Banking

When $3,000 just isn't enough--setting up your own retirement plan

Independent or small consultancies basically have two choices when it comes to setting up their own retirement plans: the Simplified Employee Pension plan and the Savings Incentive Match Plan. Here's a look at the options for consultants.


As an independent consultant establishing my own company, the primary order of business when I first talked to my accountant was—of course—taxes. But as soon as he finished briefing me on the horrors of the self-employment tax, he began to extol the virtues of establishing my company’s own retirement plan as a remedy to the IRS’s burden on consultants and other self-employed professionals.

I had originally (and I imagine naively) planned on simply setting up an individual IRA and making the modest, tax-deferrable contributions afforded by that ubiquitous federal retirement scheme.

Even then, I knew a $3,000 ceiling on tax-deferrable contributions was pretty lame. And before I knew it, my accountant was telling me how I could put as much as 25 percent of my corporate earnings away into a tax structure that can be controlled by a small firm, such as my limited liability corporation (LLC). After a little digging, I discovered some new concessions under the tax law that let you put 40 percent or more of your corporate income into flexible savings programs.

Here’s a closer look at some of your choices.

Two common choices
The options for setting up your company’s own retirement plan basically fall into two primary channels: Simplified Employee Pension IRA and Savings Incentive Match Plan for Employees IRA plans. Both plans offer the basic advantage of setting aside a portion of your salary before Uncle Sam or, even worse, your local revenue commission, gets a crack at it.

The fundamental difference lies with how the company contributes to its employees’ plans, as shown in Figure A. Your choice of plans probably will hinge on whether your firm has or plans to add any staff—under certain plan options, that can become expensive.
Figure A
  Employee contribution Employer contribution Catch
SEP IRA None Up to 25% of income, max. $40,000 All employees get same contribution from employer; can be costly with full-time staff
SIMPLE IRA Up to 100% of income, max. $7,000 Employer: Match employee contributions up to 3% of income, max. $7,000; or 2% of employee's income, up to $4,000 Lower total contribution levels for self-employed consultants
Informational source: Fidelity Retirement Services
Informational source: Fidelity Retirement Services

Simplified Employee Pension IRA
Commonly called the SEP plan, the Simplified Employee Pension IRA is probably the simplest of company-controlled savings plans—as its name suggests. The SEP plan, which requires no additional tax filings by the company, is the likely choice for one-person shops or equal partnerships, given that the employer (your federal Employer Identification Number) is the only entity that can contribute to the plan; employees (your Social Security number) can’t deposit funds. Again, simple tax returns.

The catch is that the employer must contribute equally to the account of every employee. So, if you set up a SEP plan and a couple of years down the road you add two full-time QA staffers, you’ll be contributing to their plan at the same rate as to your own retirement fund. Not a good idea, if you plan to take advantage of the 25 percent of income ceiling on annual contributions.

SEPs have an annual total contribution cap of $40,000, which covers personal income of up to $160,000. If you’ve set yourself up on a reasonable salary from your company and this still presents a barrier for you, congratulations—you make a lot of money. This high contribution level and simple administration overhead make SEP the favored option for one-person shops or small partnerships where all owners of the company can agree on an IRA contribution level.

SEP IRAs are also available to any self-employed individual, so if you haven’t incorporated your business (and you should), this is a good alternative to the basic individual IRA, which is really designed as a supplemental savings program, not your primary conduit for retirement planning.

Savings Incentive Match Plan for Employees IRA
If you plan to take on employees, the Savings Incentive Match Plan for Employees, or SIMPLE, IRA is probably the best choice for your company. Firms with 100 or fewer employees are eligible to set up SIMPLE IRAs.

Unlike SEPs, both the employer and employee contribute to SIMPLE IRAs, which creates a nice degree of flexibility in setting up your own contribution scheme. Employees can actually contribute 100 percent of their income, up to a cap of $7,000, so if your salary is $70,000 or less, you’re covered.

Your company must match employee contributions dollar-for-dollar, up to 3 percent of annual salary, with a maximum of $7,000. Or you can opt to contribute 2 percent of each employee’s salary, up to $4,000, independent of a matching program.

So, if you make that $70,000 salary, your total contributions to your own SIMPLE plan could max out at $9,100, as follows:
Figure B
100% of salary (employee) 3% match (employer) Total
$7,000 (cap) $2,100 $9,100

Obviously, that’s not as much as the 25 percent, or $17,500, you could have contributed on the same income under a SEP plan. But if you run your business primarily as a second source of income, you may want to seriously consider a SIMPLE plan, given that its 100 percent contribution level for employees is very attractive when applied to relatively low income levels.

Let’s say you do some basic after-hours support work for three clients, and you expect to make about $15,000 for these efforts next year. Under the SIMPLE plan, you’ll hit the $7,000 cap with no problem, and you can add another $450 in employee match. Under a SEP, you’d be stuck with a 25 percent contribution of $3,750.

Like SEP plans, SIMPLE IRAs require no special employer tax filings.

Other options
Investment companies may offer slight variations on these two main themes, including profit-sharing plans that are very similar to SEP plans with a 25 percent of income contribution cap (these plans require some additional tax paperwork).

One of the most interesting options I came across while researching my own options is a self-employment 401(k) plan that hit the market just this year, following changes to the tax laws. Marcia Mantell, a vice president with Fidelity Retirement Services, told me her company’s plan is getting a lot of attention from investors, particularly those who are trying to play catch-up as their retirement draws a little closer.

In layman’s terms, Fidelity’s self-employment 401(k) combines the advantages of the SIMPLE IRA and profit-sharing plans to create an overall investment capacity similar to that of a SEP plan. Employees can save 100 percent of their income, with a contribution cap bumped to $11,000; employers are held only to modest matching requirements. And employees can save 25 percent under the profit-sharing component of the plan, with a total contribution level to the 401(k) of $40,000 annually. Throw in a special deferment of $1,000 to $5,000 for folks over 50, and you have the potential to sock away a lot of your income for retirement.

So many options, so little money
Of course, times are tough, and for many consultants any discussion of saving 25 percent or more of their gross income is speculative, at best. But it never hurts to be ready, and setting up a retirement plan is next to free. Talk to your accountant and do a little research; you’re sure to find a plan that fits your long-term goals, which is what retirement saving is all about.

About Ken Hardin

Ken Hardin is a freelance writer and business analyst with more than two decades in technology media and product development. Before founding his own consultancy, Clarity Answers LLC, Ken was a member of the start-up team and an executive with TechRe...

Editor's Picks