In today’s world, there is no shortage of retirement plan options. However, how many of us can say that we know exactly what retirement plan options are available and which is the right one for me? While the 401(k) is a commonly known option for many individuals who are employed by an outside employer, what about those who are self-employed? In this article, we will dive into the various retirement options available to self-employed individuals and the appeal for each.
A Traditional IRA is a retirement account in which contributions are considered tax deductible (subject to limitations) when made, but the withdrawals are subject to tax at the time of withdrawal. For 2020, the maximum contribution for Traditional IRAs is $6,000. For those 50 and older, an additional $1,000 can be contributed, called a catch-up contribution. In 2019 and years prior, contributions were not allowed once you reached age 70, but for 2020 and later, there is no longer an age limit on making contributions to Traditional IRAs. However, contributions can only be made if you or your spouse have what the IRS considers earned income.
If earned income does not exceed $6,000, then deductible contributions are limited to total earned income. The deductibility of contributions can be limited if you or a spouse are enrolled in a retirement plan through an employer, and your income exceeds certain thresholds. Once your modified AGI exceeds $75,000 for single filers or $124,000 for married filing joint filers, no deduction is allowed if you or your spouse are covered by an employer plan. This does not mean contributions are not allowed; it simply means the contribution is no longer deductible.
Once you reach age 59 ½, you can withdraw funds from your Traditional IRA without penalties or restrictions. If distributions are made prior to reaching 59 ½, there is a 10% federal penalty on those early withdrawals (state tax penalties may also apply). However, there are exemptions to the 10% penalty, such as withdrawals for first-time home buyers, qualified educational expenses, qualified medical expenses, and birth or adoption expenses.
If you reached 70 ½ prior to January 1, 2020, Required Minimum Distributions (RMDs) are required annually. After January 1, 2020 RMDs are required once you reach 72. Because these distributions are required, you may have to pay a 50% excise on the amount you should have withdrawn if no distribution was made. Be sure to consult with your tax advisor before making any distributions from your retirement plan.
Roth IRAs are opposite Traditional IRAs in that contributions are not tax-deductible, and the earnings are tax-free when withdrawn because contributions to a Roth IRA are made with after-tax dollars. Contributions can be withdrawn at any time, tax and penalty-free. However, there are still penalties and taxes for early withdrawal of the Roth IRA earnings if withdrawn prior to reaching age 59 ½ or if your Roth IRA is less than five years old. Like the Traditional IRA, there are specific exemptions to the early withdrawal penalty. The annual contribution limit for a Roth IRA for the year 2020 is $6,000. For those 50 and older, an additional $1,000 catch-up contribution can be made. Like a Traditional IRA, there is no age limit on making these contributions. Required minimum distributions are eliminated with a Roth IRA.
While a Traditional IRA really has no constraint on contributions other than you must have earned income, a Roth IRA limits your ability to contribute based on your modified adjusted gross income (MAGI). Once your MAGI reaches $139,000 for single filers ($206,000 if married filing jointly), you do not qualify to contribute to a Roth IRA. It is key to keep this limitation in mind, as an excess contribution penalty of 6% is assessed on the excess contribution and is assessed on your tax return. This penalty will continue to be assessed year after year until the excess contribution has been corrected or until you qualify to contribute. You have until the due date of your tax return, including extensions, to withdraw the contribution or roll it over to a Traditional IRA.
If you exceed the income constraint on contributing to a Roth IRA, there are certain ways to still get your money into a Roth IRA. Your tax advisor can assist you in planning should you choose this method of saving.
SEP IRA (Simplified Employee Pension Plan)
A SEP IRA provides small business owners a simplified method to contribute to both their personal and their employees’ retirement plans. This plan is a great choice for the self-employed with no or few employees and for those with more aggressive savings goals. Like the Traditional and Roth IRA plans, you can establish a SEP IRA even if you already participate in another retirement plan.
The SEP IRA functions exactly like a Traditional IRA: contributions are made pretax, growth and earnings grow tax-deferred, and distributions are taxed as ordinary income. For 2020, annual contribution limits are the lesser of $57,000, or up to 25% of self-employed compensation with the maximum compensation limit of $285,000 for 2020. Just like with Traditional and Roth IRAs, the age limit for contributions has been eliminated for 2020 and beyond. While Traditional and Roth IRAs are typically used by many in conjunction with another retirement plan due to the contribution limitations, a SEP IRA allows self-employed individuals a far more aggressive approach to retirement savings.
The caveat is that all eligible employees must be included in the SEP plan. Eligible employees are those who are 21 or older, have worked for your business at least 3 of the last 5 years, and received at least $600 in compensation for the year. Contributions must be proportional for all eligible employees. This means that everyone’s contribution, including the owner’s contribution, has to be the same percentage of salary. While this stipulation can be a drawback to those with employees, the plan offers flexibility to the employer regarding some of the qualifications for employees to participate.
The rules surrounding withdrawals from a SEP IRA are no different than those for a Traditional IRA. The same RMD rules and similar penalty exceptions apply here as well.
A one-participant 401(k) is no different than any other 401(k), except it only covers a business owner with no employees. Two types of contributions can be made to a one-participant 401(k) plan: elective deferrals and nonelective contributions. For 2020, participants can defer up to $19,500 in regular elective deferrals, or $26,000 if age 50 or over. Additionally, nonelective contributions can be made up to 25% of compensation, which is computed as net earnings from self-employment after deducting one-half of self-employment tax plus contributions for yourself. Total contributions between elective and nonelective are limited to $57,000 for 2020.
A benefit of the solo 401(k) plan is that a business owner with no common-law employees does not have to perform nondiscrimination testing for the plan. However, should the business owner hire any employees, the no-testing advantage goes away and as long as the employees meet the plan eligibility requirements, you must include them in the plan.
The rules surrounding withdrawals from a Solo 401(k) are the same as those for a Traditional IRA, and the same RMD rules and similar penalty exceptions apply here as well.
SIMPLE IRA (Savings Incentive Match Plan for Employees)
A SIMPLE IRA is a great choice for small businesses with up to 100 employees that do not have any other retirement plan. For 2020, employers are required to contribute yearly either a matching contribution of up to 3% of each participating employee’s compensation or a 2% nonelective contribution for all employees, regardless of their participation in the plan. Employers make the election annually as to whether they want to use the matching contribution or the nonelective contribution. Employees may elect to contribute up to $13,500 in 2020 and are always considered 100% vested in the plan. If permitted by the SIMPLE IRA plan, employees over the age of 50 can make catch-up contributions up to $3,000.
An employee who earned at least $5,000 in compensation during any two years before the current calendar year and expects to receive at least $5,000 during the current calendar year is eligible to participate. While the employer can impose less restrictive participation requirements such as $2,000 in compensation, you cannot impose stricter requirements. Employers also cannot add any other conditions for participation in a SIMPLE IRA plan.
The rules surrounding withdrawals from a SIMPLE IRA are no different than those for a Traditional IRA, and the same RMD rules and similar penalty exceptions apply.
There is not a one size fits all retirement option for self-employed individuals. Choosing the retirement plan that best fits your needs depends on the facts and circumstances applied to your situation, but knowing the various options available provides value to you and your business. Please keep in mind that the above information offers a brief summary of the high points of each plan, and you should consult a professional when selecting a plan. Certain plans require specific filings initially and annually, including tests that must be performed periodically, and failing to do so can be costly.
LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.