Resources - Chapter 14 Supplement
The following is a brief overview of retirement planning options.
We've been given permission by Jan Zobel to excerpt this information from her book, Minding Her Own Business: The Self-Employed Woman's Guide to Taxes and Financial Records.
email: Jan Zobel
Retirement Planning Options
Tax-deferred retirement plans are valuable because, while saving for your retirement, you delay paying taxes on money you earn and contribute to one of these plans. Additionally, the interest and dividends earned on the money in the retirement plan are also tax deferred. Tax-deferred means that you pay no taxes on the money until it's taken out of your retirement account.
Theoretically, when you take the money out of the account, you'll be retired or working part-time, which will put you in a lower tax bracket than you were in when you invested the money. As a result, the money you contributed and the earned interest or dividends will be taxed at a lower rate than they would have been if you hadn't put the money in a tax-deferred account and instead had paid tax on it when it was earned.
Due to compounding, the earlier in life you begin contributing to a retirement plan, the less total amount you'll need to put in to accumulate a substantial amount of retirement money. The money you contribute to a retirement plan, however, should be money that you don't expect to need until you're at least 59½ years old. When you take a distribution from your retirement account, you are taxed on that money in the same way as you're taxed on other income. With few exceptions, the irs also assesses a 10% penalty if money is taken out before you're 59½. Your state may have a similar penalty, which means that if you take the money out prior to reaching the minimum age, you may lose nearly 50% to federal and state taxes and penalties.
Note: Check with the irs as these numbers frequently change
Tax Sheltered or Tax Deferred Annuities
If you're working as an employee in addition to being self-employed, you may have a 401(k) or 403(b) tax-sheltered annuity (tsa) or tax-deferred annuity (tda) retirement plan available to you. There are a number of reasons why it's a good idea to take advantage of these plans if you have one.
- Your W-2 will show that the amount you earned is your wage amount minus the amount contributed to the tax-deferred plan. As a result, you pay tax on a lower amount of wage income.
- You may not be eligible to deduct an ira contribution (explained later).
- Your employer may match your contributions to the retirement account. (If this is the case and you're not participating in the retirement plan, you're throwing money away.)
- Your plan may allow you to borrow against it in the event of emergency or to buy a house.
- It is relatively painless to have a deduction taken from your paycheck and put into your retirement account.
If you do not work as an employee or your employee job doesn't offer a tax-deferred retirement plan, consider one of the other types of retirement plans available to you.
Traditional Individual Retirement Arrangements (iras) are available to anyone with earned income (i.e., wages or self-employment income). The 2006 maximum allowable contribution to an ira account is the lesser of your earned income or $4,000 per year ($5,000 if you're age 50 or older.) If you are single and have a loss from your business and no other earned income for the year, your compensation amount is less than zero so you're not eligible for an ira.
The ability to put money into an ira doesn't necessarily mean that you'll be able to deduct the contribution.
- If your adjusted gross income is more than $50,000 ($75,000 if married) and you have a retirement plan at work, your ira will be only partially deductible.
- If your adjusted gross income is over $60,000 ($85,000 if married) and you have a retirement plan at work, your ira contribution won't be deductible at all.
- If you are married and your spouse has a retirement plan at work but you don't, you can deduct your ira contribution as long as your joint income is under $150,000. If it's between $150,000 and $160,000, your ira is partially deductible. If your joint income is more than $160,000, your ira contribution isn't deductible.
Having a retirement plan at work refers to any type of retirement plan for which you are eligible at your employee workplace at any time during the year, whether you choose to participate in it or not. Having a retirement plan at work also refers to having a sep-ira, SIMPLE, solo 401(k), or Keogh, the self-employed retirement accounts discussed later in this chapter. If you had no retirement plan at work at anytime during the year, you can fully deduct your ira contribution if you're single. See restrictions above if you are married and your spouse had a retirement plan.
Liz is single and has income in excess of $60,000. For part of this year she worked as an employee and had a 401(k) retirement plan at work. She can't deduct her ira contribution even though she no longer works as an employee.
Arthur and Irma are married and have $80,000 joint income. Arthur works as an employee where he has no retirement plan. Irma is self-employed and contributes to her SIMPLE retirement account. Although both can contribute to an ira, Arthur can deduct his contribution but Irma can't deduct hers. If their joint income had been over $160,000, neither Arthur nor Irma would have been able to deduct an ira contribution.
As already mentioned, money taken out of an ira before age 59½ is subject to an early withdrawal penalty. There are three situations in which the penalty is not assessed although tax is still due on the distribution. The first situation occurs when money taken out is used to pay medical insurance premiums for someone who has received unemployment compensation during 12 consecutive weeks in the preceding year or the year in which the withdrawal takes place. This also applies to self-employed people who would have received unemployment compensation but weren't eligible because they were self-employed.
