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Saving for Retirement

Build a Nest Egg When You Work for Yourself

The self-employed have several options when it comes to making tax-deferred contributions for retirement.

EDITOR'S NOTE: This article was originally published in the June 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

Becoming a free agent comes with a lot of perks. You can set your own hours, deduct your business expenses and run your operation without meddling from pesky bosses. And you have several choices when it comes to tax-deferred retirement plans for the self-employed.

SEE ALSO: Protect Your Nest Egg From Market Volatility

The best route depends on your income, your age, whether you have employees and how much you'd like to sock away for the future. You can set up a plan for a sideline business, even if you have a job and are contributing to a retirement plan at work.

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SIMPLE IRA. This plan is for firms with 100 or fewer employees, including companies with just one. If you have employees, you're required to contribute to their accounts, via a dollar-for-dollar match of their own contributions -- up to 3% of their pay or a flat-out 2% of pay. Whether or not you have employees, you can match your own contribution.

For 2011, participants can contribute up to the lesser of $11,500 or 100% of income (plus a "catch-up contribution" of $2,500 if you're 50 or older). If you are at least 50 and earn $50,000 from your business, you could contribute up to $15,500 -- $11,500 plus $2,500 as a catch-up and $1,500 (3% of $50,000) as a match.

A SIMPLE IRA must be set up by October 1 of the year for which contributions are made, but you can contribute until your tax return is due, including extensions. The costs are low, and the process is easy. You can set up one at a mutual fund company, brokerage or bank.

SEP IRA. Want to stash away even more? Consider a Simplified Employee Pension, known as a SEP. You can put away up to 20% of your net self-employment income for a maximum tax-deferred savings of $49,000. That means your income must be $245,000 to reach the maximum level.

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If you have employees, you can contribute up to 25% of their compensation, up to $49,000. As with the SIMPLE, you can deduct employee contributions as a business expense. There is no catch-up contribution for a SEP.

A SEP IRA is subject to the same rules as a regular IRA. You're required to take minimum distributions after you turn 70 1/2, and you can't take loans from the account.

You don't need to set up or fund a SEP until you file your tax return. That means you have until October 17, 2011, to set up or fund a plan for 2010. For both the SIMPLE and SEP, the funding delay enables you to make a larger tax-trimming contribution if your business is doing well or to reduce your contribution if your net income is lower. You can open an account at just about any mutual fund company, brokerage or bank at low or zero costs.

Solo 401(k). Only solo proprietors whose only co-worker is a spouse can open a solo 401(k), also known as an individual 401(k). This plan is more difficult to set up than a SEP or a SIMPLE, but it allows you to salt away more money at the same income level. As with a company plan, you can take loans from the solo account -- a nice benefit if you need extra money for your business.

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With a solo 401(k), you are considered both an employee and an employer. As with a company-based 401(k), you can defer the first $16,500 of pay ($22,000 if you're 50 and older). As the employer, you can contribute an additional 20% of up to $245,000 in net profit -- but only up to a total of $54,500 for both contributions.

Let's say you have net income of $70,000. You'd be able to contribute $22,000 for the employee portion. And you'd be able to contribute up to 20% of the $70,000 for the employer share. After subtracting self-employment tax for Medicare and Social Security, your total contribution would be about $35,000.

An individual 401(k) is more complex and can be more costly to administer than the SIMPLE and SEP. Plan documents can run 10 to 15 pages, and the plan must file an annual tax return. Fees range from zero to $750, depending on your administrator, says Rick Meigs, president of 401khelpcenter.com.

Until the past few years, specialized employee-benefits firms owned the solo 401(k) space, but now you can open an account at firms such as Charles Schwab, Fidelity and TD Ameritrade. Meigs says that business owners should compare the fees for prospective administrators and investments. For instance, he says, an insurance company may not charge an administrative fee, but you could end up paying a big tab for the company's variable annuity. It will likely be cheaper to go with a discount broker that charges a fee but offers low-cost index funds as investments, he says.

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Finding the Best Fit

If you have employees, you will need to choose between a SIMPLE and a SEP. A SIMPLE works best if you want your employees to fund most of their retirement costs. Choose a SEP if you can afford the employee contributions and if you have enough income to save more than the SIMPLE maximum.

The decision is more difficult if you have no employees. If your income is low, the SIMPLE is likely a better bet than a SEP. Say you're a 60-year-old earning $10,000 in consulting fees. With a SEP, you'd be able to contribute $1,858. With a SIMPLE, you'd be able to put away your entire income.

At this income level, the SIMPLE beats the SEP because the SIMPLE allows the deferral of the first $11,500 (or 100% of income) plus the match and catch-up contribution. The SEP only allows you to defer a percentage of income.

At a certain level of income, the total plan contributions for a self-employed person are just about the same whether you use a SIMPLE or a SEP. The break-even point for older workers is $88,500, says Rande Spiegelman, vice-president for financial planning for Charles Schwab. At that income, you can contribute about $16,450 to either a SEP or a SIMPLE. "Anything over that favors the SEP," says Spiegelman. If your income is lower, you could contribute more to the SIMPLE.

However, Spiegelman says, the individual 401(k) may be your best bet of all. If you think you may be earning $20,000 or more every year, it may be worth the extra expense and hassle to set up the solo 401(k). Both the SEP and the solo 401(k) allow you to set aside 20% of net profit, but the 401(k) adds that extra punch: You can contribute the first $22,000 in income if you're 50 and older. "If you ever think your business will grow, why not set up a plan with the maximum capacity?" Spiegelman says.

Your decision could hinge on how much you can afford to set aside for retirement. The 401(k) is a great option if you want to supercharge your nest egg. Perhaps you can live off your spouse's income or a pension. Depending on your business' profitability, you may be able to contribute considerably more than half of your income.

Let's say you're a 62-year-old consultant with net profit of $40,000. You'd be able to contribute $7,400 to a SEP or $15,100 to a SIMPLE, taking into account the self-employment tax. With an individual 401(k), you'd be able to boost your tax-deferred retirement kitty by $29,400. With a profit of $150,000, you could contribute $50,300 to an individual 401(k), compared with $28,300 to a SEP and $18,200 to a SIMPLE.

However, your choice would be different if you needed to keep most of your business income. "If you can't take advantage of the higher contributions and the catch-up, there's no reason to go through the aggravation of the 401(k)," says Meigs.

Another reason to forgo a solo 401(k): If you think there's a chance you'll be hiring employees. "You would have to terminate the plan and that is costly, and then you would have to roll it into a new SEP," Meigs says. "It's easier to have a SEP and continue that with new employees." You can use the calculator at www.401khelpcenter.com or www.vanguard.com to help you compare the tax-deductible contributions of all three plans.

As long as you have income from self-employment, you can open any one of these plans even if you have a job elsewhere. But the potential for tax-deferred savings could be reduced if you're also contributing to a company plan's 401(k).

The most you can contribute to an employer-sponsored 401(k) is $22,000 with the catch-up contribution. Say you're working full-time at a company with a 401(k) and you set up a solo 401(k) for a catering or furniture-restoring side business. If you're contributing $20,000 to your employer's 401(k), you can contribute just $2,000 to the solo plan.

In this case, you would be better off with a SEP because of its lower cost. You can still contribute to your company's 401(k). Plus, you can defer up to 20% of your income from the side business, as long as the total contribution from both jobs does not exceed $54,500.