What’s the best self-employed retirement plan?

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Q. Which retirement accounts are best for the self-employed?
— Working hard

A. That’s a big question, so we have a big answer.

Self-employed people have many options to choose from when considering funding a retirement plan. The right plan for you may depend on whether you have employees and how much you want to save.  

Let’s get started.

First, there are qualified retirement plans.

There are two basic kinds, said Gerard Papetti, a certified financial planner and certified public accountant with U.S. Financial Services in Fairfield.

There are defined contribution plans, which include profit-sharing and money purchase plans, and there are also defined benefit plans.

Different rules apply to each and you can have more than one qualified plan, but your contributions to all the plans must not total more than the overall limits, Papetti said.

First, a profit-sharing plan allows for discretionary employer contributions, meaning the amount contributed each year to the plan isn’t fixed and the employer can even make no contribution to the plan for a given year, Papetti said.

Note that self-employed people must show a profit in order to make a contribution, he said. In general, you can be more flexible in making contributions to a profit-sharing plan than to a money purchase pension plan or a defined benefit plan, he said.

A 401(k) is a kind of profit-sharing plan that can include a cash or deferred arrangement under which participants can choose to contribute part of their before-tax compensation to the plan rather than receive the compensation in cash, Papetti said.

A self-employed individual participating in the plan can contribute part of their before-tax net earnings from the business,” he said.

He said this contribution is called an elective deferral because participants choose, or elect, to defer receipt of the money.

Papetti notes that a 401(k) plan can include a Roth 401(k) provision that works like a Roth IRA in that there is no current tax deduction for contributions and no taxable income on distributions if taken after age 59 ½.

Papetti said a self-employed person without any employees can establish a Solo 401(k), also called a Solo K or Individual 401(k), which allows the same features and benefits as establishing a 401(k) plan. The Solo 401(k) has minimal plan administration and set up requirements compared to what’s required with a traditional 401(k) plan.

“If a self-employed person has employees, certain discrimination tests must be passed to allow them to make elective deferrals, otherwise the business owner as well as ‘Highly Compensated Employees’ will be limited in the amount they can defer,” Papetti said. “The limit is tied to the average deferral percentage the non-highly compensated employees make to the plan.”

Papetti said this limit can be eliminated if the employer adopts one of the following “safe-harbor” provisions:
1. Employer matching contributions of 100 percent up to 3 percent of employee’s elective deferrals and 50 percent of the next 2 percent for a maximum employer match of 4 percent, or
2. Employer non-elective contributions of 3 percent of compensation on behalf of each eligible employee regardless of whether they make any elective deferrals.

There is a limit on elective deferrals, Papetti said.

“For 2018, the limit on elective deferrals is $18,500,” he said. “This limit applies to all salary reduction contributions and elective deferrals. If, in conjunction with other plans, the deferral limit is exceeded, the difference is included in the employee’s gross income.”

Don’t forget about catch-up contributions. A 401(k) plan permits participants who are age 50 or over at the end of the calendar year to also make catch-up contributions, Papetti said. The catch-up contribution limit is $6,000 for 2018.

Then there’s a money purchase pension plan.

Contributions to this kind of plan are fixed and aren’t based on your business’ profits, Papetti said.

“For example, a money purchase pension plan may require that contributions be 10 percent of the participants’ compensation without regard to whether you have profits – or the self-employed person has earned income,” he said. “The maximum percentage for a money purchase pension is 25 percent of compensation.”

Next, we have defined benefit pension plans.

For these, contributions are based on what is needed to provide definitely determinable benefits to plan participants, Papetti said.

“For example, you may want to provide a monthly pension benefit of $10,000 per month upon reaching normal retirement age,” he said. “Actuarial assumptions and computations are required to figure these contributions.”

Generally, he said, you will need continuing professional help to have a defined benefit plan.

Qualified plans must meet certain requirements of the tax law and you must adopt the plan in writing. The plan can be an IRS pre-approved plan offered by a sponsoring organization or it can be an individually designed plan, Papetti said.

“Generally, unless you write your own plan, the financial institution that provided your plan will take the continuing responsibility for meeting any new qualification rules that may be changed in the future,” he said.

You will have reporting requirements.

“You may have to file an annual return/report Form 5500 by the last day of the seventh month after the plan year ends,” he said. “The IRS provides a list of forms to choose the right form for your plan.”

You should be aware of employer contribution limits.

For a defined benefit plan, the annual benefit for a participant can’t exceed the lesser of the following amounts:
1. 100 percent of the participant’s average compensation for his or her highest three consecutive calendar years, or
2. $220,000 for 2018.

