Choosing a
Retirement Plan for the Self-employed
Self-employed individuals
can adopt a qualified retirement plan (often referred to as a Keogh plan), a
simplified employee pension (SEP) plan, an individual retirement account (IRA),
or a savings incentive match plan for employees (SIMPLE IRA plan). These plans
offer self-employed individuals the same opportunity to accumulate retirement
savings in tax-deferred accounts as individuals covered by corporate retirement
plans. .
Keogh Plans
for the Self-employed
Qualified retirement plans
(e.g., profit sharing, money purchase, and defined benefit plans) established
by sole proprietorships (or partnerships) for the benefit of the sole
proprietor (or partners) and their employees are often referred to as Keogh
plans.
Keogh plans are generally
subject to the same rules as those covering corporate qualified retirement
plans. Like a corporate plan, a Keogh cannot discriminate among employees in
determining participation, benefits, or contributions. The deduction limits for
contributions on behalf of both employees and self-employed individuals are the
same as those for corporate plans. However, the deduction limit for
self-employed individuals is based on net self-employment income earned in the
trade or business for which the plan is established
Advantages of a Keogh include:
a. A taxpayer with self-employment income can generally
establish a Keogh, even though he is covered, as an employee, by an unrelated
employer's retirement plan (Ltr. Rul. 7839059). Examples of common
self-employed/employee situations include doctors, lawyers, accountants, and
corporate directors.
b. Fees for administering the plan are tax-deductible or may be
eligible for a tax credit.
c. Taxes on earnings in the plan are deferred until withdrawn.
d. The self-employed taxpayer can direct plan investments.
e. The contribution deduction is above-the-line; the taxpayer
does not need to itemize deductions to obtain a tax benefit from the
contribution, and, because the deduction reduces adjusted gross income (AGI),
it can increase the allowable amount of AGI-sensitive deductions and credits.
f. Lump-sum distributions may be eligible for favorable tax
treatment.
Deducting
Keogh Contributions
Like a corporate plan, a Keogh cannot
discriminate among employees in determining participation, benefits, or
contributions. The deduction limits for contributions on behalf of both
employees and self-employed individuals are the same as those for corporate
plans. These rules generally allow the following deductions:
a. Money Purchase and Profit-sharing Plans. For 2014, the
employer's maximum deduction for contributions to profit-sharing and
money purchase plans is limited to 25% of the total compensation of all
participants eligible to share in the contribution allocation [IRC Sec.
404(a)(3)]. For this computation, each participant's compensation is limited to
$260,000 [IRC Sec. 401(a)(17)]. Elective deferrals to a 401(k) plan are not
subject to this limit.
b. Defined Benefit Plans. The employer's deduction limit
for contributions to a defined benefit plan is in most cases the minimum
funding amount,. The minimum funding standards generally require the employer's
annual contribution to be large enough to cover the annual cost of future
benefits and administrative expenses, as well as any past benefits not funded.
These deduction limits are actuarially determined..
The deduction limit for
self-employed individuals is based on net self-employment (SE) income earned in
the trade or business for which the plan is established. Net SE income is
calculated after the Keogh contribution deduction and the deduction for half of
the self-employment (SE) tax. This first reduction results in a simultaneous
equation that effectively reduces the self-employed participant's maximum
contribution percentage (based on precontribution earned income).
Defined Benefit
versus Defined Contribution Plans
A defined benefit plan for a self-employed
individual who is over age 45 (and has significant net business income and the
cash necessary to fund required, and possibly large, annual contributions) can
be an excellent vehicle for making relatively large tax deductible
contributions. This is possible because the benefit the plan participant will
receive is established, and the contributions necessary to create a fund that
will provide the desired benefit are calculated based on actuarial assumptions
such as interest rates, years until retirement, and life expectancy. However,
defined benefit plans are most useful when the owner-participant is
significantly older (and better paid) than other employees. Otherwise
contributions required to be made on behalf of other employees may be
prohibitive. Additionally, the costs of implementing (e.g., legal fees) and
maintaining (e.g., actuarial fees) a defined benefit plan must be considered.
