BWA: Retirement Plans for the Self-Employed


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By: Harold Henke, Ph.D.
Copyright, 2002, Chartula
November 18, 2002

Important Disclaimer: the author of this article describes his experience in establishing a retirement account as a self-employed person as well as research on this subject. The author is not providing accounting or legal advice but is simply providing information on how a self-employed person can establish a retirement plan.

Another Important Disclaimer: the tax forms and publications published by the Internal Revenue Service are often not finished, because of changes to the tax code, until as late as February. Since this article was written in November, some information may change between November and February.

Overview

This article is a companion article to BWA Independent Contractors' Experiences with Business Entities and Insurance by Kemp, et al. (2002). The Kemp et al. article provides an excellent description of the types of business entities people use to conduct business and this article provides information on retirement plans that can be used with those entities.

The goal of this article is to help you as a self-employed person understand how you can simply and inexpensively setup a retirement plan which can be as effective as many, if not most, retirement plans offered by corporations. Furthermore, in addition to establishing your own retirement plan, you can also take advantage of other retirement plans, such as an Individual Retirement Account (IRA) and Roth IRA in combination with your "business" retirement plan.

This article was written primarily for those self-employed people who are "sole proprietors" as defined in BWA Independent Contractors' Experiences with Business Entities and Insurance and in this article. Though the information provided in this article can also be applied to those who operate their business as a Limited Liability Company or a Corporation.

Some Definitions

Throughout this article, the following terms are referenced:

Net Earnings or Profit From Self-Employment - this is your gross income minus deductible business expenses. Your net earnings or profit is used to determine how much money you can contribute to a retirement plan.

SEP IRA - Simplified Employee Pension (SEP) IRA is defined by the IRS as "a written plan that allows you to make contributions towards your own retirement (if you are self-employed) and your employees retirement without getting involved in a more complex qualified plan." You can think of a SEP IRA as an IRA for sole proprietors.

Sole Proprietor - The Internal Revenue Service (IRS) defines a sole proprietor as "an individual who owns an unincorporated business by himself or herself. For retirement plans, a sole proprietor is treated as both an employer and an employee." Another way to define a sole proprietor is a person who reports their income on Schedule C, Profit or Loss from Business. (It should be noted, you can work for a corporation and also have income from a business and report that income via a Schedule C. For the purposes of this article, the focus will be on people who are self-employed. ) Also, in this article, the term Independent Contractor is not used. The reason is that for reporting income and establishing retirement plans, the term Independent Contractor has no meaning.

You Already Are Contributing to Your Retirement Plan

First, it should be noted, that as a self-employed person, you are already contributing to your retirement by paying your share of the Social Security and Medicare tax, which is referred to as self-employment tax. The self-employment tax is 15.3% but you get a credit for half, so you are contributing 7.65% of your income to your Social Security retirement plan. But read on for how you can create your own retirement plan.

Establishing a SEP IRA as Your Retirement Plan

Though the Simplified Employee Pension (SEP) IRA sounds like there would be much paperwork associated with it since it is a "pension" plan, that is not the case. The SEP IRA is simple to setup and very cost effective to administer. For the majority of self-employed people, this plan is probably the best plan to setup for their retirement as a SEP IRA provides much flexibility in terms of when and how much money can be contributed to the plan.

A SEP IRA is basically an IRA where, each year, you choose to contribute a percentage of your net earnings to the SEP IRA and most importantly, you can deduct the amount you contributed against your income, thus reducing your tax bill. If you do not have employees, then administering the SEP IRA is very simple as there are no reporting requirements to the IRS. Basically, you create the retirement account, put money into it, watch it grow, and then one day when you retire, you begin withdrawing money. Until that time, you have no paperwork to deal with other than the reports you receive from your plan administrator, such as your bank or brokerage house. Simply put, a SEP IRA is very much like a deductible IRA but you can contribute more money to a SEP IRA than a deductible IRA (more on this later in the article).

