Question: I'm self-employed doing Web site design. I've been told before about Simplified Employee Pensions, or SEPs, and heard they're somewhat similar to IRAs. Could you explain whether it would be advantageous for me to look into this, and what drawbacks, if any, there are? Right now, I just have a Roth IRA, to which I contribute the maximum each year.
Answer: It is all too easy and far too common to kick the savings can down the street, especially when you work for yourself. But not only are you already actively saving, you are thinking about ways to save more. Bravo.
And I have good and bad news for you. The good is there are attractive options for the self-employed to save for retirement. The bad is that thinking about the different options can feel like an alphabet soup that has turned evil. But let me see if I can help a bit.
There are three primary savings instruments for the self-employed. You mentioned the SEP. In addition, there is also the Individual 401(k) and the SIMPLE IRA. There is a fourth option, a qualified defined benefit plan, but it is much more complicated and costly to administer and typically only attractive to very high-income older people. Because of that, let's focus on the other three.
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The SIMPLE IRA is the Savings Investment Match Plan for Employees Individual Retirement Account. Quite a mouthful. For most self-employed people, this is the least attractive option. It mandates an employer contribution — 2 percent or 3 percent of an employee's salary — which can be tough if times get lean. Of the three options, it allows the least to be saved tax-free. This plan tends to be more beneficial to a small employer that wants employees to do most of the contributing out of their own pocket. For a self-employed person, the other options are probably better.
One such option is the one you mentioned, the SEP. It is really the SEP-IRA (Simplified Employee Pension-Individual Retirement Account). Its name is a bit misleading because it is not a "pension" as commonly understood in which you get a monthly check of some amount paid to you in retirement. Rather, the SEP-IRA is really just an account, a place to stash money to prevent it from being taxed very similar to any other IRA or even a 401(k) account. And in the case of the SEP-IRA, the employer is the entity making the entire contribution. The employee cannot contribute. Now, for a self-employed person that distinction might seem a bit odd, but because the SEP-IRA can be used for a small business that has employees, it is an important distinction.
One of the nice things about the SEP-IRA is that for a self-employed person, up to 25 percent of compensation (to a maximum contribution of $49,000) can be contributed and deducted from taxes, though the exact amount that can be contributed in a year is dependent on the details of your situation. What's more, the SEP-IRA is flexible — contributions can change each year — and has relatively little paperwork to administer. All in all, it is a nice option.
Third on our list is the Individual 401(k), also known as the Solo 401(k). Most people have heard of the 401(k) because it is the dominant retirement savings vehicle in private industry. The Individual 401(k) is a version tailored for the self-employed. It boasts some very nice features. First, it allows a maximum total contribution of $49,000. Second, it is flexible and allows contributions to change. And while it requires a bit more paperwork than the SEP-IRA, it normally allows a higher contribution than the SEP-IRA in a year.
The Individual 401(k) can be either a traditional plan, in which deductions are tax deductible, or it can be a Roth version, in which the money you put in is taxed but when it comes out, it is tax-free. The contribution to an Individual 401(k) can come from the employee and the employer. The employee is allowed to put up to $16,500 into the account while the employer can make a profit-sharing contribution, with the total contribution limited to a maximum of $49,000. However, like the SEP-IRA, there are details that govern how much can be contributed in a given year.
In general, both the SEP-IRA and the Individual 401(k) are excellent savings tools for the self-employed. The SEP-IRA has the edge on being easier to administer, while the Individual 401(k) has the edge in that it normally allows a larger total contribution and can come in the Roth flavor. Both plans are relatively inexpensive and easy to administer, and both allow you to invest in all manner of investments. Which is better depends on specifics of your individual situation.
Whatever the case, nearly all the major financial firms — Vanguard, Fidelity, Hilliard Lyons, etc. — offer these plans and make starting easy.