If you're self-employed, an independent contractor or a small-business owner, you have to take responsibility for a lot of things. One of those is saving for your retirement.
Setting up a retirement plan has significant tax benefits for the self-employed: Contributions are deductible from your income, and money saved in a plan grows tax-free. Also, if you have any employees, a retirement plan can help attract and retain key people.
However, considering that the self-employed can establish several types of retirement plans, it can be confusing as to which one is best for you. Here are the four most common plans for the self-employed (all can be easily set up at any major brokerage firm) along with some guidance on picking one.
Payroll-deduction IRAs: If you don't want take on setting up a formal retirement plan, you can still open and contribute to an IRA. You can also allow your employees to do the same through payroll deductions. As the employer, you can decide to make the IRA contributions for some of your employees, and do so by increasing the gross pay by the amount you want to give them.
This provides a simple, low-cost way to help employees to save. The annual contribution limits for this type of plan is $5,500 ($6,500 for employees age 50 or older). You can set up this informal plan as late as the due date (plus extensions) of your income tax return for a specific year.
Simplified employee pension (SEP): This plan allows employers to set up SEP IRAs for themselves and each of their employees. As the employer, you must contribute a uniform percentage of pay for each employee, who aren't allowed to make their own contributions. In 2015, the most an employer can contribute is the lesser of 25 percent of pay or $53,000.
Other than contributions, setting up an SEP should involve no additional costs, and as the employer you can decide whether to make any contributions to all SEP IRAs in any given year. A SEP for this year can be set up next year as long as you do it before you file your tax return.
SIMPLE IRA Plan: This plan allows employees to contribute a percentage of their pay to an IRA and requires an employer to either match employee contributions (dollar-for-dollar) up to 3 percent of compensation, or make a fixed contribution of 2 percent for all eligible employees, even if they choose not to contribute. SIMPLE IRA plans are for employers with 100 or fewer employees.
Other than the cost of making contributions to employees, these plans typically don't incur other costs to set up and operate. Like the SEP, this plan can also be established the following year, while tax deductions for contributions can apply this year.
Self-employed 401(k) profit-sharing plan: This is my favorite type of retirement plan because it allows the self-employed to make generous contributions both as an employer and as an employee. Using this type of plan, you can make two types of contributions: one that's a percentage of net profit (this is the employer's profit-sharing component) and one that's a fixed-dollar amount up to the employee 401(k) contribution limit of $18,000 ($24,000 for those over age 50) in 2015.
For an individual who declares about $75,000 net profit from self-employment, the total pretax contribution is about $33,000 ($39,000 if you're 50 or older). This plan works best for a sole-proprietor with no employees. That's because if you have any employees age 21 or older and who work at least 1,000 hours per year, you'll have to also open accounts and make similar contributions for them.
Finally, you'll need to establish the SE 401(k) plan and account before year-end to be allowed to make a deductible contribution for this year.