4 Retirement Planning Tools For The Self-Employed

By Mark Di Vincenzo. May 7th 2016

One of the biggest mistakes entrepreneurs make is that they’re so focused on their businesses that they neglect themselves. Nearly all of them work way too many hours. Some pay themselves less than they should. And many stock away nothing -- or practically nothing -- for retirement.

When it comes to retirement, the best tip for the self employed is not to forget about it. The self-employed, many of whom don’t know what they will earn from month to month, need to set aside money every month for their retirement.

Here are the four best retirement planning tools for the self-employed.

The Individual 401(k) Plan

Also known as a solo 401(k), this plan works a lot like the 401(k) plans offered at mid-sized or large companies. Self-employed workers can choose a traditional plan or a Roth plan. Keep in mind that only business owners and their spouses are eligible for an individual 401(k). The annual contribution limit for 2012 is $17,000 with the option of a profit-sharing add-on that is 25 percent of your compensation or $50,000, whichever is less. Most mutual fund and investment management companies offer these plans.

Pros: This plan is flexible and entrepreneurs can contribute more than with the SIMPLE IRA and the SEP IRA. Additionally, business owners who save using this tool can borrow from it.

Cons: The solo 401(k) costs more than the other options (between $25 and $250 per year) and they can be more difficult to open and administer. Costs vary greatly, so you need to shop around.

Bottom Line: This plan is best for an entrepreneur who is aggressive about saving for retirement. Keep in mind that opening and operating the plan can be difficult.

The SEP IRA

The Simplified Employee Pension IRA is a pension plan funded by the employer. Annual contributions that an employer makes to an employee’s SEP-IRA cannot exceed 25 percent of total compensation or $50,000, whichever is less. Any employer, regardless of its size, is eligible for this plan.

Pros: The SEP IRA is easy and inexpensive to start and administer (no more than $50 a year). It also has higher contribution limits than the SIMPLE IRA and contribution amounts can vary each year which allows for more flexibility. The SEP can be opened as late as Oct. 15 for sole proprietors and requires no annual government reports.

Cons: The employer has all the responsibility of funding the SEP, so if you have employees, you must contribute the same percentage of compensation for them as you do for yourself. Most people can save more with an individual 401(k). What’s more, the SEP doesn’t allow for catch-up contributions and you can’t take out a loan from this plan.

Bottom Line: The SEP probably is best for a business with one or very few employees because the employer must fund the plan. It is a good plan for those who are serious about saving but want flexibility and an easy plan to administer.

The SIMPLE IRA

The Savings Incentive Match Plan for Employees is a tax-deferred retirement savings plan for small businesses. Like the SEP IRA, the employer must contribute to this plan. And employees can also contribute if they choose to do so. The employer must either match employee salary contributions up to 3 percent or contribute 2 percent of the pay for all eligible employees -- even those who don’t put in money for themselves. Employees can contribute as much as $11,500 and $14,000 if they are age 50 or older.

If you are the only employee in the company you own, you can contribute as much as $11,500 or all of your income, whichever is less, as well as 2 percent or 3 percent of your income. Only employers with fewer than 100 employees and no other retirement plans are eligible.

Pros: Like the SEP, the plan is inexpensive and easy to open and run (about $25 per year). It requires no annual government reports.

Cons: Contribution limits are lower than other retirement plans, and the SIMPLE IRA does not allow you to borrow against your account as you can with the individual 401(k) plan.

Bottom Line: The SIMPLE IRA is best for very small businesses that don’t want to contribute a lot to their retirement plans, and don’t want the option of borrowing from the plan. Contributions are mandatory, so the business owner must know that he or she can make contributions.

The Defined Benefit Plan

This plan is similar to a traditional pension plan and any employer is eligible. Contributions to a defined benefit plan are determined by a complicated formula which often results in much higher contribution limits than with other retirement plans. Usually employers contribute, but sometimes employees contribute as well.

Pros: The defined benefit plan allows employers to save much more money than the three other plans and participants can borrow from their accounts.

Cons: Contributions to the plan are mandatory and the plan is the most expensive and complicated, partially accounting for a decline of about 114,000 plans in 1985 to 38,000 or so today. An excise tax applies if the minimum contribution requirement is not satisfied.

Bottom Line: The plan is best for high-income business owners who want to put away a lot of money and have the staffs to set up and administer it.

If you are self-employed or you own your own business, you should carefully consider the pros and cons of each of these retirement tools before making a final decision on how to set up retirement plans for you and your employees.

Sources

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