Retirement Savings Plans for the Self-employed

Choosing to leave a corporate job and become self-employed does not mean you have to leave behind regular contributions to a retirement savings plan. With the right research, you’ll find that that you have similar options available to you as you did as a corporate employee. Before you choose a plan, however, you need to take a number of considerations into account and research plan options to find the one that is right for your needs.

To get started, you will need to establish how much you can fund based upon the income and structure of your business. Knowing this figure will help to ensure you choose a plan that is cost effective to manage, gives you the flexibility you need and works with your income projections.

Next, you will want to work with a financial planning professional to explore which plan is right for your needs. Each type of plan has very set parameters and knowing the ins and outs of each can be difficult to navigate. Plan types are broken down into two categories: Defined Contribution Plans and Defined Benefit Plans.

Defined Contribution Plans

These plans are good for business owners looking for flexibility each year as contributions are based on a percentage of income from the business. A Defined Contribution Plan has four variations and each variation has its own funding formula and filing requirements:

1. Solo 401(k): Allows up to $16,500 plus another 20 percent of your net self-employment income (defined as total business income minus expenses and half of your self-employment tax) — or 25 percent of your compensation if your business is incorporated — for a maximum of $49,000.
2. SEP Individual Retirement Account (SEP IRA): Allows up to 20 percent of your net self-employment income, for a maximum of $49,000.
3. Simple: $11,500 (or 100 percent of income, whichever is less) a year, plus two or three percent of income.
4. Keogh Plan: There are two types of Keogh plans.
   • Money Purchase Plan: Allows up to 25 percent of your net self-employment income, for a maximum of $49,000. Whatever percent is chosen when the plan is established must be funded each year.

   • Profit Sharing Plan: Allows up to 25 percent of your net self-employment income, for a maximum of $49,000. Similar to the Money purchase plan, you choose a percentage when establishing the plan. The difference is that you can choose to fund anything from $0 to the full amount allowed each year. This provides you flexibility.

Defined Benefit Plans

These plans can be expensive to fund and maintain each year. However, they do often allow for a much larger contribution than the Defined Contribution plan. Contributions for these plans are based on the future benefit needed. When establishing the plan, you will work with an actuary to determine what the retirement benefit should be, and then each year, the actuary will calculate the required contribution. The retirement benefit is based on age, income, assets in the plan and return on these investments in the past and projected future returns. Overall, the Defined Benefit Plan usually favors the older business owner who is closer to retirement and can afford to fund each year.

Whether you choose a Defined Benefit Plan or a Defined Contribution Plan, there are a number of things to watch out for.

1. Annual Funding: Some plans require contributions even though the business may not be able to afford to fund the plan in any given year. It is important to choose a plan that fits your situation and needs.
2. Income: The calculations are based on income from your business. Let’s say you have a Subchapter S Corporation. Your salary is what will determine the plan contribution. If this entity has a profit, as an owner, you are taxed on this, but the profit will be reported on a K-1 form. This income is not subject to FICA tax and is not allowed to be used when determining your plan contributions. If you report on a Schedule C, then your net income less one half of your FICA tax is the important number to know. So even how much to fund based on income can be a complicated formula based on how the business is structured.
3. Employees: If you have employees, understand the requirements. You may need to fund for employees.
4. Annual Reporting: While some of the plans have no ongoing reporting requirements, others may require an annual report be filed.

Knowing the different requirements of all these plans is also important because if you are in violation of plan rules, you may find your plan invalid and thus disallowing past tax benefits. Penalties and taxes can run into the thousands of dollars. Most importantly, when thinking about establishing a plan, it is important to work with a financial professional who understands these plans and can help design the right plan for you.

FPA member Scott M. Kahan, CFP^®, is president and founder of Financial Asset Management Corp. in New York City.