Contributing to a retirement plan is one of the best tax shelters available to you during your working years. The money contributed generally saves you taxes today and always grows tax deferred.
Plus, with the future of social security up in the air and traditional corporate pension plans on the path towards extinction, contributing to a retirement plan provides some peace of mind that you'll be able to retire comfortably.
Self-Employed Retirement Plans
When you're an employee at a company, you have two options. Start by taking advantage of whatever retirement plan your employer offers, such as a 401k or 403b plan. You also have the option of contributing to a traditional IRA or Roth IRA each year that you or your spouse has earned income, subject to certain limitations.
When you're self-employed, it's up to you to establish and fund a retirement plan for your business. The three most popular plans are SEP IRAs, SIMPLE IRAs, and Solo 401ks. Contributions into all these plans (except the new Roth 401k) reduce your Adjusted Gross Income (AGI) and grow tax-deferred.
What if you work for a business that provides you with access to a retirement plan, and then you do some moonlighting or consulting on the side? Each year, you're allowed to make tax deductible contributions into a SEP, SIMPLE or Sole 401k based on your net self-employment income, even if you're covered under another employer's retirement plan.
Let's compare these three self-employed retirement plans, assuming your business is an unincorporated entity.
Maximum Contribution For Self-Employed Individuals Under the Age of 50
SEPs are a very user friendly retirement savings option. Each year that you have self-employment income, you can contribute as much as 20% of your net self-employment income into your SEP. On $50,000 of income, you could make pre-tax contributions of up to $10,000 into your SEP.
The due date for establishing a SEP is the due date of your tax return, including extensions. So if you filed an extension request on April 15th, you have until October 15th to establish and fund a SEP and save taxes for 2005.
Establishing and maintaining a SEP requires very little paperwork. The only costs associated with these plans are the fees charged by the mutual fund company or the plan's financial advisor. And with a SEP, there is never a requirement to file a tax form for the plan with the IRS.
SIMPLE IRAs are a scaled down version of a 401k plan. With a SIMPLE, your contribution consists of two components. First, you can make "deferral" contributions of the lesser of your net self-employment income or $10,000 ($12,500 if 50 or older). You'll also contribute either 2% or 3% of your net income, not to exceed the amount of your deferral. On $50,000 of income, you can contribute up to $11,500 into your SIMPLE.
The due date for establishing a SIMPLE is October 1st of the first year of the plan. And like SEPs, there is very little paperwork required to set up or maintain the plan, no fees except those charged by the fund company or your financial advisor, and no annual filing requirements with the IRS.
Keep in mind that the amount you can contribute into your SIMPLE may be limited if you participate in a 401k or 403b plan through another employer. For 2006, your total "deferrals" through all your plans generally can't exceed $15,000 ($20,000 if 50 or older). So if you contribute $12,000 into your employer's 401k plan, your SIMPLE contribution would be limited to $6,000 - $3,000 in deferrals plus 3% of your income, not to exceed your $3,000 deferral.
Solo 401k's gained popularity thanks to the 2001 Tax Act. Under the current rules, you can contribute up to $15,000 ($20,000 if 50 or older) plus 20% of your net self-employment earnings into these pre-tax accounts. On $50,000 of self-employment income, you could sock away a whopping $25,000 into your Solo 401k.
You're only eligible to take advantage of this type plan if you have no employees who work for you more than 1,000 hours per year besides your spouse. The due date for establishing a Solo 401k is December 31st of the plan's first year. And like the SIMPLE, the $15,000 of deferrals is reduced if you contribute to another employer's 401k or 403b plan.
Expect the administrative burden and fees associated with Solo 401k's to exceed those of the other plans. And once plan assets exceed $100,000, you're required to file a Form 5500EZ annually with the IRS.
What If You Have Employees?
When you have staff, if you contribute to your own retirement account, you're generally required to make equivalent contributions on behalf of your eligible employees. What determines eligibility?
With a SEP, if you want to max out your annual contributions, expect to contribute 25% of your eligible employees' W-2 wages into their SEP accounts as well.
With a SIMPLE or a 401k plan, the salary deferrals come out of your employees' pocket. Your only requirement is to make the matching contributions and any additional profit sharing plan contributions on behalf of your staff. Many self-employed individuals with staff end up migrating towards either of these two plans.
One drawback of SEPs and SIMPLEs is that they don't allow for "vesting schedules". With a more sophisticated plan like the 401k plan, your employees forfeit a portion of the profit sharing plan contributions made on their behalf if they stop working for you. For most plans, an employee won't be fully vested until after completing six years of service.
Once you have staff, choosing the correct plan for your business becomes much more difficult. Make sure to seek the advice of your CPA or financial advisor, or contact one of the professionals on our Directory of Financial Advisors.
Summary of Self-Employed Retirement Plans- 2006 Rules
Here are a few other pre-tax retirement savings plans available to self-employed individuals.
With a Defined Benefit Plan (DB), the annual contribution is significantly larger than most other plans since it is based on how much money you need to set aside today to fund an income stream when you retire. While these plans allow for very substantial contributions, be aware that they lock you into making large contributions each year you have self-employment income. Plus, DBs are expensive to set up and maintain, and may require substantial contributions on behalf of your eligible employees.
Keogh plans are another option available to self-employed individuals. Keoghs aren't as popular as they once were, since the 2001 Tax Act increased the amount you can now contribute into a SEP. Even so, Keoghs offer some options not available with SEPs, including vesting schedules for contributions made on behalf of your staff. And if you have staff, Keoghs may offer more protection from your creditors than a SEP or SIMPLE.
Like most decisions in connection with your personal finances, the worst decision you can make is to put off making a decision. The sooner you start saving for your retirement, the better off you'll be.
Take some time now to determine which plan makes the most sense for you, complete the necessary paperwork to set up that plan, and get on track to max out your allowable contributions for 2006.
Blood pressure, pulse, good cholesterol, bad cholesterol, and your weight are all risk factors for heart disease monitored by your doctor. How come your doctor never takes a look at your FICO score as well?
Your FICO score is what lenders use to determine your creditworthiness. Potential employers and landlords may also get a hold of your FICO score before deciding to offer you a job or an apartment. Like your SAT score, the higher your FICO, the more attractive you'll be.
How Is Your FICO Score Calculated?
According to our friends at myFICO.com , the FICO score for most people is calculated on the weighted average of these five attributes:
Steps To Improve Your FICO
Since your FICO impacts so many aspects of your financial life, what steps can you take to improve your FICO score?
Start by taking a look at your credit report on a regular basis, since the information on your credit report is used to generate your FICO score. You're now allowed to get three free credit reports per year - one from each of the credit reporting agencies - at www.annualcreditreport.com.
Here are some other suggestions from www.myFICO.com :
Manage Your Debt
In today's world, very few people have the savings or the disposable income to be able to "pay as you go". Credit cards, mortgage debt, and installment loans are essential to most young professionals.
Take the necessary steps now to keep your FICO score healthy. By doing so, you'll be rewarded with easier access to less expensive credit.
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