Two Retirement Plans for the Self-Employed

There are lots of challenges for the self-employed, such as finding new business, financing expansion or even fixing a computer that just lost its internet connection. One challenge that every self-employed person must face is how to effectively save for retirement.

Self-employed people have to have even more disciplined than employed workers when it comes to retirement savings. There are so many temptations to use the money that you should be saving for your eventual retirement. I know this first hand!  I’m also self-employed.

You have to sort through the various types of plans, pick one….oh, and then you have to actually save some money. Yes you could use the IRAor Roth IRA, but both of those limit your contributions. I’m going to discuss two plans that I think work well, and allow even greater contribution levels than $5,000-6,000.

It really boils down to two.

First up, the SOLO 401(k). 

Sometimes referred to as the individual k. These plans are available to independent contractors, freelancers and sole proprietors. You can set up one if you have a regular job and some self-employment income on the side. Solo Ks have lots of flexibility and a large deferral limits.

Since you are technically both employer and employee, you can contribute to the plan in two ways. From the employee side, you can stash up to 100% of your pay, up to a limit of $17,000 in 2012. If you are over 50, you get an extra $5,500 catch up contribution.  All total $22,500.

As the chief bottle-washer (employer), you can sock away a whopping 20% of your earnings! If you are incorporated it increases to 25%. So, in 2012, you can contribute from both employer and employee up to $50,000, or $55,500 if you are over 50. The IRS always tries to make it easy to understand.

For the purposes of determining the amount you can contribute, “compensation” is defined as your gross income minus business expenses, minus one-half of your self-employment taxes—that is, Social Security and Medicare taxes, which in 2012 total 13.3% of the first $110,000 of income.

So, for example, if you are over 50 and have net self-employment income of $50,000, you could contribute a maximum of $22,500 as an employee, plus the maximum employer contribution of $9,294, for a total of $31,794. Get it?

So where’s the catch? Limits on elective deferrals are calculated by person, not by plan. So, if you have contributed $10,000 to another employer’s 401(k), you can defer only $7,000 in your individual 401(k).

Next is the SEP-IRA. Simplified employee pensions are often called SEP-IRAs, because your contributions go into an IRA. You can contribute up to 25% of your net self-employment income, up to a maximum of $50,000 in 2012. Contributions are deductible as a business expense.

You can have pretty much any type of investment you want in a SEP. From CDs to mutual funds to ETFs. The SEP is probably the most used plan for solo acts. Fees are usually pretty low in a SEP.

Individual 401(k)s must be established by Dec. 31, but you can contribute as late as the tax-filing deadline (generally April 15, or Oct. 15 if you file for an extension). The deadline to set up and contribute to a SEP-IRA is the tax-filing deadline.

Don’t wait, taxes are probably going up in 2013! Retirement plans are a good way to save and reduce taxable income. If you are self-employed and need some help with your retirement planning, write me at david@lexwealth.com, or call me at (859) 225-2596.