Retirement Plans For the Self Employed

Last Updated Mar 16, 2010 4:12 PM EDT

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With companies shedding millions of jobs over the last few years, you may have found yourself among the ranks of the newly self-employed. Even though you might not work for a large company, you can still create your own retirement plan with about the same (and sometimes better) tax benefits.

Here's a summary of several popular plan options:

IRA. If you're self employed, you can open up an individual retirement account (IRA). For 2010, the maximum contribution is $5,000 if you're under age 50, and $6,000 if you're 50 or older. You just have to make sure that your self employment earnings are at least as much as the amount you're going to contribute to the IRA. The contribution rules are pretty simple if neither you nor your spouse is covered by another retirement plan (such as a 401(k) or pension) during the year.

But if either you or your spouse is covered by another retirement, then there are income limits that may restrict your ability to contribute to an IRA and receive an income tax deduction. The rules are somewhat complex, but basically if you're single, your ability to contribute is reduced once you earn more than $56,000, if you're married, the phase out starts at $89,000; and if you're married and it's your spouse who is covered by another plan, then the phase out starts at $167,000.

If you do qualify to make a tax deductible contribution, once the money is in the IRA, it grows tax deferred until you reach retirement. When you begin to take distributions, the amount you take out each year is subject to income tax.

Most brokerage firms offer low cost IRA accounts.

Roth IRA. You can also contribute to a Roth IRA. With a Roth IRA , you don't receive a current income tax deduction for your contribution, but the money grows tax free once it's in the plan. This means that when you take the money out in retirement, you don't owe any income taxes. It basically works the exact opposite of a traditional IRA, which provides you with an income tax deduction for your contribution, but then taxes the money when distributed.

There are, however, income limits for Roth IRAs, regardless of whether you or your spouse is covered by another retirement plan. Basically, if you're married and make more than $167,000, your ability to contribute to a Roth is reduced and then completely phased out once your income is above $177,000. If you're single, the contribution phase out starts at $105,00 and your ability to contribute is completely phased out at $120,000.

SEP IRA. Instead of opening a regular IRA, you could also consider a SEP IRA, which stands for a Simplified Employee Pension. With a SEP IRA, you can basically contribute 20% of your net self employment earnings up to a maximum contribution of $49,000. The plans are easy to open and function similar to an IRA. SEPs are probably the most popular type of self employment retirement plan.

You can open a SEP IRA at just about any brokerage firm, and have the full array of investment options available to you. You do, however, need to adopt a SEP IRA Agreement, and the IRS has standard forms for these plans.

  • If you're self employed, a SEP IRA will generally work better than a regular IRA. Consider that if you have $80,000 of self employment earnings, you could contribute up to $16,000 (20%) in the SEP and only $5,000 to $6,000 (depending on your age) in the traditional IRA.
  • Now, a regular IRA might work better if your self employment earnings were only $10,000. With a regular IRA, you can do the $5,000 or $6,000 contribution, depending on your age. But with the SEP, you're limited to 20% of your earnings, which in this case would only be $2,000. Thus, if you have modest self employment earnings, the IRA may be better. As your earnings increase, the SEP will probably provide greater tax benefits.
Solo 401(k). The solo 401(k) offers the most flexibility and in general the highest contribution limits, but administratively it's a bit more complicated. The solo 401(k) is relatively new, which is why you don't see many self employed people using them.

With a solo 401(k), the contribution limits are $16,500 if under age 50, and $22,000 if age 50 or older. In general, the 401(k) offers greater tax benefits when compared to a SEP because the 401(k) contribution is not restricted to a percentage of your pay.

  • For instance, if you were 55 years old and had $50,000 of self employment earnings, you could put $22,000 into your solo 401(k). With the SEP, you are limited to 20% of the $50,000, or $10,000.
Moreover, you can also make an additional contribution into the solo 401(k) equal to about 20% of your net self employment earnings. You'll most likely need to have your accountant run the numbers, but basically it's like getting a SEP contribution on top of your 401(k) deferral. See my prior post on solo 401(k) plans for more details.

Many brokerage firms have low cost solo 401(k) plan options, and often allow you to invest in a broad array of investment options, similar to an IRA or SEP.

You'll have to file some additional documents to create the plan. And once you have more than $250,000 in the plan, you'll need to start filing informational returns with the IRS. The paperwork can be a little intimidating, but the flexibility and high contribution limits should be worth it.

Getting Help. Many brokerage firms will provide basic guidance on opening retirement plans, but everyone will tell you that you need to check with your own tax advisor. The retirement plan rules are technical, and there are exceptions to the general rules, so make sure you quality for the plan and then confirm the dollar amounts you can contribute.

Bottom line. The self employed can create retirement plans that offer the same and sometimes better tax and investment opportunities than large companies. Just make sure you get a little help with the process.

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Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.