Savings Help for Self-Employed

Last Updated Jun 18, 2009 4:26 PM EDT

Tax laws allow self-employed individuals to save a lot more in special independent retirement plans than in regular individual retirement accounts. This helps you make up for the loss of matching contributions from an employer.

There are a few primary types for you to choose from. Which one makes the most sense for you depends upon, among other things, how much you want to contribute, how many employees you have or expect to have, and whether you still get some income from a regular job.   

Best for the Basics: SEP IRA

The SEP IRA is probably the easiest to set up of the retirement plans for the self-employed. Most brokers, banks, and insurance firms can open one for you pretty quickly and with little paperwork.

The SEP IRA makes sense if you are freelancing between jobs, and don’t want to shelter too much income, but like the flexibility of putting away more pretax dollars than you could in a traditional IRA, which caps annual contributions at a measly $5,000 for 2009.

You can contribute up to 20 percent of your earned self-employment income, 25 percent if you’re an employee of your own corporation. The maximum is $49,000 in 2009. If you earn enough as an independent contractor to take advantage of this high contribution ceiling, it can help make up for lost 401(k) matching contributions from your employer.

Best for Big Savers: The Solo 401(k)

The primary reason to go with an Individual 401(k) is it lets you put away even more money than the SEP IRA. It will take a bit more paperwork to set up, usually through a brokerage firm. You also need to set it up by the end of the year in which you earned the income.

This route makes sense if you make pretty good coin on your own and want to shelter as much of it as possible from taxes.

The maximum contribution is the same as for the SEP IRA: $49,000 in 2009. But Individual 401(k)s allow you to make two sets of contributions that can really add up. First, you can save up to 100 percent of the first $16,500 of your 2009 income ($21,500 if you’re over 50). Then, you can contribute as much as another 20 percent of your self-employed income (25 percent if you’re an employee of your own corporation).

For example, if you net $20,000 after deductions and self-employment taxes as a freelancer, you can shelter your whole take. First, you can tuck away $16,500 right off the bat. You can then save up to another $4,000 (or 20 percent of your income), which more than covers the $3,500 you haven’t already put away.

One caveat: if in addition to moonlighting for yourself, you also work for an employer who offers a 401(k), you can’t double up your contributions. The total you can put into the company’s 401(k) and your own can’t top $16,500 combined. So, if the company matches contributions into its plan, go with that one first and capture the free money the boss is handing out. You can still fund your own plan: any contributions you make to your employer’s plan don’t diminish the 20 percent of business income you can put into your self-employment plan, whether it’s a solo 401(k) or a SEP IRA.

Best for the Pros: Keoghs

If you have employees and need a more sophisticated retirement plan, you might want to investigate a Keogh. These plans require professional help in setting up; in return, they let you get more creative, including by establishing profit-sharing plans, defined benefit plans, or money-purchase plans.

With Keoghs, a profit-sharing plan gives you some flexibility, because your contributions are dependent on profits. This means you can completely skip making contributions in a slow year. A money-purchase Keogh requires making contributions every year. The maximum deductible contribution for both the profit-sharing and money-purchase plans is 25 percent of annual income, with a limit of $46,000.

Bottom Line?

If you’re thinking much smaller — say you want to save just $4,000 — then “you’re better off doing a Roth IRA,” says Mickey Cargile, a certified financial planner and managing partner of WNB Private Client Services, an advising firm in Midland, Texas.

So before you do anything else, if you’re self-employed, consider opening a href="http://moneywatch.bnet.com/saving-money/article/ode-to-the-tax-free-roth/277182">Roth IRA if you don’t already have one. In contrast to these pretax savings plans, Roths allow you to save after-tax dollars and grow that money tax-free. They also take just minutes to set up through a brokerage firm, financial planner, or mutual fund company. But there are income limits: For 2009, only couples with modified adjusted gross income less than $176,000 can open a Roth. For singles, the number is below $120,000. Assuming you meet these income limits, you can have a Roth IRA in addition to a self-employed retirement account, just as you can have both a Roth IRA and a traditional employer-sponsored 401(k).

So if you find yourself newly self-employed against your will, don’t worry about your retirement plan. You’re more than adequately covered. That leaves you free to tell your old company to take both your old job and your old 401(k) and shove it.

  • Paulette Miniter

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