The second instance in which the penalty isn't assessed is when the money is used to pay higher education expenses for the taxpayer, her spouse, her children, or her grandchildren.
There also is no penalty when up to $10,000 is taken out to be used in buying a first home for the ira holder or an eligible relative.
Note: To find out more about the 11 types of iras visit All About iras
Up to $4,000 per year ($5,000 if age 50 or older) can be contributed to a Roth ira. (In 2008 these amounts increase to $5,000 and $6,000, respectively). The amount that can be contributed is reduced for single people with income over $95,000 ($150,000 if married.) No contribution is allowed for single people with income over $110,000 or married couples with income over $160,000. A Roth ira contribution is never deductible. The advantage of these iras is that no matter how much the account increases in value, no tax is ever owed on qualified distributions. The amount contributed can be taken out at any time without penalty or tax. The earnings on the account (e.g. interest or dividends) can also be removed without tax being owed as long as the Roth ira was opened at least 5 years prior and the account holder is over 59½ or disabled, or the money is spent to buy a first home for the ira owner or an eligible family member.. You can have a Roth ira in addition to a retirement plan at your employee job or a self-employed retirement plan such as a sep-ira or SIMPLE.
The total that can be contributed to any combination of traditional ira or Roth ira is $4,000 per person ($5,000 for those 50 or older).
The simplest retirement plan available specifically for small business owners is the sep-ira. sep stands for Simplified Employee Pension but don't let the name confuse you; this plan is for sole proprietors as well as partnerships, LLCs, and corporations. A sep-ira can be set up at the same bank, brokerage house, mutual fund company, or other financial institution where you would open a traditional or Roth ira.
Depending on your business income, you may contribute substantially more to a sep-ira than the amount allowed for an ira. The contribution to a sep-ira is based on a percentage of your net self-employment income. Calculating how much you can contribute to a sep-ira is done this way:
Net self-employment income (after expenses have been deducted)
- ½ of self-employment tax
x 20 percent maximum contribution percentage Amount that can be contributed to a sep-ira
Note that this calculation is based on a contribution percentage of 20 percent. When you open your account, you will be told that the maximum contribution you can make is 2 percent. This is because a complex computation is done to calculate the allowable contribution amount. If you're interested in the details, review the irs publication on retirement plans (see Appendix D). For expediency, know that the end result is an allowable contribution of 20%, to a maximum of $45,000. You do not, however, have to contribute the maximum to your sep-ira each year. You can change your contribution percentage with each year's return and can also choose not to make a contribution at all.
As with the traditional ira, contributions to a sep-ira are intended for retirement and a 10 percent penalty on top of the tax owed is assessed if there is a distribution before age 59½ . You cannot borrow against a sep-ira.
Contributions to a sep-ira are not a business expense. The contribution amount is deducted at the bottom of page 1 of the 1040 Form in the adjustments section (see page x). Because this is not a business deduction, it does not reduce self-employment tax. However, a taxpayer in the 25 percent federal tax bracket who contributes $1,000 to her retirement plan (whether traditional ira, sep-ira, or any of the other plans mentioned later in this chapter), will save $250 in income tax (more if she also pays a state income tax).
In addition to the higher contribution level of the sep-ira, this plan has another advantage over the traditional ira. Not only can it be opened as late as April 15, but if you need more time to come up with the money for your sep-ira contribution, you can file an extension for your tax return which gives you until August 15 to fund your self-employed retirement plan. If that's still not enough time, you can apply for a second extension which gives you until October 15 to come up with money that will save you tax on the previous year's return.
If you have employees and a sep-ira, you must make a contribution on behalf of anyone who is over age 20, if she has worked for you any part of 3 of the last 5 years and earned at least $450 each year.
Similar rules about covering employees, due dates, and maximum contribution amounts apply to another type of retirement plan available to business owners: the Keogh (pronounced key oh) defined contribution plan.
There actually are two kinds of Keogh plans. In addition to the defined contribution plan, there is a defined benefit plan. Contributions to a defined benefit Keogh plan are based on a calculation of how much needs to be contributed each year for the individual to be able to receive a predetermined amount at retirement. You need to use an actuarial table to determine the contribution amount and typically will do this with the help of a financial professional. Therefore, the focus here will be only on the Keogh defined contribution plan.
It used to be that a larger contribution could be made to a Keogh plan than could be made to a sep-ira so self-employed people chose this type of plan in order to be able to contribute the maximum possible to a retirement plan. However, in the last few years the tax law changed and the same amount can now be contributed to a sep-ira as to a Keogh. The Keogh must be set up by December 31 and an annual report must be filed for accounts with balances over $100,000. The main advantage of a Keogh over a sep-ira is that employees don't have to be covered until they've worked at least 1,000 hours during two 12 month periods. Otherwise, there is really no reason to select a Keogh plan over a sep-ira and many people are rolling over their existing plans into a different type of retirement account.
