You don't need to have your own full-time business to take advantage of self-employed retirement plans. If you moonlight or just work part time, self-employed retirement plans offer great tax benefits. In fact, if you can spare the money, you may be able to put 100% of your net profit from self-employment into a plan and deduct it as well. There are several plans from which to choose, but three are at the head of the class and work especially well if you have no other employees. If you're in the market for a self-employed plan, chances are one of them is just right for you.
- SEP Plan. A SEP (Simplified Employee Pension) plan, is often the best choice particularly if you are new to the self-employment business or your income from self-employment is pretty modest. Think of a SEP as a self-employed retirement plan with training wheels. You can always move on to a two-wheeler (self-employed 401(k)) or a rocket (defined benefit plan) later on. The main attraction of a SEP is, as the name implies, simplicity. There is very little paperwork involved and there are no annual tax reporting requirements. That's because a SEP is considered an IRA by our friends at the Internal Revenue Service (hence, the common moniker "SEP-IRA"). Special benefit to procrastinators: most self-employed retirement plans need to be set up by December 31, although contributions can be made up to the time of filing the return. But a SEP can be set up (and funded) after the end of the tax year. Another clear advantage of a SEP is that annual contributions are discretionary. If you run short in a particular year and have no money to contribute or have to cut back on the amount you contribute to your SEP, no problem. SEP contribution limits are very generous, capping out at over $40,000 which is a lot for most of us. On the other hand, if you can afford to put away even more, consider the other two self-employed plans described below.
- Self-Employed 401(k). The self-employed 401(k), also called a solo 401(k), requires a bit more paperwork (your brokerage firm or mutual fund company may have gratis prototype plans) and must be set up by December 31, but it also allows you to put more money into the plan than a SEP. In fact, up to certain limits you can put as much as 100% of your net income from self-employment into the plan which could be particularly appropriate for those who moonlight and can afford to put away all or a substantial portion of their self-employment income. Finally, the level of annual contributions is discretionary and you can generally borrow (if you must) from your self-employed 401(k) plan.
- Defined Benefit Plan. While the annual contribution limits for SEP-IRAs and self-employed 401(k) plans are generous, they're chump change compared with what you can put away and deduct in a defined benefit (DB) plan. But the ability to a shelter literally hundreds of thousands of dollars from Uncle Sam each year comes at a price. A DB plan has to be set up by an actuary no later than December 31 and require lots of annual paperwork and tax filings, all of which require annual fees. What's more, contributions are not discretionary so, depending upon how the plan is structured, you may have to make contributions in years where you have no or much reduced self-employment income. So, despite the potential for gargantuan tax deductions, opting for a defined benefit plan requires some careful forethought. DB plans work especially well for those who have high income from self-employment (six figures at least) and can expect to maintain a high income level. These high octane plans are particularly appropriate for persons in their 50s or older who want, and can afford, to create a substantial retirement purse in a short period of time.