This article was originally published on Kiplinger – https://www.kiplinger.com/
Own a business? Save more for retirement. Popular plans for the self-employed include the solo 401(k), the SEP IRA and a SIMPLE IRA.
As an employee of a financial-planning firm, Neil Brown follows his own advice and makes the maximum contribution to his company’s 401(k) plan. But he also runs a side business, as a public speaker and financial educator. So more than 10 years ago, he established a “solo 401(k)”–a special type of retirement plan for someone who is self-employed or a business owner with no employees, other than a spouse. Brown funds it with about 20% of his net profits when times are flush for his side gig, but he can skip contributions during lean years. He’s added about $100,000 to his retirement savings this way. “It works really well for me,” says Brown, a wealth manager with Burkett Financial Services, in West Columbia, S.C.
Whether you are running a side business or you are entirely self-employed, you have options when it comes to saving for retirement. It won’t be as simple as filling out a form at work, but you’ll have other advantages. You can choose among several retirement plans that, just like an employer’s 401(k), allow you to make pretax contributions that grow tax-deferred until you withdraw the money. If you choose to make after-tax Roth contributions to your solo 401(k), withdrawals in retirement will be tax-free.
Some self-employed plans allow you to contribute far above the limits for a traditional or a Roth IRA. With a solo 401(k), for example, you can put in money both as employee and as employer, meaning you could potentially contribute as much as $55,000 of your self-employment income. Compare that to the $5,500 annual IRA limit. (Note: Those 50 and older can stash up to $6,000 extra in a solo 401(k) and up to $1,000 extra in an IRA.) If you also have a company retirement plan, use it to save even more for retirement, and on your tax bills, by participating in that company plan, too.
Popular plans for the self-employed include the solo 401(k), the SEP (simplified employee pension) IRA, and a SIMPLE (Savings Incentive Match Plan for Employees) IRA. All are generally easy and inexpensive to set up and maintain. But you do need to pay attention to each plan’s limits and rules. Not all solo 401(k) administrators offer a Roth option, for example. (Compare solo 401(k)s, SEP IRAs and SIMPLE IRAs.)
With the growth of the gig economy and more people working as consultants, freelancers and contractors, there’s growing interest in all the plans, says Maura Cassidy, vice president of retirement products for Fidelity. “I think people are trying to figure all this out,” says Cassidy. “Maybe they had a 401(k) at their old job, so the first thing they start with is `Hey, I need a 401(k) for myself.’ “
Analyze Your Choices
The new tax law will have an impact on retirement plans and may affect the decisions you make about how to save for retirement. For example, sole proprietors, partnerships and other pass-through entities can now deduct 20% of their profits from their taxable income. But there’s a caveat, says Jeffrey Levine, director of financial planning for BluePrint Wealth Alliance, in Garden City, N.Y. The 20% pass-through deduction will be applied to the lesser of your qualified business income or taxable income minus any capital gains.
Here’s an example: A sole proprietor has net profit from his business of $100,000 and makes a $20,000 SEP IRA contribution. Along with his self-employment tax deduction of about $7,500, that brings his adjusted gross income to $72,500. He then claims the $12,000 standard deduction, which reduces his taxable income to $60,500. Because his taxable income is lower than his qualified business income, his pass-through deduction is 20% of $60,500, or $12,100.
If the rate cuts included in the new law expire as scheduled in seven years, you might end up in a higher tax bracket in the future. In some cases, then, it may make more sense to contribute to a Roth now rather than a traditional retirement plan. A doctor approaching retirement who is still working and already has $5 million in a retirement plan, for example, might be better off contributing to a Roth, because when he retires, he could find himself in a higher tax bracket, says Robert Keebler, a partner with Keebler & Associates, a tax advisory and estate-planning firm in Green Bay, Wis. Another strategy: Split the difference. Contribute to a Roth and a traditional plan.
Certain professional service businesses, such as law firms and doctor’s offices, can only get the full 20% pass-through deduction if they earn below $315,000 (for married couples). But an optometrist earning $375,000 could try to lower his taxable income enough to qualify by contributing pretax dollars to a retirement plan, Keebler says.
Whatever plan you choose, look for a “sweet spot” that allows you to maximize your retirement savings and lower your tax bill. Think about how much you earn and how much you can afford to save. If you’re making $300,000 annually but spending $275,000, then a regular IRA might be your best bet.
From there, ask yourself a few questions, says Fidelity’s Cassidy: Is it truly just yourself running the business, or do you have employees? Do you want a plan allowing only employer contributions, or can employees contribute? Also, compare plans based on ease of set-up, contribution limits and administration costs.
If you are a high earner, getting older and behind on your retirement savings, you might want to consider a defined-benefit retirement plan, says Paul Danziger, president of Freedom Financial Advisors, in Bethesda, Md. You can contribute more to such a plan than you can to a defined-contribution plan such as a 401(k). Danziger has a 71-year-old client, the owner of a building company, who earns about $275,000 annually and now contributes $230,000 per year. “A lot of people make a nice living, but they don’t end up saving a lot of money,” Danziger says. “They get to be 55 and they find they are way behind on retirement.”
Defined-benefit plans, though, typically have higher set up and maintenance costs. You’ll likely need to pay an actuary or third-party administrator at least $1,500 to establish the plan documents and about $2,200 to $3,000 annually to prepare tax filings.
To further explore your plan options, check out resources for small business retirement plans at IRS.gov or use free online tools such as Fidelity’s Solo 401(k) calculator.