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The ABCs of IRAs, SEPs, And Other Retirement Plans

Wednesday, July 29, 2009

By Jan Norman

Long-range planning is a wise idea even in difficult financial times. While micro-business owners have their hands full juggling inventories, meeting customer demands and studying balance sheets, they should also be planning for retirement.

The idea of one more task can seem overwhelming to the busy owner. But many banks and mutual fund companies, financial planners and brokerage firms offer programs to make the research, selection and set up of retirement plans relatively painless.

Some micro-business owners use recent declines and volatility in the stock market as an excuse to ignore setting up a retirement plan. Those headlines about portfolios losing a third or half their value would scare anyone. But you don’t have to invest your retirement funds in stocks. Fixed income funds, government or corporate bonds, certificates of deposit and Treasury bills are all options.

The key to building a retirement nest egg is to set up an account and contribute to it regularly.

Most retirement plans allow you to defer taxes on your income now in order to save for your retirement. If you have a few employees, a retirement plan can help them plan for their futures as well and be a selling point when trying to attract talented workers to your micro-business.

But which type of retirement plan is best? You don’t have to be Microsoft or Wal-Mart to have some choices. Even for the one-person micro-business, retirement planning is not just a one-product-fits-all, take-it-or-leave-it option. You do have choices among several different types of plans.

This article covers the basics about the most popular retirement plan options for the micro-business owner and the self-employed. The dollar limits used are for the 2009 tax year. Keep in mind that those limits usually change each year. And keep in mind that you should do additional research before deciding which type of retirement plan is best for you.

IRA

The individual retirement arrangement, also known as an individual retirement account (IRA), is the most basic retirement plan. It’s a personal savings account for employed individuals and their spouses. Almost any bank, brokerage, insurance company or mutual fund can set up an IRA.

There are two types: the traditional IRA and the Roth IRA.

With a traditional IRA, you don’t pay federal income tax on contributions for the year in which they are made, but you pay taxes when you withdraw the money.

With the Roth IRA, you pay income tax on contributions for the year in which they are made, but you don’t pay income tax on any of the money when you withdraw it.

To be eligible to set up a Roth IRA, your earnings must be less than $116,000 if you are single, or $169,000 if you are married and you and your spouse file a joint tax return. The amount you can contribute is reduced if adjusted gross income is $105,000 for single people or $166,000 for those who are married.

For 2009, you can contribute up to $5,000 to either type of IRA. Those over the age of 50 can contribute an additional $1,000. You must set up the account by Dec. 31 of the year for which you want to take a tax deduction, but you don’t have to deposit the money until the day you file your tax return.

If you want to contribute to both a traditional and Roth IRA in the same year, you’re still limited to a total amount of $5,000 (or $6,000 for those over age 50).

You can’t borrow from either type of IRA. With a traditional IRA, taking money out before age 59½ incurs a 10-percent penalty. With a Roth IRA, you pay no penalty or tax if the account is more than 5 years old.

SIMPLE IRA

SIMPLE stands for Savings Incentive Match Plan for Employees of Small Employers. The SIMPLE IRA is popular with businesses that have fewer than 100 employees each earning $5,000 or more in a given year.

It’s easy to set up, and your financial institution handles most of the details. Many financial institutions have pre-approved SIMPLE IRA plans and forms you can ask to review.

You can’t set up an SIMPLE IRA if you have other retirement plans, with the exception of a Roth IRA.

The employer and the employee don’t pay taxes on the money contributed to a SIMPLE IRA. They pay taxes on money withdrawn in retirement. The employer can choose to contribute 2 percent of income for each employee including himself or to match up to 3 percent of employee contributions.

The owner cannot maximize his own contribution without doing the same for employees.

For 2009, the contribution limit is 100 percent of pay up to $11,500. For those over the age of 50, the limit is $14,000.

You can’t borrow from a SIMPLE IRA. If you want to take money out before you’re 59½, you’ll pay a 25-percent penalty during the first two years you have the account. After that, the penalty is 10 percent.

SEP IRA

Simplified Employee Pension (SEP) IRA is another easy plan to set up and administer for the self-employed. It’s less expensive to start than traditional pension plans, has little paperwork and requires no annual reports to the Internal Revenue Service.

A SEP IRA is great for procrastinators because the account can be opened as late as the due date for your federal income tax return (April 15 or as late as Oct. 15 if you take an extension).

You don’t pay taxes on money contributed to a SEP, but you do pay taxes when you withdraw the money.

For 2009, you can contribute up to 25 percent of your income or $49,000 ($54,500 for those over 50), whichever is less. If you have employees, whether full or part time, you must contribute for them as well. You can contribute to a Roth IRA too if your self-employment income meets eligibility requirements.

The percentage the business contributes can fluctuate each year, which is helpful in these uncertain economic times. It’s also helpful for businesses whose revenues fluctuate widely from year to year. But the percentage the business contributes must be the same for you and each employee.

You can’t borrow from a SEP account, and if you take money out before age 59½, you will pay a 10-percent penalty, except in specific circumstances.

Keogh Plan

The Keogh plan is the granddaddy of all retirement plans for the self-employed, dating back to 1962. You must be a sole proprietorship, a partnership or a limited liability company (LLC) to have a Keogh.

You can defer income taxes on the money you contribute. You can’t borrow from a Keogh, and if you take money out before age 59½, you’ll pay a 10-percent penalty in addition to income tax.

Keoghs require annual reports to the IRS. The setup and ongoing fees for paperwork make Keoghs less attractive for most self-employed individuals than SEP IRAs that have similar contribution levels.

There are two types of Keoghs, defined contribution and defined benefit.

The defined contribution Keogh allows contributions up to $49,000 for 2009 or 100 percent of your earned income for the year, whichever is less. The amount can vary each year. However, the plan must be maintained with the intention of making regular ongoing contributions, so you have to submit annual reports to the IRS, which you don’t have to do with a SEP IRA.

The defined benefit Keogh may be attractive for self-employed individuals over the age of 50 with an established profitable business. These plans require you to put in the same percentage of income each year. Once that percentage is set, it cannot be changed for the life of the plan.

The defined benefit Keogh plan allows the older self-employed person to build a retirement nest egg more quickly. But, it’s a complicated plan that can also be expensive to set up and administer.

You must open a Keogh by Dec. 31 of the year for which you want to take the tax deduction. But you don’t have to deposit your contribution until you file your tax return for that year.

Solo 401(k)

A Solo 401(k) is for the self-employed person working alone, just as regular 401(k) plans are for employees working for a company.

The difference from a company 401(k) is that you are allowed to contribute both the employer and the employee portions. As the employer, you can contribute 25 percent of earnings from self-employment up to $49,000. As the employee, you can contribute 100 percent of your earnings from self-employment, up to $16,500 for 2009 ($22,000 if you are over 50). The total contribution limit is $49,000.

You don’t pay taxes on the money until you withdraw it. A 10-percent penalty applies for withdrawing money before age 59½.

You can borrow up to 50 percent of the amount in the 401(k) without paying taxes on the money. But you must repay it within five years under most circumstances.

Like the Keogh, a Solo 401(k) is generally more expensive to set up than a SEP IRA or a SIMPLE IRA, making it less attractive to many micro-business owners. If you’re eligible for a Roth IRA, you can contribute to both in the same year.

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Freelance writer Jan Norman continues to contribute to her 401(k) despite the wretched stock market of 2008.

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