(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)
One of the biggest benefits of being self-employed is that there are more (and better) retirement plan options available to you than are available to most taxpayers. In addition to the standard traditional IRA/Roth IRA options that everybody has, you have three more noteworthy options:
- Simplified Employee Pension (SEP IRA),
- Savings Incentive Match Plan for Employees (SIMPLE IRA), and
- Individual 401(k) — sometimes called a solo 401(k) or a self-employed 401(k).
Much of the IRS literature comparing these three options is rather complicated. Fortunately, most of that literature is irrelevant if you have no employees. If you have no employees, the primary difference between the plan options is the contribution limit for each. (Note: These limits are not cumulative, so there’s usually no benefit to opening more than one retirement plan for your business.)
If you do have employees and you want to set up a retirement plan for your business, I strongly recommended that you consult with a tax professional, not only because there are additional factors in the decision of which plan to open, but because there are ongoing reporting requirements as well.
I should also note here that there are several other types of retirement plans aside from the three listed above. But for self-employed taxpayers without employees, it’s unlikely that any of the other plan types will be a better choice.
Retirement Plans in General
Most of the retirement plan options for self-employed taxpayers function similarly to a traditional IRA. That is, contributions made to the plan reduce your taxable income, and your investments are allowed to grow tax-deferred until you start making withdrawals from the plan. Unfortunately, contributions are above the line deductions rather than Schedule C deductions, meaning they save you money on income tax but not self-employment tax.
SEP IRAs work in almost the exact same way as a traditional IRA. That is, you are allowed an above the line deduction for any contributions you make. The only really important difference is the contribution limit. For 2015, if you have a SEP, you are allowed to contribute the lesser of:
- 25% of your net earnings from self-employment, or
Once the money is in the plan, you can invest it in all of the same things you would be allowed to invest in with a regular IRA (stocks, bonds, mutual funds, CDs, etc.). Also, the same withdrawal rules apply. With a few exceptions, you cannot make withdrawals from the plan prior to age 59.5 without being penalized.
One important thing to know is that, for purposes of calculating your maximum contribution, “net earnings from self-employment” is perhaps not quite what you’d expect. Basically, it’s all your revenues, minus your expenses (makes sense so far), minus two other items:
- The deduction for one-half of your self-employment tax, and
- The deduction for contributions to your SEP IRA.
The idea of deducting your contribution amount when attempting to figure out how much you can contribute in the first place might sound a little confusing. It turns out it’s not so tricky: 25% of your net earnings from self-employment is just 20% of your net earnings from self-employment before considering your deduction for SEP contributions.
EXAMPLE: Prior to considering any deduction for SEP contributions, your net earnings from self-employment for this year are $80,000. Assuming you do not contribute to another retirement plan for your business, your annual SEP contribution will be limited to $16,000 (20% of $80,000).
SIMPLE IRAs also function much like traditional IRAs. Again, the primary difference is the contribution limit. If you have a SIMPLE IRA, you can make:
- An employee contribution equal to 100% of your net earnings from self-employment, up to $12,500 for 2015 ($15,500 if you are 50 or over), plus
- An employer contribution equal to 3% of your net earnings from self-employment.
For SIMPLE IRA purposes, “net earnings from self-employment” is your revenues, minus your expenses, times 92.35% (to account for your deduction for one-half of your self-employment tax).
EXAMPLE: You’re under 50 years old, and, after subtracting your deduction for one half of your self-employment tax, your business’s net profit is $50,000. Assuming you don’t contribute to any other retirement plans, the most you’ll be able to contribute to a SIMPLE IRA is $14,000 ($12,500, plus 3% of $50,000).
One other difference between a SEP IRA and a SIMPLE IRA is that, should you have to make an early withdrawal from a SIMPLE IRA within two years of the plan’s inception date, you will be penalized more than you would be if it were a SEP IRA (25% penalty as compared to 10% penalty).
Individual 401(k) Plans
An individual 401(k) plan functions very much like a 401(k) plan with a person’s employer. The difference is that you are allowed to make a contribution in the role of employee and a contribution in the role of employer. You are allowed to make:
- An employee contribution of 100% of your net earnings from self-employment, up to $18,000 for 2015 ($24,000 if you are 50 or over), plus
- An employer contribution of 25% of your net earnings from self-employment.
This employer contribution is the same as the contribution you can make to a SEP IRA, and it uses the same definition of “net earnings from self- employment” that is used for a SEP IRA.
Also, the total contribution is limited to the lesser of your net earnings from self-employment or (for 2015) $53,000.
EXAMPLE: You’re under 50 years old, and you have a business with no employees. Prior to considering any contributions you make, your net earnings from self-employment are $100,000 for 2015. If you have an individual 401(k) plan (and no other retirement plans to which you’re contributing), your contribution limit will be $38,000 calculated as follows:
- Employee contribution of $18,000, plus
- Employer contribution of $20,000 (20% of $100,000).