For defined contribution plans, the annual contributions and other additions (excluding earnings) to the account of a participant can’t exceed the lesser of the following amounts: 
1. 100 percent of the participant’s compensation.
2. $55,000 for 2018.

Next let’s talk about the Simplified Employee Pension (SEP).

“A SEP is a written plan that allows you to make contributions toward your own retirement and your employees’ retirement without getting involved in more complex qualified plans noted above,” he said.

Under a SEP, you make contributions to a traditional Individual Retirement Arrangement – called a SEP-IRA – set up by or for each eligible employee. A SEP-IRA is owned and controlled by the employee, Papetti said, and you make contributions to the financial institution where the SEP-IRA is maintained.

A SEP-IRA can’t be a Roth IRA.

“Employer contributions to a SEP-IRA won’t affect the amount an individual can contribute to a Roth or traditional IRA,” he said. “Unlike regular contributions to a traditional IRA, contributions under a SEP can be made to participants over age 70 1/2.”

Then there’s the SIMPLE plan, short for Savings Incentive Match Plan for Employees. This is another written arrangement that provides you and your employees the ability to make salary reduction contributions to the plan up to $12,500 in 2018.  An additional $3,000 “catch-up contribution” if age 50 or older is allowed for a total employee salary reduction of $15,500, Papetti said.

In addition, the employer must make either matching contributions or non-elective contributions, Papetti said.

A SIMPLE plan can be set up in either of the following ways, he said:
a. Set up a SIMPLE IRAs for each eligible employee.
b. Can’t be a Roth IRA.
c. Contributions to a SIMPLE IRA won’t affect the amount an individual can contribute to a Roth or traditional IRA.
d. Deadline for setting up a SIMPLE IRA plan effective on any date from January 1 through October 1 of a year.
2. SIMPLE 401(k) plan is a qualified retirement plan:
a. You can adopt a SIMPLE plan as part of a 401(k) plan if you meet the 100-employee limit.
b. Isn’t subject to the nondiscrimination and top-heavy rules of 401k plans.
c. The same limits as SIMPLE IRAs $12,500 and if permitted under the plan, an employee who is age 50 or over can also make a catch-up contribution of up to $3,000.

When it comes to employer contributions for a SIMPLE, they are generally required to make one of the two types of contributions:
1. Matching contributions up to 3 percent of compensation for the year, or
2. Non-elective contributions of 2 percent of compensation on behalf of each eligible employee who has at least $5,000 of compensation from you for the year.

“You can deduct retirement plan contributions in the tax year within the calendar year for which contributions were made,” he said. “You can deduct contributions for a particular tax year if they are made for that tax year and are made by the due date (including extensions) of your federal income tax return for that year.”

Now the important issue: Who is considered self-employed?

A partner, for starters, is an individual who shares ownership of an unincorporated trade or business with one or more persons, Papetti said. For retirement plans, a partner is treated as an employee of the partnership.

Then there’s a sole proprietor, which is an individual who owns an unincorporated business by himself or herself, including a single-member Limited Liability Company (LLC) that is treated as a disregarded entity for tax purposes, Papetti said.

For retirement plans, a sole proprietor is treated as both an employer and an employee, he said.

“The amount that can be contributed to a self-employed funded retirement plan is based on `Plan Compensation,` which requires adjustments to be made to net earnings from self-employment,” Papetti said. “Plan Compensation is used to determine the plan contribution and deduction for Self-employed individuals.”

To calculate your Plan Compensation, Papetti said, you reduce your net earnings from self-employment by the deductible portion of your self-employment tax from your Form 1040 return (page 1) and the amount of your own (not your employees’) retirement plan contribution from your Form 1040 return (page 1), on the line for self-employed SEP, SIMPLE, and qualified plans such as profit sharing and pension plans.

“Therefore Plan Compensation and the amount of a self-employed’s plan contribution/deduction depend on each other – to compute one, you need the other (this is a circular calculation),” he said. “One way to do this is to use a reduced plan contribution rate.”

He said the IRS provides a Table and Worksheet in Publication 560  to calculate the plan contribution and deduction for yourself.  

“The maximum compensation a retirement plan can consider is $275,000 when figuring contributions for a self-employed person and eligible employee participants,” he said. “However, $55,000 is the maximum contribution to a profit sharing or money purchase pension plan for an eligible employee in 2018.”

So that’s a whole lot to consider, and why we recommend you work with a professional who can go over which option makes the most sense for you.

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