Plans for everyone: the IRA and the Roth IRA

Contributions to a traditional or Roth IRA are limited to $5,000/year or to your earned income, whichever is less.   If you’re over 50, you can put in an extra $1,000.   Money put into a Roth IRA is post-tax, but withdrawals after age 59 1/2 are tax-free.  Money put into a traditional IRA can be tax-deferred, subject to income limits, but growth and pre-tax contributions are taxed when withdrawn.

An employer can set up employee IRA accounts which can be funded through payroll deduction.

Best Reference:  IRS Publication 590 — Individual Retirement Arrangements

SEP’s and SIMPLE’s

The Simplified Employee Pension (SEP) allows the self-employed person to sock away more money — 25% of net earnings, up to a maximum contribution of $49,000.  An employer can also contribute directly to a SEP for employees.

“Net earnings” is calculated after the retirement contribution.  For example,  if you earned $100,000 through your business, then you are allowed to put $20,000 in the SEP; because $100,000 – $20,000 = $80,000 and $20,000 is 25% of $80,000.  Why the IRS doesn’t just call it 20% of earnings, I’ll never know.

The Savings Incentive Match Plan for Employees (SIMPLE) allows employees to contribute up to $11,500 ($14,000 if age 50 or over).  The employer can match an employee’s contribution up to 3% of compensation or contribute a fixed amount up to 2% of compensation.

Best reference:  Publication 560 — Retirement Plans for Small Business

The Self-Employed 401(k)

The self-employed 401(k) is most advantageous to those who have relatively modest earnings and want to defer a larger percentage of their income.  It’s also called the solo 401(k) or individual 401(k).

The maximum contribution to a self-employed 401(k) is $16,500 plus 25% of your net earnings, with a total contribution limit of $49,000.   For example, if you earn $100,000, you could defer up to to $36,500 or 36.5% of your total earnings.  If you’re 50 or older you can contribute an additional $5,500 for a total cap of $54,500 (no catch-up contributions are allowed for SEP accounts).  Through a SEP, you could defer only 20% or $20,000.

A disadvantage of a self-employed 401(k) is that it only covers the owner and the owner’s spouse, if the spouse also works for the business.  To add employees, you must switch to a different type of retirement savings plan. There is also a bit more paperwork than for an IRA but nothing insurmountable.

The self-employed 401(k) should also come in the Roth flavor, but you may have to call the brokerage and ask for it.

Best reference:  Fidelity, Schwab, and other brokerages.

Qualified Plans, and Defined Benefit Plans

Qualified plans and defined benefit plans are more complicated than the other types of plans and are usually not of interest for very small businesses.

Best Brokerage for a SEP or Self-Employed 401(k)

Most brokerages will happily set up a SEP or self-employed 401(k) for you.   Schwab,  Fidelity, and Vanguard do not charge account maintenance fees.  Both firms still charge for account transactions (e.g. buying and selling stock).

Remember, you can contribute to your own traditional IRA or Roth IRA (if you’re eligible) in addition to these employer plans, but your combined contribution (e.g. IRA plus SEP) cannot exceed your earned income.

Summary

The SEP is a great option for the self-employed person who wants to put away more for retirement than an IRA allows.  If you want to contribute even more than a SEP, you can create an individual 401(k), but it will cost you some additional paperwork.  Remember, you can contribute to both an IRA and a SEP, so a good option might be to contribute to a Roth IRA and put the rest in a SEP.  Funding both pre-tax and post-tax retirement accounts provides a hedge against future tax-rate hikes.

Disclosure: No position in any company mentioned

Disclaimer: This information is provided for educational purposes only.  Your situation may differ.  For specific advice on your particular situation, please see a financial professional.

Image credit: The Rocketeer at Flickr.

Carnivals: This post as included in this week’s Carnival of Personal Finance – The Women in History Edition hosted at SimplyForties.