Did you start a new business or a new role as an independent consultant? Have you considered that you might be able to save a portion of your income for retirement? Many people are not aware that retirement saving plan options are available for business owners and individuals who are self-employed-not just for those who work at large corporations. As a self-employed individual, you have options for establishing and funding your retirement plan, such as a Simplified Employee Pension (SEP) or an Individual 401(k).
A SEP is a retirement plan designated for small businesses that allows a self-employed individual to defer income taxation on a portion of their business income. As a self-employed owner, contributions are typically limited to 25% of your net self-employment income (up to $61,000 in 2022). Net self-employment income is defined as net profit from Schedule C less the deductible portion of self-employment tax. The maximum compensation on which a SEP contribution can be based is $305,000 for 2022. The contribution to the SEP IRA is then deductible on your tax return. We recommend coordinating with your tax professional on calculating your SEP contribution. Important to note, contributions to a SEP can only be funded by the employer.
A SEP can also be established by a business that has employees. Under the SEP agreement, the business may be able to make contributions on behalf of employees – however contributions usually must be the same for employers and employees. Contributions are not required to be made each year which allows for flexibility.
SEP accounts can be established until the tax-filing deadline. This means that if you file for an extension, you could have a longer period to establish and fund your contribution.
An Individual 401(k), or i401(k), is a plan that can be funded by both employee and employer contributions and is similar to a 401(k) offered by a company. Since you are self-employed, you are both the employee and the employer. For example, in 2022 as an employee, you are permitted to defer up to $20,500 of your income to an i401(k) account (with an additional $6,500 catch-up if over age 50). As the employer, you can contribute up to an additional $40,500, similar to a profit-sharing contribution. For 2022, this means that total contributions for an individual under age 50 could be $61,000 and $67,500 for an individual over age 50. As with SEP contributions, this additional “profit sharing” is based on a portion of your net self-employment income and the maximum compensation on which a contribution can be based is $305,000 (for 2022).
To establish an i401(k), your business must not have any additional employees. The exception to this rule is if your spouse is an employee and has earned income from the business.
Although employer contributions can be made after the end of the tax year, the account must be established by the end of the calendar year for which you are making the contribution. For example, if you are planning to make contributions for 2022, the plan must be established by December 31, 2022.
Getting started with a retirement plan may sound expensive. However, both SEP and i401(k) accounts can be established for a relatively low cost. The funds for the plans will be held at a custodian, typically a brokerage firm, on your behalf. When establishing the account with the custodian, you will be provided a basic plan document that outlines how the plan will work and the various requirements. You don’t need to hire an attorney to draft the plan document for you. Many custodians provide a wide variety of investment options for you to choose from.
For individual 401(k) plans, there may be additional regulatory requirements if the account balance exceeds $250,000. You or your tax preparer may need to file Form 5500 as part of reporting for the plan, which may introduce an additional cost for plan maintenance. Many custodians will also require that you have an Employer Identification Number (EIN) for your business to establish an i401(k).
Both SEPs and i401(k)s are qualified retirement plans and follow the same withdrawal rules as other qualified plans such as IRAs. For example, since funds are contributed pre-tax, distributions from the accounts are taxable in the year received. You may also be subject to a 10% early withdrawal penalty if you are under age 59 ½. A SEP or i401(k) can be rolled over into a traditional IRA when the business ceases or you retire.
It is important to note that 401(k) limits apply to a person rather than to a plan. This means that if you have access to a 401(k) at your day job and contribute the maximum employee deferral, you cannot also contribute for employee deferrals to an i401(k) for your side-gig.
The plan that is best for your situation may be based on the make-up and level of income from your business. For a smaller or start-up business, an i401(k) may be more beneficial since employee deferrals can be made. We recommend working with your tax advisor to determine which option could provide the largest tax benefit to you.
At Modera, we know that qualified retirement plans are critical to the success of your overall financial plan. We are happy to work with your tax preparer to establish the appropriate self-employed retirement plan to help you reach your goals. Please contact get in touch to discuss.
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