We’ve already discussed what a 401(k) is and how important it is to save for retirement, but what about those individuals who are not employed by a company or organization? Many contractors and self-employed individuals are unsure how they can save for retirement and receive the benefits of tax deferral saving. Have no fear, I have the answer for you! There are four options for contractors and self-employed individuals: Individual 401(k), SEP IRA, Defined Benefit Plan, and the Simple IRA.
The Individual 401(k) is available as a traditional 401(k) and a Roth 401(k) offering the same tax benefits. The Individual 401(k) allows a contractor or self-employed individual to contribute pre-tax dollars into the account for investing on a tax deferred basis using the traditional option where earnings are not taxed until they are withdrawn. The Individual 401(k) Roth option works the same as any other Roth savings where contributions are made with after-tax dollars and are not taxed when they are withdrawn. The Individual 401(k), whether traditional or Roth, is only for the sole proprietors who have no employees.
Another perk of the Individual 401(k) is that you can make contributions as an employee and employer allowing for optimal savings. For example, as an employee, you can only save the maximum ($17,500), but also as an employer you can save an additional 25% up to $51,000 for 2013. This is great news for the super saver in you who would like to save additional funds but max out under the employee thresholds. Keep in mind as an employer, you are also responsible for the administration fees associated with the account which can be potentially greater than employer sponsored retirement savings plans. Do your homework before opening such a plan.
A SEP IRA is a good retirement savings plan for sole proprietors and small business owners with employees. The SEP IRA allows these individuals to save for retirement on a tax deferred basis up to $51,000 for 2013. The SEP IRA does not offer a Roth option. All contributions are made with pre-tax dollars and are 100% tax deductible from personal income. These individuals are able to contribute the employee maximum and the employer maximum as an additional 25% of wages. These earnings grow tax deferred and are not taxed until the savings are withdrawn after the age of 59 ½. The SEP IRA has lower administrative costs associated with these accounts and are less time consuming.
The Defined Benefit Plan is for self-employed individuals and small business owners allowing for the highest contribution amounts among all options, but it also has the highest administrative fees. This option is most appropriate for those 45 years or older who wish to make contributions greater than the maximum amounts. In fact, contributions can exceed $100,000 for this particular option, depending on age and income, but are all 100% tax deductible. This plan works in a specific way that is different than the 401(k) and IRA options. Contributions into a Defined Benefit Plan are made to fund a chosen level of annual income at a predetermined future retirement date. For example, if an individual wishes to have $100,000 annual income for a predetermined retirement date set five years from time of account opening, this person will need to contribute above that to meet that income requirement.
Lastly, the Simple IRA really is pretty simple, and it’s a great choice for independent contractors who wish to contribute more than the maximum for a traditional IRA and a large portion of their income. Those who contribute into a Simple IRA may contribute 100% of their income up to the maximum amount of $12,000, or $14,500 for those 50+ years of age. A 3% additional employer contribution is allowable for maximum savings. Simple IRA’s have relatively low administrative fees, but also have lower maximum contribution limits.
If you are in an independent contractor or self-employed, I implore you to look into these available options and maximize your retirement savings as soon as possible. Each of these options offers special benefits and should not be overlooked. If you need additional information regarding any of these savings vehicles, research online using reliable sources or contact a financial professional.