Choosing a Retirement Plan for the Self-employed

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c. Taxes on earnings in the plan are deferred until withdrawn.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

 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

 

   Contribution Limit

 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

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.