The SIMPLE (Savings Incentive Match Plan for Employees) is particularly designed for small businesses with employees but it can also be used effectively by one-person businesses. simples can be set up by partnerships, LLCs, and corporations, in addition to sole proprietors.
While Keoghs and sep-iras must, under certain conditions, cover employees, only the employer may make contributions to those plans. A simple enables employees to contribute to a tax deferred retirement plan without subjecting the employer to the expense and complex administration of a traditional 401(k) type of retirement plan. Employers with simples must either match employee contributions dollar -for-dollar up to 3 percent of pay or contribute 2 percent a year to the account of any employee who earns $5,000 or more during the year and who has received at least this much in any two preceding years. The maximum contribution required of the employer is $4,100 per employee.
The employer with a simple is limited to a yearly contribution of $10,000 for herself (plus an additional $2,500 "catch up contribution" if she's at least 50 years old.) Since simples can be set up only when there is no other business retirement plan, the employer can't also make contributions to a sep-ira or Keogh. The simple can be an especially good choice for someone who has only a small net profit from self-employment. For purposes of the simple, the self-employed person is considered both employer and employee. As the "employee," she can make a tax deferred contribution to a simple of up to 100 percent of her net profit (not to exceed $10,000, or $12,000 if 50 or older). As the "employer," she matches her employee's contributions, including her own.
Jennifer is employed as the manager of a construction company. She has a part-time business making gift baskets. Her net income from self-employment is $5,500 for the year. She wants to save as much as possible for retirement. If she opens a sep-ira, she can put aside $1,022 ($5500 minus $389 which is 1/2 her self employment tax, times the sep-ira percentage of 20 percent). If she opens a simple, she can contribute $5,500 (100 percent of her net profit) plus match that amount with 3 percent of her net profit ($165) for a total retirement contribution of $5,665 ($7,665 if she's 50 or older.)
Note that the simple must be opened by October 1 of the year for which you want to make contributions and the administration of a simple is (despite the name!) slightly more complex than a sep-ira.
Self-Employed 401(k) Plans
Within the last couple of years, a new type of retirement plan became available for self-employed people. This 401(k) plan, designed especially for sole proprietors and one-person corporations, is referred to by a number of names including solo 401(k), solo(k), self-employed 401(k), individual(k), personal(k), one-person (k), and owner-only 401(k). This retirement plan is very similar to the tax deferred retirement plans mentioned earlier in this chapter and offered by many employers. However, the difference is that this plan is easier and less expensive to set up and is available only to the owner of a sole proprietorship (and her spouse, if he works in the business.) If you have employees who work for you more than 1000 hours a year, you cannot have this particular type of 401(k) plan. The advantage of the solo 401(k) plan is that it allows the largest retirement plan contribution of any mentioned in this chapter. The owner is treated as both employer and employee. As employee, she is able to contribute 100% of her net profit up to $15,000 ($20,000 if 50 or older.) As the employer, she is able to contribute to the plan using the same calculation as used for a sep-ira contribution (net profit minus « self-employment tax, times 20 percent.)
Amma is a 57 year old sole proprietor with net profit of $50,000. She would like to contribute as much as possible to a retirement account. If she contributes to a sep-ira or a Keogh, her maximum contribution will be $9,293 ($50,000 minus $3,533 times 20 percent.) If she opens a simple, her maximum contribution will be $14,000 ($10,000 plus $2,500 "catch up" plus "employer contribution" of 3 percent.) If Amma chooses a solo 401(k), her maximum contribution will be $27,293 ($18,000 plus the "employer contribution" of $9,293.)
To have a similar calculation done for your individual situation, go to 401khelpcenter.com and choose the "Small Business Channel". From there, select "Solo(k) calculator". Enter the asked for information and you'll learn the maximum you can contribute to a sep-ira, a simple, and a solo 401(k).
In addition to the larger contribution allowed, the self-employed 401(k) plan can be set up so that you can borrow against it, in the same way that many employer plans allow this. A reporting form must be filed annually once the balance in your solo 401(k) account reaches $100,000.
One caution about contributions to a simple or self-employed 401(k): if, in addition to being self-employed, you also are an employee in a company that offers a tax-deferred retirement plan, you must take into consideration the amount you've already contributed to that plan when you calculate the maximum you can contribute to your self-employed plan. For example, if you're over 50 and have had the $18,000 maximum withheld from your paycheck and put into your employer's 401(k) plan, you can't contribute another $18,000 via your solo 401(k) plan. You can, however, make the "employer" contribution to your self-employed plan.
None of the retirement plans mentioned in this chapter have a minimum contribution requirement. Although it may be hard to find a financial institution willing to open for example, a simple with less than $1,000, that isn't because of rules that are part of the retirement plan. Some financial institutions will let you open an account with a small amount if you make automatic deposits on a monthly basis through the remainder of the year. No matter how little you're able to contribute, it's important to get into the habit of making an annual contribution to your retirement account.