When you venture out on your own as a small business owner one of the things you lose is an employer sponsored retirement account. Fortunately, there are a number of options available to those who are self employed, such as the SEP IRA, the Simple IRA, and the Solo 401(k). Each one of the self employed retirement accounts have their own list of pros and cons. I’ll review a few of them here.
SEP IRA
The SEP IRA, or Simplified Employee Pension as it is more formally known, is a great option for small business (those with fewer than 10 employees). SEP IRAs allow employers to deposit up to $49,000 or 25% of net earnings, whichever is greater, in a tax year. They are relatively easy to set up, requiring only the completion of an IRS form (IRS Model Form 5305-SEP).
Employees cannot contribute to the SEP IRA, only employer contributions are allowed. SEP IRA plans do allow for contributions to part time employees. In fact, employers are required to contribute to part time employees over 21 years of age who have worked 3 of the past 5 years and earned more than $500.
SIMPLE IRA
The SIMPLE IRA (SIMPLE stands for Savings Investment Match Plan for Employees) differs from the SEP IRA in that is usually reserved for larger businesses (less than 100 employees). Employees may contribute up to $11,500 per year, and employees over 50 years of age may add an additional $2,500 in catch up contributions.
One of the advantages of the SIMPLE IRA over a traditional 401k is that employer contributions to the SIMPLE IRA are fully vested right away, meaning the employee can take the money with them should they leave. Most 401k plans have a waiting period before employer contributions are vested with employees.
It’s important to note two unique things about the SIMPLE IRA. If you are an employer, you must provide matching funds up to 3% of your contribution. Withdrawals from the SIMPLE IRA before reaching full retirement age of 59 1/2 also carry a steep penalty – 10% early withdrawal penalty plus a 25% penalty if you cash out withing the first two years of contributing to the plan.
Solo 401(k)
A Solo 401k is available for both you and your spouse, and excludes employees who work fewer than 1,000 hours a year. If you have employees who work more on a full time basis, this plan won’t work for your business.
In 2010 you may contribute up to $16,500 of your pre-tax income to a Solo 401k, similar to what you can invest in a regular 401k account sponsored by an employer. If you are over 50 you can add a “catch-up” contribution of $5,500 per year. Employers may also add profit sharing up to 25% of an employee’s pay, but may not exceed $49,000.
Thanks to this profit sharing component, the Solo 401k allows the most possible contributions of the three plans.
Which Self Employed Retirement Plan is Best?
That’s a tough question to answer, because it depends largely on the size of your business, the relationship of your employees (full time, part time, both), and your personal goals for your own retirement. For small businesses, it seems the SIMPLE IRA is the easiest to establish, and provides the most flexibility. For a sole proprietorship, or small partnerships, with significant earnings, the Solo 401k allows for the most contributions, and could be a way to build wealth very quickly.
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