From: www.itworld.com

Retirement plans for the self-employed

by David Essex

December 11, 2000 —

 

One of the biggest drawbacks to setting off on your own as a consultant or
freelancer is losing company-funded retirement plans such as 401ks and pensions. But
unless you've already socked away enough money for retirement, it's not a good idea to
stop saving for the future just because you've lost access to such employer-sponsored
plans. Luckily, there are numerous tax-advantaged -- albeit self-funded -- vehicles for
putting money aside for the day when you stop working. And more options may be coming
soon.

I have been a full-time freelance writer since mid-1998, and I've pored over
financial Websites and Internal Revenue Service (IRS) publications more than is
probably healthy. I've been looking for retirement plans with high contribution limits
and a lot of tax advantages, plans with built in flexibility so that they can be put to
use for college and emergencies as well as retirement if need be. I've learned a few
tricks, dispelled some myths, and gotten a grasp on the pluses and minuses. My advice
should be pretty universal, but bear in mind who it's coming from: I'm an
unincorporated sole proprietor with no employees, a middle-income,
living-below-my-means do-it-yourselfer who would no sooner hire an accountant than I
would keep Emeril Lagasse around as my personal chef.

The basics

Retirement plans for one-person microbusinesses vary chiefly in their annual
contribution limits and in how they're reported to the IRS. They all let you buy into
the broad range of stocks, bonds, mutual funds, money markets, and other investments
offered by thousands of banks and brokerages, and are tax deductible.

Keogh plans let you contribute the most money -- up to around 19 percent of your
adjusted business income (the latter being what you clear after expenses, minus half
the self-employment tax, minus the contributions themselves). The annual contribution
can't exceed $30,000. Sales literature for all these plans often throws out
impressively high round numbers like 25 and 15 percent , but if you're self-employed,
your actual contribution is always reduced to a "percentage equivalent" that's about
three-quarters the advertised number.

There are four types of Keoghs. Money-purchase plans require you to commit
to a minimum annual contribution of about 3 percent of adjusted business income, but
they also allow the highest contribution. Profit-sharing plans vary your
annual contributions based on how well your business did, from zero to a top limit
around 11 percent annually. Defined-benefit plans guarantee a certain income
in retirement, like corporate pension plans do, and are harder to fund and administer.
I chose a fourth type, called a paired plan. This plan provides the most
flexibility, letting me contribute the profit-sharing maximum (about 11 percent of
income) as well as nearly 8 percent to a money-purchase plan, while locking me in to
only the money-purchase contribution.

Another popular plan is called the Simplified Employee Pension (SEP) Individual
Retirement Account (or IRA -- to the IRS, the a stands for
arrangements). SEP IRAs let you contribute and deduct substantially less than
Keoghs: you can put in anything from nothing up to about 12 percent of your income, all
of it deductible. The cap is also $30,000.

SEP IRAs are said to be as easy to establish and contribute to as regular IRAs, and
that's their main attraction over Keoghs. But it's a myth that Keoghs are much harder
to administer for individuals, though they may be if you have employees. My broker,
Fidelity Investments (Boston) reduces the process to a few simple forms, and its
customer-service reps are a free call away. You do have to write separate checks for
each type of Keogh, making sure to keep their account numbers and percentages straight.
But a special year-end report to the IRS (merely a longish form) must only be filed if
assets exceed $100,000. I spend maybe six hours a year administering my Keogh, a small
price to pay for the higher contribution limit.

Savings Incentive Match Plans for Employees (SIMPLEs) have smaller contribution
limits that generally can't exceed $6,000. They are technically salary-reduction plans
with employer contributions, a small-business 401k of sorts. There's little point in
having one unless your income is modest or you plan to add employees and want low
contribution limits. Since your combined contribution to all plans is capped at around
19 percent (or $30,000) by law, it's fruitless to use a SIMPLE IRA to supplement the
other higher-limit plans.

