Retirement Plans for Self Employed
As a self employed individual you work hard taking all the business risk only to realize that a large share of your income will have be given away to the government in the form of taxes. Of course, there are several small deductions that you can take and bring down the amount of taxable income. This list of deductions is long and each individual item can be worth only a few hundred dollars. This is where retirement plans come in and allow you to deduct several thousand dollars on your income taxes.
There are several retirement plans for self employed individuals out there, but each one is more complicated than the other. Selecting the best plan for yourself and your firm is no easy task and it often leads to frustration.
To make the task easier, we narrow it down to just two variables that are crucial in the decision making process. These are:
- Employees: Does your business have employees (Yes/No)?
- Free Cash Flow: How much money are you looking to put aside in a retirement plan for yourself?
For a self-employed individual the following retirement plans could prove beneficial:
- Low Cash Flow: In this situation you can opt for the solo/individual 401(k) plan. People below 50 can make contributions of up to $18,000 and those above the age of 50 can make additional $6,000 contribution adding to a total of $24,000. These limits are adjusted annually by the IRS based on the cost of living increases.
- Medium Cash Flow: Regardless of the size of the business, profit sharing plan is a good plan for a self employed person or a business with medium cash flow or inconsistent cash flow. It allows clients to contribute up to $54,000 annually or 25% of eligible compensation, whichever is lower. This type of retirement plan also provides flexibility in choosing the amount of contributions in any given year. This plan can be beneficial if the company employs the spouse as well and contributions can be made for the spouse, thereby increasing the total amount of contributions.
- Large Cash Flow: With a high cash flow, a self employed individual can always go for a single life Defined Benefit Plan. These plans depend on the age and the compensation of the individual and can allow contributions from 60,000 to 250,000 in some situations. You can use our defined benefit calculator to estimate the amount of contributions in the first year.
Are contributions made to retirement plans tax deductible?
Yes, the contributions to a retirement plan are tax deductible.
What are the contribution limits for retirement plans?
The limits vary each year and by plan type. For a 401(k) plan, the maximum possible contribution is $18,000 if the participant is below the age of 50. An additional $6,000 can be contributed as a catch-up amount if the participant is older than 50.
For a profit sharing plan, the maximum possible contribution is 25% of eligible compensation or $54,000, whichever is lesser. The $54,000 limit is inclusive of any 401(k) contribution that the participant makes. Some people make the mistake of contributing the maximum of $54,000 to the profit sharing plan and then contributing an additional $18,000 to a 401(k) plan. This is clearly incorrect. A participant above the age of 50 can contribute the additional $6,000 to the 401(k) plan and that amount is not included when calculating the maximum contribution of $54,000. Such a person can contribute a total of $60,000.
The annual contribution limits to a DB plan vary based on the design and the funding status. Only the plan actuary can provide you an estimate for this.
Is there a deadline to contribute to a retirement plan?
Retirement plan contributions can be made through out the financial year. Contributions to the 401(k) plan should be done before the end of the year. Contributions to other plans can be made after the end of the year, but before the company files its tax returns. The actual deadline could vary based on the type of the plan and the tax election of your company. You should consult with your CPA to get specific deadlines relevant to you.
Can you not contribute to a retirement plan in a particular year?
Yes! A contribution can be skipped in a particular year if are having a tough year in your business. Some retirement plans may have a minimum required funding, however, the amount depends on how well funded the plan has been in the past.
Can a self-employed person contribute to more than one pension plan?
Only a lucky few would land up in this situation where they have enough free cash flow and one retirement plan is not sufficient to absorb it. However, you should also make sure that the first retirement plan that you get allows the maximum possible contribution. If you still have excess money, you can go ahead and start a second retirement plan. Please note things get complicated here and you should consult with an experienced actuary to ensure you are compliant with all IRS limits. Contributing to multiple plans would require maintaining and paying fees for multiple plans, so you might only want to do this when the total cash flow is more than what can be contributed to one plan.
If you are you indeed in such a great situation you should consider the situation below:
Typically a defined benefit plan will create an opportunity for a large contribution. However, you can still contribute to other plans if you have maxed out the contribution to a DB plan. If you have a DB plan, you can contribute a maximum of $18,000 as a salary deferral and an additional amount of $6,000 if you are above the age of 50. Additionally, contribution to a profit sharing plan or a SEP IRA will be limited to only 6% of your W-2 income.
If you are convinced that a retirement plan is an appropriate tax saving instrument for an individual like you, feel free to reach out to us.You can email us at firstname.lastname@example.org and one of our consultants will get in touch with you.
You can read here how to set up a retirement plan for yourself. The process to set up any form of retirement plan would be similar to as mentioned in this article.