Monday, June 22, 2015

Retirement Plan Options for The Self-Employed

Self-employed individuals have to juggle the many responsibilities that come with being their own bosses. Planning for retirement can get lost in the shuffle.
Americans have a hard time saving, even when most have ready access to retirement plans at work. In 2013, the National Institute on Retirement Security released a report titled “The Retirement Savings Crisis,” which estimated that about 45 percent of U.S. households had no assets in retirement savings accounts. Of those that did, most fell short of the amount needed, with a median balance of only $3,000.
That same year, TD Ameritrade conducted a survey of the savings habits of self-employed people and traditional employees, which painted just as bleak a picture. Only 36 percent of traditionally employed individuals polled responded that they were saving regularly for retirement or were doing so to the extent that they would like. Thirty-one percent of selfemployed respondents reported that they were saving regularly.
While these statistics show that most U.S. households are struggling to save adequately for retirement, self-employed individuals are finding it even more difficult. This is likely because they have to do much more work to get started. Not only do they have to think about how much to save in a particular retirement plan, but they also have to establish and maintain that plan. When you consider that income for self-employed people can be very unpredictable, putting away money for retirement can seem even more daunting. While the plans outlined below won’t ease the challenges of unpredictable earnings, they do provide a blueprint for how to save when the opportunity arises.
Traditional And Roth IRAs
Traditional and Roth IRAs are probably the two most popular accounts for people saving outside of employer-sponsored plans. Both require very little effort to establish and virtually no ongoing reporting requirements or maintenance. In 2015, individuals can contribute a maximum of $5,500 to their accounts. The Internal Revenue Service allows those 50 and over to contribute up to $6,500.
The main difference between a traditional IRA and a Roth IRA is that traditional IRA contributions are tax-deductible (subject to income phaseouts), while contributions to a Roth IRA do not reduce a participant’s taxable income. However, assets in a Roth IRA grow tax-free and qualified distributions are not taxable, while distributions from a traditional IRA are subject to income tax. Another difference is that a Roth IRA does not require individuals to take distributions, while a traditional IRA has minimum distribution requirements once participants reach age 70 1/2.
The deduction for traditional IRA contributions is limited for participants who are covered by retirement plans at work (presumably not the case if self-employment is their sole occupation) or if their spouses are covered by a plan at work. For participants who have spouses covered by retirement plans at work during 2015, the deduction begins to be reduced at a modified adjusted gross income (MAGI) of $183,000 and is completely phased out for those with MAGI of $193,000 or more. The phaseout for Roth IRA contributions occurs for single taxpayers with MAGI of between $116,000 and $131,000 and for married taxpayers with MAGI of between $183,000 and $193,000.
Whether individuals contribute to traditional or Roth IRAs will depend on how much they expect their tax situations to change. Conventional wisdom says that if they expect to be in higher tax brackets in the future, Roth IRAs make more sense. That’s because it is generally better to forgo the tax deduction for contributing to traditional IRAs when their tax burdens are relatively low in order to withdraw money tax-free when they are in higher tax brackets in the future.
Both traditional and Roth IRAs impose an additional 10 percent penalty on distributions made before age 59 1/2. In addition, borrowing from the accounts is not allowed. This may deter some self-employed professionals. The IRS does waive the 10 percent penalty for distributions in certain situations, including to cover higher education expenses, unreimbursed medical expenses in excess of certain adjusted gross income thresholds and first-time home purchase expenses (up to $10,000), and if the owner becomes disabled or dies. Note that with traditional IRAs, income tax is still owed on the distributions. Those with Roth IRAs can avoid paying tax on the earnings of the distribution if the distribution occurs after five years from January 1 of the taxable year for which the contribution was made.
The IRS has outlined specific ordering rules for distributions from Roth IRAs that provide the accounts with a major advantage over traditional IRAs for those who are uncertain if they will need to withdraw money. Amounts distributed from a Roth IRA are treated as coming out in this order: regular contributions, conversion contributions and earnings.
The significance of this ordering is that withdrawals can be made from a Roth IRA up to the amount of prior contributions at any point without incurring taxes or penalties. While I don’t recommend tapping retirement accounts as a matter of routine, this feature can come in handy in emergencies. It should also help relieve some of the anxiety of not being able to access funds in the IRA without incurring additional costs.
The major disadvantage of having traditional and Roth IRAs serve as main retirement savings vehicles is the low contribution thresholds. Most people will need to save more than the prescribed limits to meet their needs. The next option solves this problem.
Simplified Employee Pension (SEP-IRA)
SEP-IRAs have the same characteristics as traditional IRAs, but they allow self-employed professionals to save on a much larger scale. The current contribution limits for self-employed professionals in 2014 and 2015 are the lesser of 20 percent of net business income or $52,000 ($53,000 for 2015). Contributions to SEP-IRAs are discretionary, so someone having a lower-income year is not forced to contribute for the year.
The maximum amount of income that can be considered for the contribution is $260,000 for 2014 and $265,000 for 2015. The 2014 contribution limits are still relevant because SEP-IRAs can be established until the taxpayer’s tax-filing deadline, including a six-month extension. This is another advantage over traditional and Roth IRAs, which must be funded by the April filing deadline.
Establishing a SEP-IRA is relatively straightforward. The IRS requires a formal written agreement to establish the plan by completing Form 5305-SEP; an approved prototype plan document offered by a bank, insurance company or approved financial institution; or an individually designed SEP document. Most financial institutions will have their own approved plans that can be adopted to open accounts.
SEP-IRA contributions are considered to come from the business, not the individual. This is an important distinction, because it allows a plan participant to contribute to a Roth IRA in the same year he or she makes a SEP-IRA contribution. Therefore, the participant can take advantage of the tax-free growth of Roth IRAs and increase the tax diversification of retirement savings. Having retirement funds in tax-deferred and tax-free accounts creates additional flexibility to deal with changing tax situations when the funds are being distributed.
Solo 401(k)
As the name implies, the Solo 401(k) is for self-employed professionals who do not have outside employees (although a spouse can contribute to the plan if he or she is employed by the business). The plan works just like a 401(k) operated by a large corporation. It can be structured as a traditional 401(k) or as a Roth 401(k). The 2015 contribution limits are:
  • Annual employee deferral – $18,000 ($24,000 if 50 or older), up to 100 percent of compensation or earned income for a self-employed individual.
  • Employer discretionary contribution – up to 25 percent of compensation as defined by the plan or 20 percent of earned income for a self-employed individual.
  • Total maximum contribution – $53,000 ($59,000 for those 50 and above)
In some cases, a participant may be able to contribute more to a Solo 401(k) than to a SEP-IRA because it allows deferral of up to 100 percent of compensation or earnings. The Solo 401(k) can also be more attractive than the Roth IRA, since it allows for more savings on a tax-free basis. Unlike with IRAs, participants can borrow from 401(k)s, the lesser of $50,000 or 50 percent of the account balance. However, if 50 percent of the balance is less than $10,000, a participant may borrow up to $10,000. Generally, the loan has to be paid back within five years. However, the loan’s repayment period can be extended to up to 15 years if it is used to purchase a primary residence.
Solo 401(k)s require more administration than IRAs do. Specifically, plans that have more than $250,000 in assets must file Form 5500-series returns each year. In addition, if the plans allow participants to take loans, those loans will need to be administered to ensure that they comply with regulations. Despite the increased administrative burden, Solo 401(k)s are attractive options for self-employed professionals.
The plans discussed above can help bridge the retirement savings gap plaguing America. While self-employed professionals have other options, these offer the most flexibility and the least administrative burden.