Any good retirement strategy should also include regular IRAs, especially if you
need to put more money aside to reach your goals. You can put up to $2,000 annually in
a traditional IRA and, in the year 2000, deduct the full amount if your adjusted gross
income (AGI) is under $52,000 and your tax status is Married Filing Jointly. The
deductibility limit rises to $80,000 in 2007 ($50,000 for single filers). You can make
these deductible contributions even if you have an employer-sponsored retirement plan
such as your SEP IRA; conversely, they're always deductible for the spouse who doesn't
have such a plan as long as your joint AGI is under $150,000.

The pivotal year 1998 also brought the Roth IRA, which is like the traditional IRA
except for one important difference: contributions aren't deductible, but money in the
account, including any earnings, can be taken out tax-free six months after your 59th
birthday. (With deductible IRAs and retirement plans, you pay income taxes on
withdrawals.) You can convert existing IRAs to a Roth, within certain income limits,
creating a sort of "Super-Roth" much bigger than one built on annual contributions. You
pay income tax on the amount converted, however. For this reason, it usually makes
sense to convert if you think your tax bracket in retirement will be the same or lower
than it is now. It's a question of paying now or paying later.

An under appreciated Roth advantage is that contributions and conversions can
usually be withdrawn at any time without penalty: you've already paid the taxes.

When tax-advantaged is a dis-advantage

So far, so good. A self-employed married person with a $60,000 AGI can put away nearly
$18,000 a year, most of it tax deductible. But another not-so-obvious consideration is
so significant that it's sometimes called the IRA's dirty little secret. All investment
earnings (and any deductible contributions) are taxed as income -- at 15 or 28 percent
for most people -- when they're withdrawn. (That is, unless they're in a Roth, and
you're retired or meet certain other requirements.) If the money goes instead into a
taxable account, any growth attributable to capital appreciation -- say, an increase in
a stock's value, but not including interest and dividends -- is taxed at the more
favorable long-term capital gains rate, typically 10 or 20 percent, when you take the
money out. And you can withdraw contributions to such accounts tax free, though the
calculations aren't as simple as with Roth principal withdrawals.

Most experts figure deductible IRAs held for 10 years or longer are still a better
deal because the earnings aren't subject to yearly taxes (income or short-term capital
gains) as the earnings of taxable accounts are. Still, consider diverting some of your
deductible IRA and retirement-plan money, or maxing out those accounts and putting
leftover money into a taxable account. In retirement, you can minimize your tax bill by
varying the amounts withdrawn from each type of account according to their recent
returns and your other income.

The new laws effective since 1998 also make it possible to take money from SEPs,
SIMPLEs, and IRAs to pay for higher education for yourself, spouse, children, or
grandchildren, or for a $10,000 down payment on a house, without paying the usual
10-percent early withdrawal penalty. So if you're ahead of the game in saving for
retirement, these accounts can be vehicles for other financial goals, though you should
proceed with caution.

Promises, promises

Congress has been promising to sweeten these retirement goodies for years. Now, after
several proposals have fallen flat, it appears that a bill called the Retirement
Security and Savings Act of 2000 might become law this year. Among other things, the
act soon raises IRA contribution limits to $5,000 a year and indexes them to
inflation. "There's a lot of support for it," says Kathy Hamor, executive director of
the Savings Coalition of America in Washington, D.C., pointing to a 401-25 vote in the
House and unanimous approval by the Senate Finance Committee. Election-year politics
may affect passage, however. "We just don't know what's going to happen because of the
time constraints," Hamor says. "I haven't heard whether Clinton's going to sign it."

Both major presidential candidates have proposals to expand retirement options.
Democrat Al Gore wants to create a new IRA-like option that would be matched by the
government, while Republican George W. Bush favors new accounts funded partly with
money diverted from Social Security contributions.

Which of the existing options you should choose depends on how much you can afford
and whether you'll end up sharing your good fortune with employees, says Gene
Fairbrother, a business consultant who provides advice to members of the National
Association for the Self-Employed (Dallas). Fairbrother says he saw a sharp drop in use
of Keoghs when SIMPLEs became available in 1997, especially among self-employed people
with employees, most of whom must legally be covered by the plans. "My first question
to them is how much can they afford," he says. "The vehicle is what determines how
much."

Resources


ITworld.com