Tax preparation for the self-employed can be so confusing that it’s easy to overlook deductions. One such deduction that can save you a lot of money is to establish an IRA for your small business—and it isn’t too late to set one up for the 1999 tax year if you do so before the filing deadline of April 17th.
This article highlights the types of retirement savings plans most applicable to self-employed professionals:
- Keogh plans
- SIMPLE IRA
Although only one plan is still available to you for the 1999 tax year, you do have three choices should you want to set up an account for the 2000 tax year. While these options are also suitable for businesses with employees, I’ll discuss them from the viewpoint of the sole proprietor.
Withdrawal options for these plans are the same as for traditional IRAs: Withdrawals before age 59 1/2 are subject to penalties plus income taxes. You can set them up at just about any bank, brokerage firm, online trading company, or other financial institution.
IRAs for the self-employed
The advantage of these types of IRAs is that you can contribute more to them than to a traditional or Roth IRA—much more. The maximum contribution to standard IRAs is $2,000 per year, whereas contributions to other IRAs can be as high as $30,000.
You must have self-employment income, however, in order to open any of these types of IRAs. Also, if you use either an SEP-IRA or Keogh plan, you can’t also contribute to a traditional or Roth IRA.
If you don’t have employees, the SEP-IRA is generally your best bet. It involves the least paperwork and is the easiest to set up and maintain.
You can find the IRS’s guide to your options online. The search page address is http://www.irs.ustreas.gov/forms_pubs/findfiles.html. You'll want to search for Publication 560, Retirement Plans for Small Businesses.
SEP-IRA: The best choice for solo contractors and good for 1999
If you have self-employment income and no employees, the SEP-IRA (Simplified Employee Pension) is probably the best plan for you. It’s also the only self-employment IRA that you can still set up for the 1999 tax year.
SEP-IRAs are quite flexible—you can contribute varying amounts as necessary, up to the maximum. They don’t have the regular reporting requirements that the other plans entail. If your self-employment income is in addition to income you earn as an employed worker, you can still use the SEP-IRA even if you participate in an employer-sponsored 401(k) plan.
But, if you have any employees or plan to have employees in the future, the SEP-IRA may not be the best choice because you must set one up for all eligible employees. (However, one condition of eligibility is that the employee must have worked for you in three of the last five years.) If your employees don’t make voluntary contributions from their own paychecks, you’ll have to make contributions for them or you won’t be able to make contributions for yourself. Your employees are vested immediately. If you have more than 25 employees, however, you can’t use the SEP-IRA and will have to use one of the other options outlined here.
Lastdaytosetup: Tax return date (including extensions), which for the 1999 tax year is April 17. Lastdaytocontribute: Tax return date, including extensions. Maximumcontribution: Smaller of $24,000 or 15 percent of income (based on your self-employment income after you deduct one-half of your self-employment tax and—in a wonderful example of IRS recursiveness—the contribution itself). Advantage: Simplest for the sole proprietor with no employees.
Keogh plans: More options and higher contribution limits
You can set up a Keogh plan for just yourself, if you have no employees, or for yourself and your employees, if you have any. However, it is too late to set one up for 1999. The Keogh plans are intended to offer more options than the SEP-IRA, but the trade-off is more complexity and more paperwork.
You can choose from one or more of several types of Keogh plans. They’re worth looking into if the higher maximum contribution would be helpful to you. For either of the two types of defined contribution plans, contributions are based either on your business profits (the profit-sharing plan) or a fixed percentage set when you create the plan (money purchase pension plan).
If you have employees, you’ll need to set up a plan for them as well and contribute to their plans just as you contribute to your own plan. However, you can set up a vesting period that requires them to be employed a certain number of years before they are entitled to all the money in the account.
Lastdaytosetup: End of the tax year (December 31 for calendar-year filers). Lastdaytocontribute: Tax return date. Maximumcontribution: Smaller of $30,000 or 25 percent of compensation for most Keogh plan options. Advantage: Higher maximum contribution limit than SEP-IRA.
SIMPLE IRA: Watch out for mandatory employer contributions
The SIMPLE (Savings Incentive Match Plan for Employees) IRA is intended to be an easier way for an employer to set up a retirement plan for employees. You can use it if you have fewer than 100 employees, or if you’re the only employee, but again, it’s too late to set one up for the 1999 tax year. Under SIMPLE, you can set up either an IRA or a 401(k) type of plan.
You must set up a plan for every eligible employee. Employees can choose to make their own contributions out of their salary. Employer contributions are mandatory; either a dollar-for-dollar match of employee contributions up to 3 percent of employee compensation, or a fixed contribution of 2 percent of employee compensation. The employer can deduct contributions, and employee contributions are excluded from taxable income.
Lastdaytosetup: October 1 of the tax year, unless your business was established after 10/1. Lastdaytocontribute: Employer’s tax return date. Maximumcontribution: Employees, including yourself, can contribute up to $6,000; employer contributions either match employee contributions up to 3 percent of total compensation or are fixed at 2 percent regardless of whether the employee contributes. Advantage: You may want to consider the SIMPLE plan if you have no employees and a fairly small amount of self-employment income. Using the maximum employee contribution of $6,000 plus the 2-3 percent employer contribution means that you can put away more money under SIMPLE than you could using the 15 percent rule of the SEP-IRA. It can be a good option if you’re employed and want to sock away your moonlighting income for retirement.
The last word
Regardless of which plan you decide to go with, it’s important to set up some sort of retirement savings plan once you’ve gone out on your own. Without the incentive of an employer-sponsored plan, it can be easy to put off saving for something as far down the road as retirement. But if you save right, these high-limit plans can help you reach that destination sooner than you thought while reducing your total tax bill in the meantime.
If you have any doubts about your tax liability, consult a tax professional. To comment on this article, please post a comment below or follow this link to write to Meredith.
Meredith Little has worn many hats under the broad term of freelance writer, including technical writer, documentation specialist, trainer, business analyst, photographer, and travel writer.