Oh, the joys of self-employment – no one standing over your shoulder watching your every move; no one dictating sick days; and even better retirement options than the employment world can offer! Thinking of quitting your day job? Hang on – before you write up your letter of resignation, you should educate yourself on self-employment retirement options and their tax consequences.
SEP, which stands for Simple Employee Pension, allows you to contribute between 20% and 25% of self-employment income or salary, with a limit of $42,000 in 2005. 25% of your income! The full amount of the contribution is also deductible on your taxes just like other retirement accounts. This means you can stash pre-tax income away and let it grow tax-free; up to $42,000. This amount can also be adjusted from year to year, in case circumstances require an adjustment.
SEP’s require very little red tape; they are as easy to claim as IRA’s but you can contribute considerably more money. For this reason, they are often the preferred self-employment retirement vehicle.
These plans are a little more complicated to manage than SEP’s. There are two variations of Keogh plans: defined benefit pension plans and profit sharing plans. Keogh’s are the self-employment versions of corporate retirement plans.
Keogh plans have a yearly limit of $42,000, but the contribution amount depends on your compensation. Unfortunately, once you set up this type of account, you are stuck with the defined contributions. There are also several other requirements on a Keogh plan, making it less desirable to many people planning for their retirement.
Solo 401(k)’s are set up a little differently than the SEP or Keogh. With these accounts, you can contribute up to the initial $14,000 of your compensation. In addition to this amount you may also contribute 20% of your self-employment income or 25% of your salary.
Solo 401(k)’s are utilized less often than SEP and Keogh plans. However, they should also be considered when you are setting up your retirement portfolio.
Roth IRA or Traditional IRA
A Roth IRA or traditional IRA is the icing on the retirement cake. Each of these accounts is very easy to set up. While the Roth IRA is not tax deductible, contributions to a traditional IRA are. You must pick one or the other and the yearly limit, for 2005, is $4,000 (if you are under the age of 50). Either account grows tax free, but because a traditional IRA is funded with pre-tax dollars, you pay taxes as regular income when money is withdrawn after an age limit. Money may be withdrawn tax-free, however, from a Roth IRA if done so during retirement.
While the amount deductible for one of these accounts is relatively small compared to the other retirement options, it is a nice addition to your retirement portfolio. Everyone knows every little bit helps in your retirement years and it is often worth it to reduce your current taxable income.