Retirement-saving Tools for the Self-employed or Small Business Owners

By Clifton Linton
Senior Writer, mPower

In This Story Easy SIMPLE Plans SEP Plans Complicated Keogh Plans IRAs: Roth and Traditional

"Help! I'm self-employed; what's the best retirement plan for me?"

Finding the most effective and least burdensome tax-deferred retirement-saving plan if you're self-employed or own a small business may take research. There is no one-size-fits-all option.

It depends on how much you want to save each year, whether you have employees, if you want to help them save, and, if so, how much you're willing to contribute to their retirement. Regardless of your answers, there's probably a tool that's right for you.

minute: read this article at a glance.

When it comes to tax-deferred retirement saving plans, 401(k)s and IRAs get the lion's share of the spotlight. Neither, however, may be an ideal fit for the self-employed person or small business owner. 401(k) plans can be costly and complicated, and, for self-employed workers, not available at all. And IRAs, while easy to set up, currently have an annual contribution limit of only $2,000.

So, what's the answer? Defining your working situation comes first.

Nailing down a definition of "self-employed" or "small business owner" is tough: A self-employed individual may or may not have employees, while small business owners may be incorporated or not, and may have up to 100 employees or just work on their own. This panoply of variations often leaves these folks scratching their heads, wondering how they can save for retirement. There are a variety of retirement-saving tools available to the self-employed and small business owner. Broadly, they fall into two categories: those that require employer contributions (SEPs, SIMPLE plans and Keoghs) and those that don't (Roth and traditional IRAs).

Figuring out the right plan for you depends on a myriad of factors. A gen Xer launching a new dot-com may have different needs than a lawyer hanging out her own shingle. You must consider the amount of time and money you have to spend on a retirement plan, how much you value your employees (if you have any), and "where are you in your business cycle," said Dee Lee, author of the book Let's Talk Money.

Easy SIMPLE Plans

A few years ago, the IRS created two low-paperwork, tax-deferred saving plans ideal for small business owners and the self-employed. Called Savings Incentive Match Plans for Employees, or SIMPLE, they come in an IRA flavor and a 401(k) flavor.

SIMPLE IRAs are probably the most popular saving plan for self-employed workers. This plan has a minimal paperwork requirement (a big bonus), flexibility with employer matching contributions, and offers the ability to save, tax-deferred. SIMPLE IRAs also work well for small businesses with more than a handful of employees.

To qualify to participate in a SIMPLE IRA, an eligible employee or small business owner must receive a minimum of $5,000 a year in compensation.

Info Union employees whose benefits are covered in a collective bargaining agreement and nonresident alien employees who have no U.S.-source wages may be excluded from a SIMPLE IRA.

The law requires small business owners with SIMPLE IRA plans to offer a matching or gift contribution to any employees.

If you offer a gift contribution, known in IRS lingo as a nonelective contribution, it must be given to each eligible employee (or yourself, if you are the only employee) and be equal to 2 percent of compensation, limited to a maximum annual compensation of $170,000. Including the maximum permitted salary deferral of $6,500 a year, the most a person can save in a SIMPLE IRA plan using this formula is $9,900.

Many employers opt to make a matching contribution rather than a gift. With a match, employers are required to offer a dollar-for-dollar matching contribution up to 3 percent of salary up to $6,500 a year. Even though it costs a little more, the match only has to be offered to those employees who participate in the SIMPLE IRA plan. But, you can also stash a little extra cash into a SIMPLE IRA plan using matching contributions, points out Phillip Cook, a certified financial planner in Torrance, Calif.

If you earn enough to make a full employee contribution and qualify for a full employer match, the most you can save for the year is $13,000.

The way this plan works is as follows: The employer gets to choose the financial institution to maintain the SIMPLE IRA and accept contributions. Contributions may be invested any way the employee wants.

SIMPLE 401(k)s plans are less popular than SIMPLE IRAs mostly because they require more paperwork. The advantage of having a SIMPLE 401(k) is that plan participants can take out loans against their balance.

In many ways, such as contribution limits, the SIMPLE 401(k) is identical to the SIMPLE IRA. A leading difference is that the SIMPLE 401(k) plan must have a trust with a financial institution and the plan may be subject to discrimination testing.

Withdrawal rules for SIMPLE plans are similar to IRAs. See IRS Publication 590, Individual Retirement Arrangements (IRAs) (Including Roth IRAs and Education IRAs), for more information about IRA withdrawal rules.

For the 2000 tax year, employers need to set up a SIMPLE 401(k) or SIMPLE IRA plan by October 1, 2000.

