Self-employed people—from Uber drivers to high-powered consultants—need to save for retirement, and a tax-advantaged retirement plan is the best way. Designed for the self-employed, the Simplified Employee Pension (SEP-IRA) and the Solo 401(k) are relatively easy to set up. Both plans offer tax-deductible contributions, enabling you to cut your taxes and get tax-deferred growth. Another plus: you can still reduce your 2014 federal income taxes because either plan allows you to contribute up until your tax-filing deadline, including the six-month extension. If you got an extension and haven’t filed your return yet, you have until Oct. 15 to make 2014 contributions to your plan.
However, while a SEP-IRA can still be established up until Oct. 15, those who wish to make a profit-sharing contribution to a Solo 401(k) must have established the plan by Dec. 31, 2014. Which plan is best for you? Here are the main features and the pros and cons of each. A SEP-IRA is similar to a traditional IRA. Investment earnings grow taxed-deferred until withdrawal, but self-employed individuals can save and deduct much more than the $5,500 ($6,500 if 50 and over) for contributions to a traditional IRA. SEP-IRA contribution limits are the lesser of 20% of net business income or $52,000 for 2014, $53,000 for 2015. Banks, insurance companies and brokerage firms offer SEP-IRAs, which often can be opened up on the Web. Make sure the sponsor offers a range of solid investment options.
One caveat: if you have employees, you must contribute the same percentage of salary for them as you do for yourself. If you can’t afford to or don’t want to do that, a SEP-IRA isn’t the best plan for you. Since SEP-IRA contributions are deemed to come from the business, not the individual, a participant can also contribute to a Roth IRA in the same year he or she makes a SEP-IRA contribution. By contributing to both, you can take advantage of tax-free Roth IRA growth and increase the tax diversification of your retirement savings and have more flexibility when you’re taking out money during retirement. The Solo 401(k) is for self-employed individuals without employees, other than a spouse, who may contribute to the plan if he or she is employed by the business. It can be structured as a traditional 401(k) or as a Roth 401(k).
The maximum 2015 contribution is $53,000 or $59,000 for those 50 and older. (The 2014 limits are $52,000/$57,500.) The contribution includes: • Annual employee deferral – up to 100% of compensation or earned income for a self-employed individual, to a maximum of $18,000 ($24,000 if 50 or older). This lets some people contribute more to a Solo 401(k) than to a SEP-IRA. • Employer discretionary contribution – up to 25% of compensation as defined by the plan or 20% of earned income for a self-employed individual. An advantage a 401(k) offers over an IRA is that participants may borrow from a 401(k). If you choose a Solo Roth 401(k), you won’t get a deduction, but all withdrawals are tax-free if you wait until age 59 ½. The plan lets you save much more than a Roth IRA.
Another big plus is that contributions to a Solo Roth 401(k) aren’t subject to income limits, unlike the Roth IRA. Is the Roth or traditional version better? It depends. If you expect to be in a higher tax bracket in the future, the Roth version may make more sense. If your current tax rate is low, you may be better off forgoing a deduction now in order to withdraw money tax-free when you’re in a higher bracket in the future, . But it doesn’t have to be an either-or proposition. You can have both traditional and Roth 401(k) plans and divide your contributions between them.
A Solo 401(k) plan can require more administration than an IRA, especially if the plan allows for loans. A plan with more than $250,000 in assets must file a Form 5500-series return annually. Fortunately, the IRS has simplified some versions of the form, which has reduced the administrative burden for most plans. Besides the SEP-IRA and Solo 401(k), traditional and Roth IRAs are also an option. In 2015, most individuals can contribute a maximum of $5,500 to their accounts, while those 50 and over can contribute up to $6,500. For most self-employed people, the SEP-IRA is probably a better choice than a traditional IRA because the contribution limits are much higher.
Furthermore, deductions for traditional IRA contributions are limited by income for participants who are covered by a retirement plan at work or if their spouse is covered by a plan at work. If you’re nervous about tying money up in retirement accounts, it’s good to know you can take withdrawals from a Roth IRA up to the amount of your prior contributions at any time without incurring taxes or penalties. This feature can come in handy in emergencies.
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