What is the best way for people who are self-employed to save for retirement?
If you’re self-employed or have a sideline business, your best retirement-savings options are a Simplified Employee Pension (SEP) or a solo 401(k) plan. In both cases, your contributions are tax-deductible and grow tax-deferred until you withdraw the money in retirement
With a SEP, you can contribute up to 20% of your net self-employment income (which is your business income minus half of your self-employment tax) up to a maximum of $49,000 for 2011 ($50,000 for 2012). A solo 401(k) has the same maximum contribution limits as a SEP, but you can stash away more money at lower income levels because you fund a solo 401(k) as both an employer and an employee. So you can contribute up to 20% of your net self-employment income to a solo 401(k) plus up to $16,500 in employee salary deferral up to a maximum contribution of $49,000 for 2011. (In 2012, you can contribute up to $17,000 in employee salary deferral plus 20% of net self-employment income up to a maximum contribution of $50,000). And if you are 50 or older by the end of the year, you can make catch-up contributions to a solo 401(k) -- but not to a SEP -- of up to $5,500, for a maximum contribution of $54,500 for 2011 ($55,500 in 2012).
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If you operate a sideline business, you can probably shelter more money in a solo 401(k) than you can in a SEP. That’s because the employee portion of your contribution to a solo 401(k) is not based on a percentage of income. So if you earned $12,000 in net self-employment income in 2011, for example, you could contribute the entire amount to a solo 401(k) plan. With a SEP, by contrast, you would be limited to a $2,400 contribution -- 20% of your net self-employment income.
But you can’t double dip. If you have a 401(k) through an employer and have some freelance earnings on the side, then your total employee deferrals to your employer plan and your solo 401(k) can’t exceed the maximum limit for the year. . If you contributed $10,000 in 2011 to a regular 401(k) through your employer, for example, then the employee-deferral portion of your solo 401(k) contributions would be limited to $6,500, bringing your combined contribution up to the maximum employee salary deferral for 2011 of $16,500 ($17,000 for 2012). Note, however, that you could still contribute up to 20% of your net self-employment income to a solo 401(k) plan as long as your combined contribution did not exceed your total self-employment earnings for the year.
Although the solo 401(k) generally allows you to shelter more self-employment income than a SEP, a SEP is easier to set up. SEPs are available at most brokerage firms, mutual fund companies and banks. Fewer companies offer solo 401(k)s. You can get a list of solo 401(k) administrators and other information at 401khelpcenter.com. One of the most popular plans is Fidelity’s self-employed 401(k) plan, which charges no set-up or annual account fee and lets you invest in any Fidelity or non-Fidelity mutual fund, as well as stocks, bonds and other investments available to Fidelity’s brokerage customers.
If you’re interested in a solo 401(k), you need to act soon. The account must be opened by December 31 to qualify for 2011 contributions, even though you have until April 16, 2012, to make contributions for 2011. You have more time to set up a SEP. The deadline to open and fund a SEP for 2011 is April 16, 2012 (or October 15, 2012, if you file for an extension).
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