Retirement planning vehicles for the self-employed

As we approach year-end, we should take a moment to consider retirement planning.  I urge my self-employed readers to start a retirement plan if one is not already in place.  Depending on your current circumstance, a cash balance pension plan (type of defined benefit plan) or a SIMPLE IRA (type of tax deferred employer-provided plan) might be suitable for you.  I will discuss both of these (and other retirement vehicles) in future posts.  For this entry, however, I'd like to focus on two popular and available options for the self-employed; the SEP IRA and the solo 401(k).

The SEP IRA
A Simplified Employee Pension Individual Retirement Arrangement (otherwise known as the SEP IRA), is typically adopted by business owners who seek to provide retirement benefits for the business owners and their employees.  

• There are no significant administrative costs for a self-employed person with no employees.
• All employees must receive the same benefits under the SEP plan (assuming the business has employees)
• The account can be opened at most major custodians and it offers the same investment flexibility as a typical IRA
• You can contribute up until your tax filing date (this includes the extension filing deadline of 10/15)
• Your contributions is limited (for 2013) to 25% of your compensation, or $51,000
• All contributions are made from the business.

The Solo 401(k)
A Solo 401(k), which is also known as a Self Employed or Individual 401(k), is a retirement savings vehicle designed specifically for employers with no full-time employees other than the business owners and their respective spouses.  A key element of this particular type of plan is that it covers only the business owners and their spouses, thus not subjecting the 401(k) plan to complex ERISA (The Employee Retirement Income Security Act of 1974) rules.

• Contributions include both employee and employer deferral components
• Contribution limits (for 2013) are $51,000, or $56,500 to "catch-up" if you are 50 years of age (or older) at any point during 2013
• These retirement vehicles can be opened at most any major custodian
• These retirement vehicles limit participation to sole owners, business partners and their spouses

So how do you choose between the two options?

Consider cash flow

• When you use a SEP-IRA with your employees, you will need to contribute the same percentages for your employees as you defer for yourself. This becomes an expensive proposition.  I generally recommend this plan for the self-employed with no employees.

• SEP-IRA contributions are calculated as a percentage of compensation, so if this amount varies significantly year to year, so will your allowable contribution.  A Solo 401(k), by contrast, allows you to defer the lesser of $17,500 ($23,000 if you're 50 or over) or 100 percent of your 2013 income plus the profit sharing contribution.  This flexibility may provide a better option for those with variable income and cash surplus.

Consider timing

• Both plans allow for contributions up to the tax filing deadline (including extension deadlines if you have extended your tax return).  The Solo 401(k), however, must have been established during the calendar year in which you would like to participate.

Consider features

• Loans are available from Solo 401(k)s but not from SEP-IRAs

• You may be able to enable a Roth feature on a Solo 401(k) if you plan documentation allows for it.  This is not currently possible with a SEP-IRA

• Both plans can be established at most custodians, and most custodians have a prototype plan document that can be used if you do not have your own.

Best regards,

Jason M. Gilbert, CPA/PFS, CFF
T: 516-665-1940
E: [email protected]