If you had a SEP IRA instead, your contribution would be limited to $20,000 (20% of $100,000). Alternatively, if you have a SIMPLE IRA, your contribution limit would be even lower ($12,500 plus 3% of net earnings from self-employment).
The conclusion here? In most circumstances you can contribute more — sometimes much more — to an individual 401(k) than you could contribute to a SEP IRA or SIMPLE IRA.
(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)
Individual 401(k): Roth Option
In addition to usually allowing for greater contributions, individual 401(k) plans have another benefit: If you would prefer to do so, you can make Roth contributions to an individual 401(k) rather than pre-tax (“traditional”) contributions.
Note, however, that many brokerage firms do not allow for this option, so be sure to check with the brokerage firm you’re considering if it’s important to you to be able to make Roth contributions.
If you decide to open an individual 401(k) with a Roth option, it’s important to know that only the employee contributions (those limited to $18,000 per year or $24,000 if 50 or older) can be Roth contributions. The employer contributions (those limited to 25% of your net earnings from self-employment) must be made as traditional, tax-deferred contributions.
Is an Individual 401(k) Always Best?
Given the dual advantages of Roth contribution capability and (usually) higher contribution limits, one might wonder why anybody would choose a SEP or SIMPLE IRA over an individual 401(k).
Previously, a significant disadvantage to individual 401(k) plans was that they came with higher administrative costs. In the last few years though, price competition has brought costs down considerably at some brokerage firms. For example, Fidelity’s individual 401(k) has no set-up or administrative costs at all. Similarly, Vanguard’s individual 401(k) has no set-up fees and only a modest administrative fee: $20 per year for each mutual fund in the plan — and this fee is waived if you have at least $50,000 of assets with Vanguard.
Given the decline in costs, the only real remaining drawback is paperwork. Setting up an individual 401(k) will likely require you to fill out more forms than opening a SEP or SIMPLE IRA (either of which can usually be done online in just a few minutes). In addition, individual 401(k) plans require you to file Form 5500-EZ with the IRS every year once the plan reaches $250,000 in assets.
Deadlines for Retirement Plans
A SEP IRA can be set up as late as the due date (including extensions) for the business’s tax return for the year. The deadline for contributions is the same date. For a sole proprietor, this means that you can set up the plan and make contributions for a given year as late as April 15 of the following year (or October 15 of the following year if you filed for an extension).
Assuming you’ve never had one before, a SIMPLE IRA can be set up as late as October 1 of the first year for which you wish to make contributions. (If you have had a SIMPLE IRA before and are setting up another one, you must set it up by January 1 of the first year for which you wish to make contributions.)
For a sole proprietor, the deadline for SIMPLE IRA employee contributions is January 30 of the following year. The deadline for the employer contribution is the due date (including extensions) for the business’s tax return for the year (i.e., April 15 of the following year, or October 15 if you filed for an extension).
The deadline for opening an individual 401(k) is December 31 of the first year for which you wish to make contributions. For a sole proprietor, contributions can be made up until the due date (including extensions) of your tax return for the year (i.e., April 15 of the following year, or October 15 if you filed for an extension).
What if You Have Other Retirement Accounts?
Given that you now have so many different options available to you, it’s important to know how each of these plans interacts with other retirement accounts. None of the above-mentioned plans will affect your ability to contribute to a traditional or Roth IRA. They could, however, affect your ability to claim a deduction for a contribution to a traditional IRA, because if you have one of the business retirement plans described above, you are considered to be covered by a retirement plan at work, which means that if your adjusted gross income is over a certain amount, you will not be able to claim a deduction for a traditional IRA contribution.
In addition, if you have another job as an employee and you are allowed to contribute to a 401(k) at that job, contributions you make to your plan at work — to take advantage of an employer matching contribution for instance — will count against the limit for employee contributions to an individual 401(k) or SIMPLE IRA. Conversely, employee contributions you make to an individual 401(k) or SIMPLE IRA will count against the contribution limit for your plan at work.
EXAMPLE: Jan is 40 years old and has a full-time job that offers a dollar-for-dollar match for contributions she makes to her 401(k), up to $4,000. She also has a part-time business for which she has an individual 401(k). Prior to considering any contributions, her net earnings from self-employment are $40,000.
To get the maximum match from her employer, she contributes $4,000 to her 401(k) at work. The maximum employee contribution she can make to her individual 401(k) for the year is $14,000 ($18,000 — $4,000). In addition, she can make an employer contribution of up to $8,000 (20% of her net earnings from self-employment, before considering contributions).
- As a business owner, you have several options for retirement plans. In most cases, contributions to these plans reduce your taxable income.
- Generally speaking, you want to choose the plan that has the highest contribution limit for your situation.
- In most cases, an individual 401(k) plan will allow for the largest contribution. In addition, individual 401(k) plans allow for Roth contributions (though this is not available at all brokerage firms).
- SEP IRAs and SIMPLE IRAs, however, can sometimes be good choices because of their simplicity.