This is a guest article by Robert D. Flach. Robert has been preparing business and individual tax returns for people in all walks of life since 1972. He writes the tax blogs THE WANDERING TAX PRO and the NJ TAX PRACTICE BLOG.
Ryan has asked me to write a guest post on the topic of retirement plans for the self-employed. Because there is so much information to present I will do so in several parts.
Self-employed individuals have many types of retirement plans from which to choose. While these plans are available regardless of the type of business “entity” chosen, I will be discussing them from the point of view of the Schedule C filer. In such a situation the determination of the amount of the allowable contribution begins with the “net profit” reported on Line 31 of Schedule C or Line 3 of Schedule C-EZ.
All of the retirement plans that I will discuss are available to the one-man business with no employees, and I will limit my discussion to the contributions of the business owner. However these plans will require coverage of any qualifying W-2 employees of the business, and special rules will apply to contributions for employees.
SEP IRA – Simplified Employee Pension Plan
The first, and easiest to create and maintain, is the SEP, aka SEP-IRA. SEP stands for “Simplified Employee Pension”. Basically a SEP is a traditional IRA account, although the contribution limitations are much higher. A separate IRA account is established for each covered participant.
Plan establishment and contribution deadlines. A SEP IRA, like the Traditional IRA, it is one of the few things you can do to reduce your tax liability after the ball drops on One Times Square on December 31st (FYI, the ball is dropped by one of my 1040 clients). The biggest benefit of the SEP, other than its simplicity, is that you have until the due date of the Form 1040 that includes the Schedule C or C-EZ for which the contribution is being made, including extensions (as late as October 15th of the next year), to set up the plan and make the contribution.
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SEP IRA Contribution limits. For 2008 one can contribute up to $46,000 to a SEP. This is increased to $49,000 for 2009. The amount of the contribution is 25% of “compensation.” For the owner of a Schedule C business this translates to 20% of the net profit on the Schedule C or C-EZ less the “above-the-line” adjustment to income for 50% of “self-employment tax.”
Example SEP IRA contribution:
The “bottom line” of John Q Puhlic’s Schedule C is $80,000. This is John’s only “earned” income (i.e. he has no W-2 income). His self-employment tax is $11,304, so the 50% deduction is $5,652.
John’s maximum SEP contribution is $14,870, calculated as follows:
$80,000 – $5,652 = $74,348 x 20% = $14,870.
We can prove this as follows –
$80,000 – $14,870 = $65,130 – $5,652 = $59,478 “compensation” x 25% = $14,870.
If the $80,000 was earned in 2008 John can submit a Form 4868 Application for Automatic Extension and wait until the first week of October 2009 (technically October 15, 2009) to create the SEP and make the contribution. John does not have to contribute the full $14,870. He can contribute any amount up to $14,870.
SEP IRA contributions are not mandatory. You are not required to make a contribution every year that there is a net profit or to maintain a particular level of contributions. You can choose to contribute the full amount one year, only 10% the next, and nothing at all, even though there is a net profit, the year after.
Serve one, serve all. To establish a SEP you must have a written agreement to provide benefits to all eligible employees. The self-employed owner is considered to be an “employee” for SEP purposes; an owner-employee is both an employer and an employee. You can use the IRS model SEP plan document – Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement.
Benefits of a SEP IRA
Here are some of the reasons a SEP IRA might be a good retirement plan option for you or your small business:
- Light administration. Easy to set up and maintain.
- Contribution deadlines. You have until the tax filing deadline to establish and fund your SEP IRA.
- Large contributions. You can contribute up to $46,000 in 2008 ($49,000 in 2009).
- Immediate vesting. Once the individual SEP-IRA account is established with a bank or mutual fund or brokerage house or any other financial institution the owner-employee is 100% vested. The minute the contribution is made to the account the money belongs to the employee. Withdrawals from a SEP-IRA account are treated the same as from any other IRA account, with the same 10% penalty for premature withdrawal.
You can visit the IRS SEP rules page for more information on the SEP plan.
Here is more information about Self-Employed Retirement Plans.