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Self Employed Retirement Plans

One of the advantages of working for a large company is the ability to participate in a 401(k) plan – often with company matching.  Well, if you’re self employed, this isn’t an option – so, what are your options for saving for retirement while being self employed?  Let’s look at some potential ways to solve this issue:


The Simplified Employee Pension Individual Retirement Account, or SEP-IRA, is the most popular way for a self employed individual to save for retirement.  This plan allows a simplified way for employers to contribute towards their employees’ retirements – in the case of self employment, the employer is the same person as the employee.

If you have any employees and you want to implement a SEP, all eligible employees must participate – eligibility is determined by at least 21 years of age, worked for the employer in 3 of last 5 years, and has earned a minimal amount of income in last 2 years (last I checked it was $550).  Employers do have the option to create less restrictive criteria for his or her business.  SEP-IRAs are typically created for small businesses with few employees where an employer wants to have a retirement plan for his employees but does not want to have high administrative costs.

Employees can contribute up to 25% of their income or no more than $49,000 (in 2010) – whichever is lesser.  Self employed contributions are determined as follows:

  • If the business is an S or C corporation, the business will pay the owner a W-2 income.  In this case, SEP-IRA contributions can be up to 25% of the owner’s W-2 income up to the contribution limit ($49,000 in 2010).
  • If the business is a sole proprietorship, unincorporated partnership or an LLC, the SEP-IRA contributions can be between 0 and 20% of net adjusted self employment income (or net adjusted business profits) – See an accountant for the appropriate definitions and how to calculate these numbers.

To summarize, the SEP-IRA has the following characteristics:

  • Tax-deductible contributions
  • Tax-deferred growth
  • Easy to setup at a number of brokers
  • Minimal paperwork
  • Great for self employed individuals

Solo 401(k) Plan

Another option to consider for the self employed is the Solo 401(k) Plan.  While this plan will typically involve slightly more paperwork, it does have a few features that might be better than the SEP-IRA.

While the Solo 401(k) Plan has the same contribution limit as the SEP-IRA with regards to the $49,000 figure (adjusted in the future based on cost of living) in 2010, there is a different in what you can contribute.  The difference is that with the Solo 401(k), you can contribute 100% of the first $16,500 in income from the business (or $22,000 if you’re over 50 years old) for the year 2010.  Plus, you can contribute 20% of the net business profit until you hit the $49,000 max level.

For a real example on how the Solo 401(k) allows you to contribute more than the SEP-IRA, consider the following from the WSJ:

How can an entrepreneur sock away more with a solo 401(k) than with a SEP IRA? Clint Gharib, director of managed products and insurance at J.P. Turner & Co. in Atlanta, uses the example of a 51-year-old sole proprietor whose business income was $100,000. If the proprietor used a SEP IRA, he or she could invest only 20% of $92,936 ($100,000 minus $7,064, half the self-employment tax), or about $18,600.

But the same proprietor could put $22,000 in a solo 401(k), plus 20% of $92,936, for a total of about $40,600. Under some accounting rules and business structures (if incorporated, for instance), this same entrepreneur might be able to put as much as 25% of his or her salary in a SEP IRA—but that amount would still be far less than a solo 401(k) allows.

To summarize, the Solo 401(k) has the following characteristics:

  • Tax-deductible contributions
  • Tax-deferred growth
  • Easy to setup at a number of brokers
  • Slightly more paperwork
  • Able to contribute more with less income than SEP-IRA
  • Great for self employed individuals

Be sure to check with an accountant before implementing any of these options.