into them, getting a tax break now, and — you hope — getting a reduced tax rate later when you withdraw the money, and the interest it's earned.

You have four main categories of retirement plans to choose from:

1. Traditional IRAs
2. Saving Incentive Match Plans for Employees (SIMPLE Plans)
3. Simplified Employee Pensions (SEPs)
4. Keogh Plans

To decide which plan might be best for you, review the following summaries and discuss your options with your accountant or financial planner.

Traditional IRAs

If you received taxable compensation during the year, and if you were not 70-1/2 years or older by the end of the year, you may set up and contribute to a traditional IRA.

You are setting up the IRA as an individual, not as a business owner. Anyone who has earned income (or has a spouse who has earned income) can have an IRA.

Contribution Limits

With a Traditional IRA you can contribute up to $3,000, or your earned income for the year, whichever is less. Your earned income includes any compensation you have gotten from your business.

Because you are self-employed, your compensation from the business is the net earnings. To calculate the net earnings:

1. Add up your total income from your business operations.
2. Subtract any deductions you can take on your tax return, including
   • The deduction you get for half of your self-employment tax (because you have paid both halves of this tax, as employee and as employer)
   • The deduction for the amount you intend to put into other self-employed retirement plans.

(This calculation gets a little circular, because you have to figure out how much you are going to put into the IRA, then deduct that from your income, then figure what your earned income is for the year, to see if you have contributed too much, and so on.)

If you don't work, you can only make contributions if you receive alimony or file a joint return with a spouse who has compensation.

If you’ll be age 50 or older by the end of the year, you can contribute an additional $500 beyond the basic $3,000 limit, so your maximum contribution can be $3,500 – as long as your earned income is sufficient.

Deducting what you Contribute

You may be able to deduct your contribution in whole or in part. How much you can deduct depends on your income, filing status, and whether you’re covered by another retirement plan. The actual amount you can deduct is calculated on various IRA worksheets that are provided with the instructions to Form 1040 and Form 1040A.

If you or your spouse are covered by a retirement plan at any time during a year in which IRA contributions are made, you may not be able to deduct the full amount of the contributions on your return. Depending on your level of income and your filing status, you may find that your deduction gets reduced or eliminated. Ask your tax preparer or accountant for assistance if you find yourself in this situation, or use tax return preparation software such as TurboTax to help you figure out just how much you can deduct.

If you happen to put more money into the IRA than you can deduct on your return, you’re allowed to leave the money that you can’t deduct in your IRA. For example, if you contribute $2,000 and can only deduct $500, you can leave the other $1,500 in the IRA as what’s called a “nondeductible contribution.” Later, when you withdraw the $1,500 you won’t be taxed on this money (because you have already paid taxes on it).

For more information, see FAQ on the Traditional IRA.

SIMPLE Plans

SIMPLE Plans can be a set of SIMPLE IRAs for all participants or a SIMPLE 401(k) Plan for all.

You can set up a SIMPLE plan for yourself, and any employees you have. The plan can be a set of SIMPLE IRAs for all participants, or a single SIMPLE 401(k) Plan for all.

If you do set up a SIMPLE IRA, and you have employees, then you must set up one for each employee.

If you work by yourself, you are considered both employer and employee.

Contributions

SIMPLE plans allow for both the employer and employee to contribute to retirement accounts on the employee's behalf. Employees make these contributions through salary reductions, and employers make matching or non-elective contributions.

• Matching contributions require that the employer match each employee’s salary reduction on a dollar for dollar basis.
• Non-elective contributions are made by the employer, without giving the employee the choice to take the cash instead.

Contribution Limits

The maximum amount an employee can contribute to the plan (via salary reductions) is $8,000. Also if you’ll be age 50 or over by the end of the year, you may contribute $500 more, for a maximum contribution of $8,500. Remember: As a self-employed person, you are both the boss and the staff, so you get to make contributions as an “employee” of the business, and as the employer.

The maximum contribution allowed by the employer is dependent upon whether the contributions are matching or non-elective.

• Matching contributions are limited to 3 percent of the employee's compensation. A lesser percentage can be matched, but more red tape is involved. So basically you, as an “employee” of your own business, can also contribute another 3 percent of your “compensation” (remember, your net earnings) plus the $8,000.
• Non-elective contributions are limited to 2 percent of an eligible employee's compensation.

SIMPLE 401(k) plans must satisfy the rules that apply to any 401(k) plan, and these rules are much more involved. However, the contribution limits and the employer eligibility requirements for the SIMPLE 401(k) are virtually the same as those for the SIMPLE IRA.

