As you begin to ponder your inevitable retirement from the Freelance life, you’ll need to examine options for saving. Those who generate an income large enough to make planning and saving for the future an obvious course of action probably have an investment counselor to act as guide through the minefield.
Yet at some point, less wealthy Freelancers must also understand how to finance the next phase of their lives. Choosing the best retirement plan option is confusing and subtle differences can magnify both at tax time and when it’s time to retire. I hope that you find this post useful as you formulate the plan for your future.
The Simplified Employer Pension Plan
Somewhat similar to Solo 401K, the SEP IRA retirement plan may be used by Sole Proprietors, LLCs, C Corporations, S Corporations and Partnerships. As an added bonus, the SEP IRA may be used not only by those who have both W2 and self employment income, but also by business owners who employ more than just the spouse.
Contributions to the SEP IRA are made pre-tax and contributions are tax deductible. It is permissible to contribute up to 25 % of W2 earnings plus up to 20% of self employment income, to the maximum annual contribution of $49,000.00 in 2010. There is no “catch up contribution” provision with SEP IRA.
If you have a job, including one where you are able to participate in a retirement plan, along with a sideline business, then SEP IRA is your option of choice. Up to the maximum, the amount you choose to contribute, or even if you choose to contribute, in a given year is up to you. Contributions are held tax deferred and withdrawals made after age 59 1/2 are taxed as ordinary income. Withdrawals made prior to age 59 1/2 are subject to the customary 10 % premature withdrawal penalty and additionally, will be taxed as ordinary income.
Small business owners with employees may institute a SEP IRA for themselves and their employees. Business owners are able to make generous tax deductible contributions to the company SEP IRA on behalf of themselves, the on-the-payroll-wage-earning spouse and other employees.
The business owner decides at what level to fund the plan, up to 25% of annual compensation. The % of funding for the business owner must equal what is offered to employees. Each employee has an individual SEP IRA account and the business owner pays the entire contribution. The pre-tax money paid into each SEP IRA account is tax deductible for the business and is a tax free benefit for the employee.
If you like, it is possible to convert a SEP IRA to a Solo 401K, something you may choose to do when you turn 50 and want to make those catch up contributions. Other retirement accounts can be consolidated into the SEP IRA, with the exception of a Roth 401K, which is an after-tax fund. It is not possible to borrow against the value of the SEP IRA. April 15 is the deadline to establish and fund your SEP IRA account in order to receive a tax deduction for the previous year.
Unlike SEP and Solo 401K, Roth 401K contributions are made with after-tax income. Which option you choose will, like most of life’s choices, depend upon how much money you generate. Depending upon your financial situation, you may decide to split the difference and have both a (pre-tax) Solo 401K and an (after tax) Roth 401K.
It is permissible to use the salary deferred portion of your Solo 401K to make a Roth 401K contribution. Remember that the maximum annual contribution is $16,500.00 for those younger than 50 years and $22,000.00 for those 50 years and older. Profit sharing Solo 401K contributions are not eligible to be made as a Roth 401K contribution, since they are made pre-tax and are tax deductible and you cannot commingle the two.
While Roth 401K income deferred contributions are NOT tax deductible, withdrawals you make after age 59 1/2 years are tax free IF five years have passed since your first contribution to the Roth (known as the 5 year rule). Roth distributions must begin at least by age 70 1/2, unless you roll over to the Roth IRA.
BTW, if you transition into a job that offers a retirement plan, you may be tempted to roll your SEP IRA or Solo 401K into the new retirement account. Be advised that may or may not be a smart move. Maintenance fees will be much lower for an account attached to a large company vs. that of an individual; but there is much more investment flexibility available in your Solo 401K vs. what is available to a big corporation.
Thanks for reading,