Retiree Portfolio Retirement for the Self-Employed

Retirement plans for small-business owners vary in their complexity and in the amount of the annual contributions allowed. These programs may be as simple as a run-of-the-mill traditional IRA or as complicated as a pension plan (i.e., defined benefit plan) established within a Keogh. A basic understanding of these plans will enable self-employed persons to implement the retirement program most appropriate for their circumstances.

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By David Braze (TMF Pixy)
October 15, 2001

Retirement plans for self-employed persons differ both in complexity and in the amount allowed as an annual pre-tax contribution. The most common plans for small firms or the self-employed are the traditional or Roth IRA, the Simplified Employee Pension (SEP-IRA), the Savings Incentive Match Plan for Employees (SIMPLE), and the Keogh. The specific tax requirements for IRAs may be found in IRS Publication 590 (Individual Retirement Arrangements), while those for the SEP, SIMPLE, and Keogh are found in IRS Publication 560 (Retirement Plans for Small Business).

Traditional or Roth IRA
The least complicated retirement plan available to the self-employed is a plain old IRA. In the absence of any other plan, a fully deductible contribution may be made to a traditional IRA. If a tax-deductible contribution is precluded because of coverage by another plan, an after-tax contribution to a traditional IRA is still allowed whenever the self-employed worker is younger than age 70. And if that worker meets the adjusted gross income limits for a Roth IRA contribution, then no age limit applies. Therefore, in nearly all cases a self-employed person may make a contribution to a traditional or a Roth IRA. While an IRA contribution may be reportable on the individual's income tax return, no other required reports must be made to the government.

There is a limit to how much can be contributed to an IRA in a single year. However, workers over the age of 50 can make additional "catch-up contributions." The annual limits for normal and catch-up contributions are as follows:

Year   Normal   Catch-up 
------------------------ 
2001   $2,000    $0 
2002   $3,000    $500 
2003   $3,000    $500 
2004   $3,000    $500 
2005   $4,000    $500 
2006   $4,000    $1,000 
2007   $4,000    $1,000 
2008   $5,000    $1,000 
2009+ Indexed*   $1,000 

*Normal contribution limits will increase annually by $500 whenever cumulative inflation exceeds the next higher $500 increment.

SEP-IRA
A SEP-IRA is a written agreement by an employer to make contributions to an employee's traditional IRA. Under this arrangement, the employer may contribute up to $30,000 or 15% of an employee's compensation annually to the traditional IRA. When made to the employer's own account, the contribution may not exceed a maximum of 13.0435% of the annual net self-employed earnings or $25,500, whichever amount is less. Employees are always 100% vested in SEP contributions when they are made, and the assets in the account are subject to the same rules regarding distribution and transfer as any other traditional IRA. While the written SEP agreement must be completed and retained on file by the business owner, there are no other filings or reports that must be submitted to the federal government.

SIMPLE
Established by the Small Business Protection Act of 1996, a SIMPLE may be set up by employers who have no other retirement plans and who have 100 or fewer employees with at least $5,000 in compensation for the previous year. A SIMPLE may be structured as an IRA or as a 401(k) plan. Except for the completion of a form when the plan is first implemented, there is no federal filing requirement imposed on an employer who establishes a SIMPLE-IRA. A SIMPLE-401(k) will have annual federal filing requirements.

In 2001, employees may elect to defer any percentage of compensation up to $6,500 per year to the SIMPLE, and the employer is required to make a matching contribution of up to 3% of the employee's pay based on that election. The $6,500 amount will increase to $7,000 in 2002, with $1,000 annual increases through 2005, when it will reach $10,000. In 2006 and thereafter, the $10,000 limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed.

For contribution purposes, the small-business/self-employed owner is treated as any other employee. That means the business owner may receive the full employer's contribution plus make an individual salary reduction contribution provided he or she has the net self-employed compensation to do so.

Contributions are immediately vested with the employee, and deposits and earnings in the account will accumulate tax-free until withdrawn. In general, distributions from a SIMPLE are taxed like those from a traditional IRA. Withdrawals prior to age 59 1/2 are subject to the 10% early withdrawal excise tax in addition to ordinary income tax. Unlike a traditional IRA or SEP, however, employees who withdraw money from a SIMPLE IRA within two years of their first participation in the plan will be assessed a 25% penalty tax on such withdrawals instead of 10%. In those first two years, the funds may be transferred only to another SIMPLE. This extra penalty does not apply to early withdrawals from a SIMPLE 401(k). After the first two years, distributions from both types of SIMPLE may be transferred to another SIMPLE or to a traditional IRA, but they are ineligible for transfer to a qualified retirement plan.

Keogh
A Keogh plan is a qualified retirement plan established by the Self-Employed Individuals Tax Retirement Act of 1962, otherwise known as the Keogh Act, or HR-10. Keogh plans may be set up as either a defined benefit or defined contribution plan. As defined contribution plans, they may be structured as a profit sharing, a money purchase, or a combined profit sharing/money purchase plan. In 2001, Keogh contributions are limited to the smaller of $35,000 or 25% of taxable compensation per year for employees, and to the smaller of $35,000 or 20% of taxable compensation for owner-employees. In 2002 and later, the dollar limit will increase to $40,000, with subsequent adjustments for inflation in $1,000 increments thereafter. An annual filing to the federal government is required when the plan assets of the participants exceeds $100,000.

Be aware that SEP contributions are discretionary on the part of the employer. But when made, the same percentage must be contributed to all employee accounts. The same proviso is true of Keogh plans that only have a profit sharing feature. But all other Keogh plan arrangements require an annual contribution even if the business has no profits. Additionally, the SIMPLE requires an annual contribution to employee accounts of at least 1% of compensation regardless of profitability. Therefore, the small-business/self-employed owner should keep ongoing profits in mind when choosing between a SEP, SIMPLE, or Keogh arrangement.

As you can see, self-employed folks have a number of tax-advantaged retirement savings plans available to them. These programs may be as simple as a run-of-the-mill traditional IRA or as complicated as a pension plan (i.e., defined benefit plan) established within a Keogh. Regardless, all will provide a means through which self-employed workers may accumulate the savings they will need for their retirement. (Need help determining which plan is best for you? Perhaps TMF Money Advisor is the perfect solution.)

See you next week. In the meantime, post away on the Retirement Investing or the Retired Fools boards.

Best to all... Pixy

The Motley Fool may be all about investors writing for investors, but Dave Braze is all about retirement. He will reach that blissful state finally (and none too soon, in the minds of his editors) in another 46 days.