Eligibility

An employer may establish a SIMPLE retirement plan if the business:

• Had 100 or fewer employees who earned $5,000 or more in compensation during the preceding year
• Continues to have 100 or fewer employee each year that the plan is maintained
• Considers eligible all employees employed at any time during the calendar year, whether or not they're eligible to participate
• Treats the SIMPLE IRA as the only retirement plan to which contributions are made or benefits accrued

Eliminating or reducing the prior-year compensation requirements can create less restrictive eligibility requirements.

Simplified Employee Pension (SEP)

You can set up a Simplified Employee Pension (SEP) plan also known as a SEP IRA, for yourself, and any employees who are eligible. Basically, as the employer, you are contributing to an account which is similar to a traditional IRA - not a Roth IRA.

Eligibility Requirements

To be eligible to participate in a SEP program, an employee must:

• Be at least 21 years old,
• Have worked for the employer in at least 3 of the last 5 years, and
• Have received at least $450 in compensation

Less restrictive participation requirements can be substituted. Ask your accountant or financial planner for guidance and requirements.

Contribution Limits

Contributions are limited to the lesser of

• 25 percent of the employee's 2004 compensation for, or
• $40,000

As an employer, you are not required to contribute to SEPs every year. However, when contributions are made, they must be made to the SEP-IRAs of all participants who performed services during the year for which the contributions are made, including employees who died or terminated before the contributions are made.

As a self-employed person, you are considered an employee of your own business. You get compensation from the business. Your compensation is the net earnings from your business. To calculate the net earnings:

1. Add up your total income from your business operations.
2. Subtract any deductions you can take on your tax return, including
   • The deduction you get for half of your self-employment tax (because you have paid both halves of this tax, as employee and as employer).
   • The deduction for the amount you intend to contribute to your own SEP IRA.

(This calculation gets a little circular, because you have to figure out how much you are going to put into the SEP, then deduct that from your income, then figure what your earned income is for the year, to see if you have contributed too much, and so on.)

Example: Bill’s business nets $10,000 so Bill can make a $1,859 contribution to his SEP. Now why isn’t it $2,500? Because the rule is that compensation is defined as your net earnings from your business after you deduct the SE tax deduction and SEP deduction itself… a circular calculation. So, here’s the math: $10,000 - $707 - $1,859 = $7,434 x 0.25 = $1,859, the contribution amount.

Keogh Plans

There are two main types of Keogh plans, a defined benefit plan and a defined contribution plan. Defined benefit plans tend to be much more involved because they require actuarial assumptions and computations to accurately determine benefits to participants. To set up and fund a defined benefit plan, you need professional assistance.

Here, we focus on defined contribution plans. There are two types:

• A profit sharing plan provides definite formulas for allocating the overall company contribution to participants and for distributing accumulated funds to participants after they reach a certain age, after a fixed number of years, or upon other occurrences.
• A money-purchase pension plan sets up a fixed contribution, based on the participant’s compensation. For example: If the plan requires that contributions equal 10 percent of a participant’s compensation, 10 percent of the participant’s compensation must be contributed every year, regardless of profitability or affordability.

As a self-employed person, you can create a Keogh just for yourself. In that situation, you are considered an employer with only one employee (you). If you do have real employees, you can set up a Keogh for yourself and your employees, but you must include them in the plan. You cannot just set up a Keogh for yourself, and exclude your employees.

Contributions

Contributions go into an individual account that's set up for each plan participant. Both the employer and the employee contribute to defined contribution Keogh plans. The employee's contribution is not tax deductible, unless the plan is also an elective deferral plan (a 401(k) plan). Earnings on both employer and employee contributions remain tax-free until they're distributed in later years.

Eligibility

To be eligible to participate in a defined contribution plan, an employee must:

• Be at least 21 years old
• Have worked for your company for at least 1 year. (Plans other than 401(k) plans require at least 2 years of employment and provide that after not more than 2 years of service the employee has a non-forfeitable right to all of his or her accrued benefits).

Contribution Limits

Contributions and other additions to a participant's defined contribution plan cannot be more than the lesser of:

• 100 percent of compensation paid to the participant
• Deduction limit = 25 percent or 41,000 for 2004

Next Steps

The next step is to choose the option that's right for you — and your employees, if you have any.

You should then consider how you want to invest the money in the plan — in stocks, bonds, mutual funds, regular savings accounts, or some combination.

Tip: get professional assistance in choosing how to invest this money.

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