One of the many advantages of being a freelancer, independent contractor, or other self-employed person is the ability to control your own retirement plan. This both helps ensure a secure future and, because your plan contributions will likely be tax-deductible, makes financial sense right now.
To choose the best retirement plan, first learn about the different features of the plans available to you. Here's what you need to know.
Who is Self-Employed for Purposes of These Plans?
You can create one of the plans described below if you are self-employed and have no employees. (Once you add employees, you can still establish a plan, but the considerations become more complicated.)
To be considered self-employed, you must be in business:
- by yourself (for example as a freelancer, independent contractor, or sole proprietor)
- with others in a partnership, or
- as a limited liability company or limited liability partnership.
If you operate your business as either an S corporation or a C corporation, you are not considered self-employed. (For more on the various ways you can do business, see Nolo's Introduction to Business Structures area.)
Considerations When Choosing a Plan
Before you select a retirement plan, think about the qualities that the plan should have to meet your needs. Here are some questions to ask about the plans you are considering:
What are the tax benefits? Some plans allow you to make larger contributions than other plans. Generally, the larger the contribution, the bigger the tax break.
What are the costs of the plan? Some plans require a lot of administrative work. For some, you will need to hire an actuary (a number-crunching specialist) to calculate contributions. Some plans require you to make reports to the government. All of these things cost money and time; only you can decide if the plan's benefits outweigh the administrative costs.
Does the plan require you to make contributions every year? This is an important consideration if the income from your business varies from year to year. During leaner years, you may want the option of making a small contribution or no contribution at all. Not all plans will give you this flexibility.
What is the deadline for establishing the plan? Some types of plans must be established by December 31 of the year you want to make contributions. Others may be established as late as the extended due date of your income tax return.
The Most Common Types of Plans
SEPs. Simplified employee pensions, commonly knows as SEPs or SEP-IRAs, are simple and flexible. They allow you to contribute up to 25% of your business income, with a cap of $49,000 for the 2010 plan year. The plan will not lock you into a contribution amount, so you can always contribute less than the maximum -- or nothing at all.
If you've waited until the last minute to figure out your retirement plan options, this may be the plan for you: You can open a SEP as late as the extended due date of your income tax return.
SEPs are easy and cheap to establish and administer. You can start one at a bank, brokerage firm, or insurance company, usually for free and in the amount of time it takes to complete a simple form. You do not have to file government reports, and ongoing administrative costs are nil.
Solo 401(k)s. If the contribution limits on a SEP aren't quite high enough for you, a solo 401(k) might be what you are looking for. This 401(k) plan for self-employed individuals allows you to contribute up to $16,500 plus 20% of your business income (with a cap of $49,000 in 2010). If you are older than 50, the deferral limit is $22,000 for 2010 and the cap is $54,500. As with a SEP, you have the option of contributing little or no money in leaner years.
This type of plan requires more paperwork than a SEP IRA. When your account grows to $250,000 or more, you will have to file a special tax return for the plan. In addition, a solo 401(k) costs more than a SEP to establish and maintain.
You must establish the plan by December 31 of the year in which you want to make the contribution (and take the tax break).
Defined Benefit Plans. This type of plan is like the old-fashioned pension plan that your parents or grandparents enjoyed. Defined benefit plans promise to pay you a specific dollar amount, usually each month or year, for the rest of your life, starting at retirement.
The plans are complicated and costly to set up, in part because they require an actuary to calculate your contribution amount. And these plans are not flexible; contributions are mandatory. But if you are making a lot of money, and you want the ability to make large contributions, you should consider this type of plan. To establish a defined benefit plan, you will need the assistance of a financial planner or pension specialist.
To learn more about the retirement plans available to the self-employed, along with other ways to reduce your tax burden, see Working for Yourself: Law & Taxes for Independent Contractors, Freelancers & Consultants, by Stephen Fishman (Nolo).