Let’s say that you fit into one of these unconventional preretirement profiles:
- You’ve retired from your long-term career but are free-lancing as a consultant for a few years
- You still are working, but you’ve taken free-lance jobs to boost your retirement capital
- Your employer has downsized, and now are working for it as an independent contractor
- After retiring you’ve started your own business in a new field
In each of these cases, you have self-employment income that could be eligible for additional tax shelter – even if you are covered by an employer’s regular retirement plan. You have the opportunity to build much more retirement capital on a tax-deferred basis.
A Simplified Employee Pension (SEP) operates very much like a regular IRA:
- Contributions are tax deductible, and you pay no tax on your investment earnings until they are withdrawn.
- You may make withdrawals (but not receive loans) at any time. Withdrawals are taxed as ordinary income tax rates of up to 35%.
- Withdrawals prior to age 59 ½ incur a 10% penalty in addition to the tax that you would owe.
- You can roll over the proceeds from a SEP to an IRA for continued tax deferral.
- A schedule of annual withdrawals from the account must begin by April 1 of the year following the year that you reach age 70 ½.
With a SEP you can contribute and deduct up to 20% of your self-employment income up to a maximum of $49,000, adjusted annually for inflation, or 25% of your compensation income if you have incorporated. The maximum compensation that you can consider when figuring SEP contributions and the deduction for contributions is $245,000.
The Solo 401(k)
The Solo 401(k) is available to self-employed individuals and, generally, business owners who have no other full-time employees (except a spouse).
There are two components to your 401(k) contributions, which is what differentiates the plan from a SEP. You may defer up to 100% of the first $16,500 of your self-employment income every year ($22,000 of age 50 or older) – the same amount that can be contributed to a traditional 401(k) plan.
On top of that, you can contribute and deduct an additional amount of up to 20% of your self-employment income or 25% of your W2 compensation income (the profit sharing portion of your contribution). In total, you can contribute up to $49,000 to a Solo 401(k). You can double the amount if your spouse works with you. Contributions are completely discretionary: They may rise and fall, or even be skipped in any year, depending upon how your self-employment income is doing.
If you are covered by an employer’s qualified retirement plan, your contributions to plans based upon your self-employment income will be limited by that fact – consult with your tax advisors to learn more.
With the increased questionability on Social Security, are you putting more emphasis on your own retirement strategies? If you are a business owner what tools are you using?