SIMPLE plans are designed for companies with 100 employees or less (including self-employed workers) with no other qualified plan, such as a 401(k) or pension plan.

SEP Plans

The Simplified Employee Pension, or SEP, is similar to profit-sharing and pension plans in that all contributions come from the employer. The advantage of this plan is that deferral rates are much higher than in SIMPLE plans.

Ed Slott, a CPA and editor of Ed Slott's IRA Advisor newsletter, chose to offer an SEP to his staff of two. "It's the best plan for employees," he said. "I have great employees. I want to retain them and motivate them. The plan is a great ... incentive to keep a great crew."

In comparison to SIMPLE plans, SEP contribution rules are a little tricky. As the employer, any deferral you make for yourself you must also make for your employees, if you have any.

For this reason, SEPs tend to be favored by small businesses with only a handful of employees, Slott said.

The contribution limit formula for an SEP plan is as follows: The contributions can't be more than the lesser of 15 percent of an employee's compensation or $30,000. That said, employers can't include salary above $170,000 in a year in calculating an employee's contribution limit. Fifteen percent of $170,000 is $25,500.

If you did your math in the last paragraph and wondered, "How is this possible?", then you need to know that in order to save a total of $30,000, your employer must have some kind of additional plan in combination with the SEP. One way an employer could boost the deferral to $30,000 would be to combine the SEP with a money-purchase plan, Slott said. A money-purchase plan is a little like a traditional pension plan in that the employer contributes to an employee's account based on that person's income and years of service.

A SEP plan may be set up at anytime during the calendar year. Business owners can even wait to open an SEP until they file their tax return.

Employees aren't permitted to contribute to SEP plans, unless they are the sole employee (in other words, the business owner). Employee salary reductions are permitted, however, in special SEP plans called SARSEP plans, which aren't covered in this article.

One reason many small business owners choose SEP and SIMPLE plans is that they don't have to be offered every year. If your business has a bad year, you could choose to discontinue the plan temporarily.

Read a breakdown of small employer retirement plan features.

Complicated Keogh Plans

A less popular retirement plan available to small businesses and self-employed workers is the Keogh, or HR-10 plan. The reason it's less popular, according to financial planners interviewed for this article, is that the IRS considers a Keogh a qualified plan, requiring substantially more complicated paperwork than SEP or SIMPLE plans.

With a Keogh plan, the small business owner or self-employed person needs to set up a trust account into which all employer and employee contributions are deposited. The plan document will stipulate how the contributions may be invested.

In addition to needing a trust and a plan document, the business owner needs to file an annual report (Form 5500) on the plan to the IRS. Further, a small business owner offering a qualified plan must offer the plan each year regardless of the health of the business.

A Keogh plan can be set up as a profit-sharing plan, a money-purchase plan or a combination of the two.

While employees may make after-tax contributions to an employer-sponsored Keogh plan, the primary contribution comes from the employer. The IRS requires that employers contribute the same amount to each employee as they contribute for themselves.

The IRS has made a paperwork concession for what is known as a one-participant plan. In this case, if the plan covers only you and your spouse, and/or one or more partners and their spouse in a business arrangement, you can file a short (two to three pages) Form 5500EZ.

The big advantage the Keogh plan has is that you can save more per year in it. You can save up to 25 percent of pay, not to exceed $35,000 a year, in a Keogh plan. "The Keogh is for top-end individuals. The more money you have (to save), the better the Keogh is for you," commented Lee.

As with SIMPLE 401(k) plans, plan participants can take a loan from their Keogh plan.

For more details on how to set up a Keogh plan, read IRS Publication 560 Retirement Plans for Small Business.

Because a Keogh is considered a qualified plan, money from the plan paid to plan participants is called a distribution. The withdrawal and distribution rules for 401(k) plans apply to Keogh plans.

IRAs: Roth and Traditional

If you're just beginning a business and have little extra money to set aside for retirement, can't afford to offer any retirement benefits to employees, or are a freelancer and the options above don't interest you, you might want to consider opening a Roth IRA or traditional IRA.

The drawback to these tools is their low annual contribution limits of only $2,000.

With a traditional IRA, your contributions are pretax. At retirement, you may withdraw money from the plan, but at that point you must pay taxes on the original contribution and any profits earned.

With a Roth IRA, your contributions are made after-tax. When you withdraw money at retirement, you don't pay any tax on the profits the account earned, providing you follow the rules.

For more about Roth and traditional IRA rules, visit the IRAjunction.

