Self-employment can be rewarding personally and financially, but it comes with some tough challenges: long hours, an uncertain income, and a lack of structured benefits such as health insurance and retirement plans. In a recent survey, 61% of self-employed individuals said they were anxious about saving enough for retirement, 59% were not making regular contributions to a retirement plan, and 55% were behind in their retirement savings.1
Anyone can set up an IRA, but contribution limits are relatively low — $5,500 in 2016, or $6,500 if you are 50 or older. Self-employed individuals have additional options that may allow larger contributions for themselves and their employees.
SEP IRA — As employer, you can make tax-deductible employer contributions of as much as 25% of net earnings, up to $53,000 in 2016. If you have eligible employees, you are required to contribute to SEP IRAs in their names at the same contribution rate; of course, the dollar amounts would be different for different salary levels. You are not required to contribute to a SEP IRA every year.
In addition to any employer contributions, you and your eligible workers can generally make pre-tax employee contributions up to the normal IRA contribution limits. Like a traditional IRA, the SEP IRA belongs to the individual owner, so future contributions can be made even if your business closes or an employee leaves your employment.
You can set up a SEP IRA and make 2016 contributions up to the April 2017 income tax filing deadline. However, 2016 contributions to the following plans must be made by December 31, 2016.
SIMPLE IRA — In 2016, you and your employees can make pre-tax salary contributions up to $12,500 ($15,500 for those 50 and older). Employees may choose whether or not to contribute, but as employer you are required to make an annual contribution to participating employees — either a 2% fixed amount of each eligible employee’s salary or a 100% match of the first 3% of employee contributions. SIMPLE plans are typically used by small businesses with no more than 100 employees.
Solo 401(k) — You can make pre-tax salary deferrals up to $18,000 ($24,000 if you’re 50 or older) in 2016. As employer, you can also contribute an additional 20% of your earnings (25% if the business is incorporated) and deduct it as a business expense. Total contributions (not counting catch-ups) are capped at $53,000 in 2016.
In future years, contribution limits for these plans may be adjusted upward for inflation. Distributions from tax-deferred retirement plans are taxed as ordinary income. Early withdrawals (prior to age 59½) may be subject to a 10% federal income tax penalty. IRAs and 401(k) plans have exceptions to avoid the 10% early-withdrawal penalty, including the owner’s death or disability. Annual required minimum distributions from these plans must begin for the year in which the participant turns 70½.
Setting up a retirement plan for yourself is relatively straightforward. You might seek professional guidance when setting up a retirement plan that includes employees.
1) LifeHealthPro.com, December 14, 2015