Conversely, self-employed individuals under
age 45 may be reluctant to establish a defined benefit Keogh plan because of
the costs involved in computing the annual contribution, compared to the amount
of contribution required for a defined contribution plan (usually not significantly
greater compared to other types of self-employed plans since retirement is many
years away). Thus, defined contribution (e.g., profit sharing) plans are
typically the most popular choice for younger self-employed taxpayers and those
without the cash necessary to fund and maintain a defined benefit plan.
Money purchase plans
operate similarly to profit-sharing plans. However, the plan must contain a set
formula under which contributions are made instead of allowing discretionary
contributions. Once adopted, contributions determined by the formula must be
made annually. The contribution deduction limit for money purchase plans is 25%
of total compensation for all employees. Since the contribution limit of
profit-sharing plans is equal to that of money purchase plans, there is no
advantage to establishing a new money purchase plan.
Plan Loans
Keogh plans can make plan loans to
owner-employees under the same rules applicable to other participants. However,
the plan document must set out specific loan provisions.
How to Set Up a Keogh Plan
A Keogh plan must legally exist by the
taxpayer's year-end to claim a deduction for the contribution. Thus,
calendar-year taxpayers must adopt the plan by December 31. In addition, the
trust agreement (if the plan uses a trust) and the plan itself must be in
writing and communicated to any employees by that date [Reg. 1.401-1(a)(2)].
Some states require that the trust be funded with at least a nominal amount of
money prior to year-end.
The easiest and quickest way to establish a
plan is for the taxpayer to adopt a master or prototype plan (offered by most
financial institutions). The sponsoring organization has already applied to the
IRS for plan approval of the master or prototype plan document, then provides
the taxpayer with a copy of the approved plan and determination letter.
Due
Date of Keogh Plan Contributions
Contributions to Keogh plans are generally
deductible only in the year paid. However, a special rule permits a deduction
for certain contributions made after year-end. Under this rule, a contribution
is treated as made on the last day of the tax year if: (a) it is identified as
being made for that year, and (b) it is actually made by the due date of the
taxpayer's return, including extensions [IRC Sec. 404(a)(6)]. If the
contribution is made by mail, the postmark date is the controlling date (see
Ltr. Rul. 8551065, which applies to traditional IRA contributions and which,
presumably, also applies to contributions to other retirement plans).
One-person 401(k) plans are becoming
increasingly popular for a business that employs only the owner. Given the
right circumstances, these plans can allow a large amount to be contributed on
behalf of the owner while maintaining flexibility in making contributions in
future years. The cost of preparing the annual return (Form 5500 required after
plan assets exceed $250,000) is nominal in comparison to the additional funding
a one-person 401(k) plan allows. Also, because the plan has no employees other
than the owner, it is not subject to the complicated nondiscrimination tests
normally applicable to 401(k) plans.
For 2014, a business owner can make an
elective deferral contribution of up to $17,500 ($23,000 if he is age 50 or
older) plus an employer contribution of up to 20% of SE income or 25% of
compensation. In calculating the allowable employer contribution, the owner's
SE income or compensation is not reduced by the owner's elective deferral
contribution [IRC Sec. 404(n)].
However, the total
contributions (elective deferral plus the employer contribution) cannot exceed
the lesser of 100% of the participant's compensation or $52,000 ($57,500 if age
50 or older) for 2014.
SEPs Offer
Simplicity but Less Flexibility
In a SEP plan, the employer makes annual
contributions on the employee's behalf to an IRA established for the employee
(referred to as SEP IRAs). A SEP is generally easy to adopt, and the rules
governing participation are straightforward. An advantage of establishing a SEP
(rather than a Keogh plan) is that reporting, recordkeeping, and funding
requirements are minimal. A taxpayer who is self-employed and files a Schedule
C or F also has the ability to adopt a SEP plan after year-end, and to make
contributions up to the due date of their personal tax return.
An employer is not required to make SEP
contributions every year or to maintain a particular contribution level.
However, contributions may not discriminate in favor of highly compensated
employees. This means contributions for all eligible employees must generally
bear a uniform relationship to includable compensation [IRC Secs. 408(k)(3)(C)
and (D)]. A contribution rate that decreases as compensation increases is
considered uniform [Prop. Reg. 1.408-8(c)(1)].