Matthew Lea, editor, mPower, also contributed to this article.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Retirement-saving Tools for the Self-employed or Small Business Owners

By Clifton Linton
Senior Writer, mPower

In This Story Easy SIMPLE Plans SEP Plans Complicated Keogh Plans IRAs: Roth and Traditional

"Help! I'm self-employed; what's the best retirement plan for me?"

Finding the most effective and least burdensome tax-deferred retirement-saving plan if you're self-employed or own a small business may take research. There is no one-size-fits-all option.

It depends on how much you want to save each year, whether you have employees, if you want to help them save, and, if so, how much you're willing to contribute to their retirement. Regardless of your answers, there's probably a tool that's right for you.

minute: read this article at a glance.

When it comes to tax-deferred retirement saving plans, 401(k)s and IRAs get the lion's share of the spotlight. Neither, however, may be an ideal fit for the self-employed person or small business owner. 401(k) plans can be costly and complicated, and, for self-employed workers, not available at all. And IRAs, while easy to set up, currently have an annual contribution limit of only $2,000.

So, what's the answer? Defining your working situation comes first.

Nailing down a definition of "self-employed" or "small business owner" is tough: A self-employed individual may or may not have employees, while small business owners may be incorporated or not, and may have up to 100 employees or just work on their own. This panoply of variations often leaves these folks scratching their heads, wondering how they can save for retirement. There are a variety of retirement-saving tools available to the self-employed and small business owner. Broadly, they fall into two categories: those that require employer contributions (SEPs, SIMPLE plans and Keoghs) and those that don't (Roth and traditional IRAs).

Figuring out the right plan for you depends on a myriad of factors. A gen Xer launching a new dot-com may have different needs than a lawyer hanging out her own shingle. You must consider the amount of time and money you have to spend on a retirement plan, how much you value your employees (if you have any), and "where are you in your business cycle," said Dee Lee, author of the book Let's Talk Money.

Easy SIMPLE Plans

A few years ago, the IRS created two low-paperwork, tax-deferred saving plans ideal for small business owners and the self-employed. Called Savings Incentive Match Plans for Employees, or SIMPLE, they come in an IRA flavor and a 401(k) flavor.

SIMPLE IRAs are probably the most popular saving plan for self-employed workers. This plan has a minimal paperwork requirement (a big bonus), flexibility with employer matching contributions, and offers the ability to save, tax-deferred. SIMPLE IRAs also work well for small businesses with more than a handful of employees.

To qualify to participate in a SIMPLE IRA, an eligible employee or small business owner must receive a minimum of $5,000 a year in compensation.

Info Union employees whose benefits are covered in a collective bargaining agreement and nonresident alien employees who have no U.S.-source wages may be excluded from a SIMPLE IRA.

The law requires small business owners with SIMPLE IRA plans to offer a matching or gift contribution to any employees.

If you offer a gift contribution, known in IRS lingo as a nonelective contribution, it must be given to each eligible employee (or yourself, if you are the only employee) and be equal to 2 percent of compensation, limited to a maximum annual compensation of $170,000. Including the maximum permitted salary deferral of $6,500 a year, the most a person can save in a SIMPLE IRA plan using this formula is $9,900.

Many employers opt to make a matching contribution rather than a gift. With a match, employers are required to offer a dollar-for-dollar matching contribution up to 3 percent of salary up to $6,500 a year. Even though it costs a little more, the match only has to be offered to those employees who participate in the SIMPLE IRA plan. But, you can also stash a little extra cash into a SIMPLE IRA plan using matching contributions, points out Phillip Cook, a certified financial planner in Torrance, Calif.

If you earn enough to make a full employee contribution and qualify for a full employer match, the most you can save for the year is $13,000.

The way this plan works is as follows: The employer gets to choose the financial institution to maintain the SIMPLE IRA and accept contributions. Contributions may be invested any way the employee wants.

SIMPLE 401(k)s plans are less popular than SIMPLE IRAs mostly because they require more paperwork. The advantage of having a SIMPLE 401(k) is that plan participants can take out loans against their balance.

In many ways, such as contribution limits, the SIMPLE 401(k) is identical to the SIMPLE IRA. A leading difference is that the SIMPLE 401(k) plan must have a trust with a financial institution and the plan may be subject to discrimination testing.

Withdrawal rules for SIMPLE plans are similar to IRAs. See IRS Publication 590, Individual Retirement Arrangements (IRAs) (Including Roth IRAs and Education IRAs), for more information about IRA withdrawal rules.

For the 2000 tax year, employers need to set up a SIMPLE 401(k) or SIMPLE IRA plan by October 1, 2000.

