We all know saving for retirement is important for everyone but for self-employed individuals, it’s not as easy. You may feel overwhelmed at the multitude of options, rules, and limitations for the different plan types. Below is a summary of self-employed retirement options and important details for each, including the annual contribution limit and deadline to establish for a 2019 tax return.
Traditional or Roth IRA
- Contribution Limit: Lesser of compensation or $6,000 for 2019 (plus $1,000 catch-up)
- Advantage: Fast and easy to set up
- Disadvantage: Low contribution limits
- Deadline to establish: 4/15/2020
- Best Candidate: An individual who wants to start small savings for retirement fast and easy
Individual retirement accounts (IRA) are a tax-favored means of saving for retirement. The maximum amount that can be contributed to a traditional or Roth IRA is the lesser of your compensation (earned income) or $6,000 for 2019 (plus $1,000 for those over 50 years old). Traditional IRA contributions are deductible when made (subject to IRS income limitations and if the taxpayer or their spouse are covered by plans at work). Roth IRA contributions are after-tax, but distributions are tax-free. Participation in a Roth is subject to income limitations as well. For a distribution from a Roth IRA to be qualified, the taxpayer must have the account established for 5 years and reach the age of 59 ½. A Traditional IRA only has the 59 ½ year age requirement. For Traditional IRAs, distributions will be required once the taxpayer reaches the age of 70 ½. Roth IRAs have no minimum distribution requirement until after the death of the owner.
One-Participant (Solo) §401K
- Contribution Limit: Lesser of $56,000 for 2019 or 25% of net self-employment income
- Advantage: High contribution capacity | Catch-up contributions allowed
- Disadvantage: No full-time employees allowed
- Deadline to establish: 12/31/2019
- Best Candidate: An individual with no full-time employees that wish to stash large savings
A one-participant §401(k) plan is exactly as the name states, a §401(k) plan for only one person (including that person’s spouse). It is not an eligible plan for businesses with full-time employees. However, part-time employees who work less than 1,000 hours per year can be excluded from the plan. A one-participant §401(k) plan can also be treated as a Roth §401(k).
A self-employed individual can contribute up to the maximum annual elective deferral limit applicable to regular §401(k) plans ($19,000 in 2019 plus $6,000 for those over 50 years old). In addition, nonelective profit sharing contributions can be made up to 25% of net self-employment income. The total contributions, including elective and nonelective, cannot exceed the §401(k) annual contribution limit ($56,000 plus $6,000 catch-up in 2019). Solo §401(k) owners also enjoy a deduction for all contributions (assuming no income limitations). Form 5500-SF annual filings are required if the plan assets exceed $250,000.
Simplified Employee Pension (SEP) IRA
- Contribution Limit: Lesser of $56,000 for 2019 or 25% of compensation for employees and 20% of net self-employment income for business owners
- Advantage: Easy to administer and flexible
- Disadvantage: No catch-up contributions | Proportional contributions for employees
- Deadline to establish: 4/15/2020 (10/15/2020 if extension applies)
- Best Candidate: An individual with little-to-no employees that wish to stash large savings
Simplified Employee Pensions (SEPs) provide similar benefits as Traditional IRAs but are only available to self-employed individuals. In addition, the contributions have the potential to be larger considering the limit is much higher and based on net self-employment earnings. A SEP also allows for employees to be covered but it does not have the ability to be treated as a Roth IRA.
Under a SEP arrangement, the employer contributes to individual IRAs for covered employees. Self-employed individuals are treated as employees for this purpose. The limit on annual additions to an employee’s SEP account is effectively the lesser of $56,000 (for 2019), or 25% of the employee’s compensation from the employer for the year. For the self-employed individual, the maximum is the lesser of $56,000 or 20% net earnings from self-employment (business profit less one-half of self-employment tax).
One of the main concerns a self-employed individual with employees would have is the SEP’s required proportionate contributions. The contributions made for all employees (including the self-employed individual) must be an equal percentage when comparing to compensation. For example, if the self-employed individual contributes 10% of compensation, each employee must receive a contribution of 10% of their compensation. In addition, employees cannot make elective deferrals and are immediately 100% vested in employer contributions.
Savings Incentive Match Plan for Employees (SIMPLE)
- Contribution Limit: $13,000 for 2019 (plus $3,000 catch-up)
- Advantage: Employees may contribute | No reporting requirements
- Disadvantage: Plan requires minimum elective deferrals
- Deadline to establish: 10/01/2019
- Best Candidate: An individual that wants to establish a plan for employees
A “SIMPLE” plan is a type of simplified retirement plan for small businesses with employees. A SIMPLE plan may be established if a business employs 100 or fewer employees who earned at least $5,000 in compensation for the preceding year.
Unlike a SEP, a SIMPLE plan allows employees to make elective contributions to an individual retirement account (IRA). Employee contributions must be based on a percentage of their compensation and cannot exceed a certain amount per year ($13,000 plus $3,000 catch-up for 2019). For the self-employed owners, compensation is considered net earnings from self-employment. Businesses are generally required to make matching contributions or non-elective contributions on behalf of employees. If nonelective contributions are selected, every eligible employee must receive a contribution regardless if they are making elective contributions. All contributions for the self-employed individual and all non-elective contributions for employees are deductible.
Defined Benefit Plan
- Contribution Limit: Calculation performed by an actuary based on age and retirement benefit
- Advantage: High contribution limits and high tax benefits
- Disadvantage: Plan can be expensive and administratively burdensome
- Deadline to establish: 12/31/2019
- Best Candidate: An individual that wants to maximize contributions quickly
A defined benefit plan promises (i.e., defines) a benefit for a participant at retirement, typically based on such factors as the participant’s years of service with the employer and compensation history. The benefit typically is expressed as an annuity for life, beginning at retirement.
The amount that an employer must contribute to a defined benefit plan is determined by an actuary. Because defined benefit plans guarantee an employee’s level of benefits and require the employer to make the contributions needed to fund those benefits, the resulting uncertainty from year to year as to the amount of the employer’s contribution obligation constitutes a key disadvantage of such plans. Defined benefit plans also have certain related costs that can make them expensive to maintain. The upside to defined benefit plans is the high contributions made are deductible. For self-employed individuals close to retirement, this allows for higher savings and higher tax benefits.
Whew, that was a lot of information. Keep in mind this is just a brief overview of the common retirement options available to self-employed individuals. Before you choose a plan, you should consider your overall financial savings and tax situation.
At MKS&H we can help you determine which retirement plan makes the most sense for you! Contact us for a consultation.
Article Contributed by Stephanie Walsch, CPA