The best retirement plan for an independent contractor depends largely on how many, if any, employees work for them. If you work as a solo independent contractor, retirement plans are generally simpler and less costly than if you have employees. Once you hire employees, you may be obliged to contribute to their retirement plans as well as to your own, placing additional burden on your company financials.
It is standard practice at large corporations to provide 401(k) plans to full-time employees, but as a small business owner, the cost of providing retirement plan benefits may be a large portion of revenues or profits. Before selecting one plan over another, think carefully about the ongoing financial commitments to contribute to a retirement plan or plans of many employees and what the financial liability will mean not just for your personal finances, but for your company’s finances too.
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Solo 401(k) Retirement Plan
A solo 401(k) plan permits a business owner to contribute up to $53,000 annually or $59,000 if over the age of 50. Unlike some other retirement plan options, a solo 401(k) can allow a business owner contribute a large amount towards retirement savings in a short period.
A solo 401(k) plan is just one of the many labels applied to one-participant 401(k) plans according to the IRS. Other names for the same plan include solo-k, uni-k, and one-participant k plans. The solo 401(k) is a traditional 401(k) plan that covers a business owner with no employees, or the owner and a spouse, and allows you to contribute large amounts quickly.
In a solo 401(k) plan, the business owner is considered both the employer and the employee. As the owner, you may defer the first $18,000 annually or $24,000 if over the age of 50, even if these elective deferral amounts represent 100% of your earned income (plus an additional 25% of salary for higher income earners). Here is an example of how it works:
As the business owner, in addition to contributing as much as $18,000 (or $24,000 if over age 50), you are also entitled to choose employer non-elective contributions of up to 25% of your earned income. To highlight how this works, consider a business owner with $100,000 of earned income. The business owner can defer the first $18,000 (or $24,000 if over the age of 50) directly into the solo 401(k) retirement plan. And the business owner can contribute up to an additional 25% of salary ($25,000) for a total contribution of $43,000.
For a business owner over the age of 50 who is earning $50,000 in W-2 wages, it is possible to defer the first $24,000 and an additional 25% of salary ($12,500) for a total contribution of $36,500.
The maximum contribution permitted annually for a solo 401(k) plan is $53,000 for those under the age of 50 and $59,000 for those over the age of 50. What makes the solo 401(k) so attractive is that you don’t need to earn as much as other plans, such as the SEP IRA, to contribute the same amount to your retirement plan.
While the solo 401(k) is attractive in allowing you to contribute a large amount in a short period to your retirement nest-egg, it is more administratively burdensome than other retirement plans. Once you accumulate $250,000, you will be obligated to file annual report Form 5500-SF with the Internal Revenue Service to declare assets in the plan.
How To Finance Your Business From Your Solo 401(k) Plan
A business owner looking to grow their business can finance expansion by borrowing the lesser of $50,000 or 50% of contributions from their solo 401(k) plan.
An added benefit of the solo 401(k) plan is the opportunity to borrow from plan contributions to finance your business. The most you are permitted to borrow is $50,000 or 50% of your contributions, whichever amount is lower.
For solopreneurs who need money to grow their business, this is an attractive financing choice because interest rates are reasonable. The fly in the ointment is that you must repay borrowed funds within 5 years, so make sure to crunch the numbers for the business before electing this financing option.
SEP-IRA Retirement Plan
A SEP-IRA has a high contribution limit, no requirement to make annual contributions, and all contributions are made with pre-tax dollars. Business owners are required to contribute the same percentage of pay to employee SEP-IRA plans as they contribute to their own SEP-IRA plan.
Similar to a solo 401(k), a SEP-IRA has a high contribution limit. The limit is $54,000 in 2017 ($53,000 for 2016). However, the most that can be contributed annually is the lesser of 25% of annual compensation or $54,000. So if the business owner earns $100,000 annually, then no more than $25,000 may be paid into his or her SEP-IRA retirement plan.
Another attractive feature of the SEP-IRA is that contributions do not have to be made every year, so if your business encounters cash flow issues you are not required to continue making contributions. A further advantage of the SEP-IRA is that all contributions are made with pre-tax dollars, so you benefit from the inherent tax advantages.
Where the SEP IRA has drawbacks for the small business owner without abundant cash flow is employees must receive the same percentage of pay into their SEP-IRA plans as the percentage the business owner contributes to their own plan.
Consider a small business owner earning $100,000 annually who has three employees and wishes to direct 10% of earnings ($10,000) to a SEP-IRA plan. If each of the three employees earns $50,000, the business owner must contribute 10% of $50,000 ($5,000) to each employee SEP-IRA plan, for a total of $15,000.
For a business owner with employees, you can see that choosing a SEP-IRA can quickly becomes costly. If the business is growing and plans are in place to hire more employees, careful evaluation of projected costs should be made before electing the SEP-IRA.
SIMPLE IRA Retirement Plan
A SIMPLE (Savings Incentive Match Plan for Employees) IRA allows independent contractors to contribute more to a retirement plan than is possible through a traditional IRA. For business owners with employees, the SIMPLE IRA gets more complicated: an employer must select the amount of contribution matching, notify employees of periods when contribution levels may be changed and keep election periods open for at least 60 days.
Independent contractors without employees will find the SIMPLE IRA to be an attractive retirement plan option. While contributions to a traditional IRA are restricted to $5,500 annually (or $6,500 over the age of 50), contributions to a SIMPLE IRA of up to $12,500 annually (and $15,500 for those over age 50) are permitted.
For business owners with employees, the IRS mandates that the employer must select one of the contribution methods below and inform employees which one is chosen for the following year.
- 2% non-elective contribution: contribute 2% of each employee’s compensation to the employee’s plan, irrespective of whether the employee contributes; or
- 3% matching contribution: match each employee’s contribution on a dollar-for-dollar basis up to 3% of the employee’s total compensation.
It is permitted to reduce the 3% figure to a lower amount provided it is above 1%. Over a 5 year period, a selection amount below 3% is permitted in only two calendar years.
The SIMPLE IRA is more administratively burdensome than some other plans because employees must be notified when they can change their contribution amounts during the plan’s election period, which must be at least 60 days long. The IRS stipulates that at least one election period between November 2 and December 31 is made available to employees, though the employer can open up additional election periods if they wish.
Traditional IRA & Roth IRA Retirement Plans
Traditional and Roth IRA retirement plans have lower annual contribution limits than other retirement plan options but are a good choice for those early in their careers or unable to contribute more than the threshold limits each year. The Roth IRA is generally the better choice if you believe your tax rate will increase over time. Plus, the Roth IRA has greater flexibility because contributions (not earnings) may be withdrawn tax-free and penalty-free.
In a traditional IRA, pre-tax dollars are contributed while in a Roth IRA after-tax dollars are contributed. In both cases, contributions are limited to $5,500 annually ($6,500 over the age of 50). Although the cap is lower compared to other plans, traditional IRA and Roth IRA plans are good starter options for independent contractors who don’t have the means to set aside a larger amount for retirement.
The Roth IRA has the edge over the traditional IRA in two ways:
- If you expect your tax rate to increase over time, the Roth IRA is the better choice because you pay lower taxes upfront than you would otherwise in retirement years with a traditional IRA.
- You can withdraw your contributions without paying taxes or penalties at any time – because after-tax contributions were made, the IRS has already received tax payments. However, investment gains are subject to Roth IRA withdrawal rules, including a minimum five year period that the account must be held.
No matter which retirement plan you choose, the power of compounding gains over long time periods can significantly increase the size of your retirement nest-egg, so find the best IRA provider to meet your needs and get started.