SIMPLE plans are designed for companies with 100 employees or less (including self-employed workers) with no other qualified plan, such as a 401(k) or pension plan.

SEP Plans

The Simplified Employee Pension, or SEP, is similar to profit-sharing and pension plans in that all contributions come from the employer. The advantage of this plan is that deferral rates are much higher than in SIMPLE plans.

Ed Slott, a CPA and editor of Ed Slott's IRA Advisor newsletter, chose to offer an SEP to his staff of two. "It's the best plan for employees," he said. "I have great employees. I want to retain them and motivate them. The plan is a great ... incentive to keep a great crew."

In comparison to SIMPLE plans, SEP contribution rules are a little tricky. As the employer, any deferral you make for yourself you must also make for your employees, if you have any.

For this reason, SEPs tend to be favored by small businesses with only a handful of employees, Slott said.

The contribution limit formula for an SEP plan is as follows: The contributions can't be more than the lesser of 15 percent of an employee's compensation or $30,000. That said, employers can't include salary above $170,000 in a year in calculating an employee's contribution limit. Fifteen percent of $170,000 is $25,500.

If you did your math in the last paragraph and wondered, "How is this possible?", then you need to know that in order to save a total of $30,000, your employer must have some kind of additional plan in combination with the SEP. One way an employer could boost the deferral to $30,000 would be to combine the SEP with a money-purchase plan, Slott said. A money-purchase plan is a little like a traditional pension plan in that the employer contributes to an employee's account based on that person's income and years of service.

A SEP plan may be set up at anytime during the calendar year. Business owners can even wait to open an SEP until they file their tax return.

Employees aren't permitted to contribute to SEP plans, unless they are the sole employee (in other words, the business owner). Employee salary reductions are permitted, however, in special SEP plans called SARSEP plans, which aren't covered in this article.

One reason many small business owners choose SEP and SIMPLE plans is that they don't have to be offered every year. If your business has a bad year, you could choose to discontinue the plan temporarily.

Read a breakdown of small employer retirement plan features.

Complicated Keogh Plans

A less popular retirement plan available to small businesses and self-employed workers is the Keogh, or HR-10 plan. The reason it's less popular, according to financial planners interviewed for this article, is that the IRS considers a Keogh a qualified plan, requiring substantially more complicated paperwork than SEP or SIMPLE plans.

With a Keogh plan, the small business owner or self-employed person needs to set up a trust account into which all employer and employee contributions are deposited. The plan document will stipulate how the contributions may be invested.

In addition to needing a trust and a plan document, the business owner needs to file an annual report (Form 5500) on the plan to the IRS. Further, a small business owner offering a qualified plan must offer the plan each year regardless of the health of the business.

A Keogh plan can be set up as a profit-sharing plan, a money-purchase plan or a combination of the two.

While employees may make after-tax contributions to an employer-sponsored Keogh plan, the primary contribution comes from the employer. The IRS requires that employers contribute the same amount to each employee as they contribute for themselves.

The IRS has made a paperwork concession for what is known as a one-participant plan. In this case, if the plan covers only you and your spouse, and/or one or more partners and their spouse in a business arrangement, you can file a short (two to three pages) Form 5500EZ.

The big advantage the Keogh plan has is that you can save more per year in it. You can save up to 25 percent of pay, not to exceed $35,000 a year, in a Keogh plan. "The Keogh is for top-end individuals. The more money you have (to save), the better the Keogh is for you," commented Lee.

As with SIMPLE 401(k) plans, plan participants can take a loan from their Keogh plan.

For more details on how to set up a Keogh plan, read IRS Publication 560 Retirement Plans for Small Business.

Because a Keogh is considered a qualified plan, money from the plan paid to plan participants is called a distribution. The withdrawal and distribution rules for 401(k) plans apply to Keogh plans.

IRAs: Roth and Traditional

If you're just beginning a business and have little extra money to set aside for retirement, can't afford to offer any retirement benefits to employees, or are a freelancer and the options above don't interest you, you might want to consider opening a Roth IRA or traditional IRA.

The drawback to these tools is their low annual contribution limits of only $2,000.

With a traditional IRA, your contributions are pretax. At retirement, you may withdraw money from the plan, but at that point you must pay taxes on the original contribution and any profits earned.

With a Roth IRA, your contributions are made after-tax. When you withdraw money at retirement, you don't pay any tax on the profits the account earned, providing you follow the rules.

For more about Roth and traditional IRA rules, visit the IRAjunction.

Matthew Lea, editor, mPower, also contributed to this article.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.