Despite a SEP's simplicity and ease of
adoption, SEP plans do have disadvantages. For example, all eligible employees
must be covered. An eligible employee is one who at a minimum (a) has attained
age 21; (b) has performed any services for the employer during at least three
of the preceding five years; and (c) has received at least $550 in compensation
(for 2014) [IRC Sec. 408(k)(2)]. Additionally, employees have a nonforfeitable
right to contributions (i.e., are immediately vested). Thus, there is no
partial vesting, and no possibility that contributions will be reallocated back
to the employer or key employee. Finally, every eligible employee must set up
or modify an IRA to accept a SEP contribution. Failure of even one
eligible employee to do so destroys the ability of the employer to use a SEP.
However, employers may overcome this problem by setting up an IRA on the
employee's behalf [Prop. Reg. 1.408-7(d)(2)]. Finally, if contributions are
made to IRAs of some but not all eligible employees, none of the SEP
contributions are deductible (Brown).
How to Adopt a
SEP Plan
For most self-employed taxpayers, adopting a
SEP means completing and signing Form 5305-SEP, "Simplified Employee
Pension-Individual Retirement Accounts Contribution Agreement." The form
is not filed with the IRS, but should be maintained as part of the employer's
permanent records. In addition, a copy of Form 5305-SEP (including the
accompanying instructions) must be given to each employee covered by the SEP.
Post Year-end
Tax Planning with a SEP
Unlike Keogh plans, a SEP does not have to be
adopted by the taxpayer's year-end; it can be adopted any time before the
deadline for filing the taxpayer's return, including extensions
For 2014, the contribution limit for a SEP is
the lesser of (a) 25% of up to $260,000 of compensation or (b) $52,000. For
self-employed individuals, the contribution limit is based on net
self-employment (SE) income earned in the business that established the SEP.
Net SE income is calculated after the SEP contribution deduction and the SE tax
deduction. This first reduction results in a simultaneous equation that
effectively reduces the self-employed participant's maximum contribution
percentage (based on precontribution earned income).
SIMPLE IRA plans are
available to employers with 100 or fewer employees receiving at least $5,000 of
compensation in the prior calendar year. Self-employed individuals are also
eligible to participate in a SIMPLE IRA plan. An employer may impose less
restrictive eligibility requirements by eliminating or reducing the prior year
compensation requirements, the current year compensation requirements, or both,
under its SIMPLE IRA plan. However, the employer cannot impose any other
conditions on participating in a SIMPLE IRA plan (Notice 98-4, Q&A C-2).
The employer may not currently maintain any other qualified retirement plans
while making contributions to a SIMPLE IRA plan.
The greatest advantage of SIMPLE IRA plans is
that they are easier to operate than Keogh plans. SIMPLE IRA plans do not have
to meet the nondiscrimination requirements, minimum participation and minimum
coverage rules, vesting rules, or the top-heavy rules applicable to qualified
plans. However, if a plan will cover only the owner-employee, the complicated
nondiscrimination rules do not apply. This may make a one-person 401(k) plan
worth consideration. Although the fees for setting up and maintaining a
one-person 401(k) plan may be higher, the additional allowable contributions
may be substantial.
Contribution
Limits
SIMPLE IRA plans allow employee elective
contributions and require employer matching contributions or nonelective
contributions. For 2014, employee elective contributions are limited to
$12,000.
SIMPLE IRA plans can also
allow catch-up contributions for taxpayers age 50 or older by the end of
the applicable year. The catch-up contribution for 2014 is an additional
$2,500.
601.44 Employer
contributions must be made under one of two formulas [IRC
Sec. 408(p)(2)(A), (B), and (C)(ii)]:
a. Matching Contribution Formula. Employers must
generally match employee contributions on a dollar-for-dollar basis, up to 3%
of the employee's compensation for the calendar year. However, in two out of
every five years, the employer has the option of electing a matching percentage
as low as 1% of each eligible employee's compensation. For purposes of the
matching contribution, compensation is not limited.
b. Nonelective Contribution Formula. In lieu of making
matching contributions, the employer may contribute 2% of compensation for each
eligible employee having at least $5,000 of compensation during the calendar
year. For purposes of this formula, compensation of each eligible participant is
limited to the Section 401(a)(17) limit ($260,000 for 2014), thus limiting the
contribution to no more than $5,200 (for 2014) per employee.
