Taxes Made Simple

(an Excerpt from Surprisingly Simple: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less)

One of the single greatest parts of being self-employed is that there are more (and better) retirement plan options available to you than there are to most taxpayers. In addition to the standard traditional IRA/Roth IRA options that everybody has, you have three more options:

1)    Simplified Employee Pension (SEP)
2)    Savings Incentive Match Plan for Employees (a.k.a. SIMPLE IRA)
3)    Qualified Plans (sometimes referred to as Keogh plans)

The bad news: Most of the IRS literature comparing these three options is particularly complicated.
The good news: Darned near all of that literature is irrelevant if you have no employees. If you have no employees, the primary difference between the plan options is simply the contribution limit for each. [Note: If you do have employees, and you want to set up a retirement plan for your business, it’s strongly recommended that you get professional guidance.]

Retirement Plans in General

The basic idea behind each of your options is very similar to the idea behind a traditional IRA. That is, you get a tax deduction for each of the contributions you make to the plan, and your investments are allowed to grow tax-deferred until you start making withdrawals from the plan. Unfortunately, the deductions you receive for these contributions are not Schedule C deductions. They are, however, “above the line” deductions.

SEP IRAs

SEP IRAs work in almost the exact same way as a traditional IRA. That is, you are allowed an above the line deduction for any contributions you make. The only really important difference is the contribution limit. For 2007, if you have a SEP, you are allowed to contribute the lesser of:
1)    25% of your net earnings from self-employment
2)    $45,000

Once the money is in the plan, you can invest it in all of the same things you would be allowed to invest in with a regular IRA (stocks, bonds, mutual funds, CDs, etc). Also, the same withdrawal rules apply. With a few exceptions, you cannot make withdrawals from the plan prior to age 59.5 without being penalized.

One important thing to know is that, for purposes of calculating your maximum contribution, “net earnings from self-employment” is perhaps not quite what you’d expect. Basically, it’s all your revenues, minus your expenses (makes sense so far), minus two other items:
1)    The deduction for one-half of your self-employment tax.
2)    The deductions for contributions to your SEP IRA.

Obviously, the idea of deducting your contribution amount when attempting to figure out how much you can contribute in the first place is a little confusing. Thankfully, the IRS gives you a cheat sheet to simplify the calculation. You can find it toward the end of IRS Publication 560.

SIMPLE IRAs

SIMPLE IRAs also function much like traditional IRAs. Again, the primary difference comes down to contribution limits. If you have a SIMPLE IRA, you can contribute (for 2007) 100% of your self-employment earnings up to $10,500 for people under 50, or $13,000 if you are 50 or over.
One other potentially important difference is that, should you have to make an early withdrawal from the plan within two years of the plan’s inception date, you will be penalized more than you would be if it were a SEP IRA (25% penalty as compared to 10% penalty).

SEP vs. SIMPLE

As you’ve probably already noticed, SEP IRAs generally allow for a larger contribution than SIMPLE IRAs. The primary exception is for people whose business is a part-time business. More precisely, if you make less than $42,000 from your business, a SIMPLE IRA is going to allow for higher contributions than a SEP IRA.
 

Qualified Plans

The term “qualified plans” in this context encompasses several different types of plans. The four most common types are:
1)    Profit-sharing plans
2)    Money purchase plans
3)    Solo 401(k) plans
4)    Defined benefit plans.

Generally speaking, due to their lack of flexibility, profit-sharing plans and money purchase plans (sometimes known as "Keogh Plans" are not worth worrying about. Your needs can probably be met using a SEP IRA, SIMPLE IRA, Solo 401(k), or defined benefit plan.

Solo 401(k) Plans

A solo 401(k) plan functions very much like a 401(k) plan with a person’s employer. The difference is that you are allowed to make a contribution in the role of employee and a contribution in the role of employer. You are allowed to contribute:
1)    100% of your earnings from self-employment, up to $15,500 for 2007 ($20,500 if you are 50 or over), plus
2)    an employer contribution of 20% of your earnings from self-employment.
The total contribution is limited to the lesser of the taxpayer’s earnings from self-employment, or (for 2007) $45,000. The only real downside to this type of plan is that it is generally more expensive to set up than a SEP IRA or a SIMPLE IRA.

 

Defined Benefit Plans

Defined benefit plans offer by far the largest potential for tax-deferred growth. The 2007 limit for a defined benefit plan contribution is the lesser of:
1)    100% of the participant’s average self-employment earnings for his or her highest 3 consecutive calendar years, or
2)    $180,000.

The downside to a defined benefit plan is an extreme lack of flexibility. When you set it up, you’re required to determine a projected benefit (amount of income) that the plan will produce for you once you retire. Then, you are required to make contributions each year that will (according to current actuarial estimates) be able to provide the determined projected benefit.

As you might guess, due to the increased complexity involved, many investment firms will charge higher maintenance fees for a defined benefit plan than for any other type of retirement plan.

Pulling it All Together: How Things Work when You Have Multiple Plans

Given that you now have so many different options available to you, it’s important to know how each of these plans interacts with other retirement accounts. Conveniently enough, none of the above-mentioned plans will affect your ability to contribute to a traditional IRA or a Roth IRA. Also, if you have a full-time job as an employee, and you are allowed to contribute to a 401(k), starting your own business-related retirement plan will not affect your eligibility to contribute to your 401(k) at work.

It is important to know that any contributions you make to your 401(k)  (if you have one at work) or a business-related retirement plan will count toward your contribution limits for your business-related retirement plans. As an example, assume you make $40,000 from a full-time job, and $200,000 from your business. You have a 401(k) at work, and a SEP IRA for your business. Also, you are under 50 years old. Because $45,000 is less than 25% of your earnings from self-employment, your SEP IRA contribution limit is $45,000. However, if you contribute any money to your 401(k) at work, the amount you contribute is deducted from your maximum contribution to your SEP. So if you contributed $4,000 to your 401(k), you could only contribute $41,000 to your SEP IRA.

Given that having multiple plans doesn’t increase your maximum contribution amount, it generally makes sense to only have one retirement plan for your business. However, if you also have a “real job” that offers a matching contribution, be sure to at least make sufficient contributions to get the maximum match. Generally you want to make your decision in order to maximize your potential contributions, while still keeping in mind the fees that would be associated with each type of plan at your favorite investment firm/bank.
 

Chapter 14 Simple Summary 

• As a business owner, you have several options for retirement plans.  In most cases, contributions to these plans count as above the line deductions.

• Generally speaking, you want to choose the plan that has the highest contribution limit for your situation.

• Due to their simplicity, SEP IRAs and SIMPLE IRAs are often excellent options. If your self-employment earnings are under $42,000, you will be able to contribute more to a SIMPLE. Earn above $42,000, and you will be able to contribute more to a SEP.

• Solo 401(k) plans and defined benefit plans can allow for very large contributions, but they are likely to be accompanied by higher set-up and maintenance costs from your bank or investment firm.

For More Information, Take a Look at The Book.

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Read another chapter (Self-Employment Tax Explained).