Advantages of the SEP IRA

Here are the key advantages of a SEP IRA:

You can contribute up to 13% of your net earnings for 2001 (20% of net earnings in 2002) and each dollar you contribute to the SEP IRA is deductible and offsets income, which reduces your tax bill.

You can choose to contribute as much as you want or as little as you want per year. For example, during a "good" year, you may choose to maximize your retirement savings by contributing 13% of your net earnings but then, the next year is a "bad" year and you decide you can't afford to contribute to the SEP IRA that year, that is okay. The SEP IRA enables you to determine how much money you want to contribute based on your business income with no minimum requirement. You can choose to contribute 13% one year, 5% the next year, and 12% the following year. The contribution amount is for you to decide. Also, if you decide to be no longer self-employed and go to work for a corporation, you can leave your SEP IRA, as is, and do not have to roll over your SEP IRA to your employer's plan.
You can contribute money to the SEP IRA up until the due date of the tax return. This means that if you file your taxes on April 15, you have until that date to contribute money to the SEP IRA for that tax year. This gives you 15 months to save money to contribute to the SEP IRA. (Other plans, such as the SIMPLE IRA have shorter contribution periods.)
You can manage the money you put into the SEP IRA just like any other IRA, which means you can invest your money in the fastest rising dot.com company, gold, or a good index mutual fund.
You can establish a SEP IRA through most financial institutions which offer IRAs. Typically, you only need to fill out a one or two page form to establish a SEP IRA. Also, most institutions charge a small maintenance fee or no maintenance fee to maintain the account. Therefore, it only takes 15 to 30 minutes to establish your own retirement account and often, costs nothing, to administer that retirement plan, year after year.

Some Considerations About the SEP IRA

Here are a couple of items to consider about establishing a SEP IRA:

Depending on how much money you want to contribute to a SEP IRA, you may be able to obtain the same result with a traditional IRA. If you self-employed, you can create a SEP IRA and deduct your contributions; conversely you could do the same with an IRA. For example, if you have an existing IRA, instead of contributing to a SEP IRA, you could contribute your money to the IRA and deduct those contributions. If your contributions to a SEP IRA are less than the maximum contribution to an IRA ($2000 in 2001; $3000 in 2002), then it would be simpler to contribute to a deductible IRA. But if you expect your self-employment income to increase over the years, then a SEP IRA is a better solution as there are less limitations for deductions based on income levels.
If you have employees or use another business entity other than sole-proprietor, you could use a plan such as the Keogh, SIMPLE IRA, or SIMPLE 401K and you may not want to use the SEP IRA. You can use the SEP IRA but the SEP IRA is primarily designed for self-employed individuals or business owners with few or no employees.

Beyond the SEP IRA

Besides contributing to the SEP IRA, you may also be able to contribute to a deductible or non-deductible IRA as well as a Roth IRA. An important point, if you establish a SEP IRA for yourself, you will be considered to be a participant in a defined pension plan. This means that deductible contributions to a regular IRA will be limited. But with that said, you may want to contribute to the following retirement plans, all in one year:

SEP IRA - contributions fully deductible.
Regular (deductible) IRA - if SEP IRA is established, contributions to regular IRA may be partially deductible depending upon net earnings.
Roth IRA - contributions not deductible but capital gains and interest are not taxable when withdrawn.

Summary

One aspect of being self-employed is that you have to fund and manage your own retirement program but fortunately, the SEP IRA offers a very cost effective and simple solution. By filling out a one or two page application, you can set up a retirement plan that you control and which can be as effective, if not more effective, than those plans offered by many corporations. You decide how much you want to contribute based on your business and you control how the money you save is invested. By establishing your account with any large brokerage, you can have as many if not more investment choices than those found in a typical corporate retirement plan.

For more information on retirement plans for the self-employed, read the Department of Treasury, Internal Revenue Service, Publication 560, Retirement Plans for Small Business and Publication 334, Tax Guide for Small Business.