Retirement Accounts for the Self-Employed

Lower your taxable income by contributing to a SEP IRA or solo 401(k).

I earned $40,000 as a freelance consultant this year, and I am wondering what kind of retirement account is best to shelter my self-employment income? Do I need to make my 2010 contribution by December 31?

Whether you’re self-employed or just earn some freelance income on the side, it’s a great idea to contribute to a small-business retirement plan, which lowers your taxable income now and grows tax-deferred until you withdraw the money in retirement. You have two main choices: a simplified employee pension (SEP) IRA or a solo 401(k).

A SEP IRA is easier to set up. You can open an account with most brokerage firms, mutual fund companies and banks, and you can usually invest in funds, stocks, bonds, CDs and other investments that are available for IRAs. For 2010, you can contribute up to 20% of your net self-employed income (your total business income minus half of your self-employment tax), up to $49,000. You have until the April 18, 2011, tax-filing deadline (or October 17, 2011, if you file an extension) to set up and contribute to the account.

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But at your income level, a solo 401(k) is a better way to maximize your savings. That’s because you can make contributions both as an employee and as an employer . As an employee, you can contribute up to $16,500 for the year; as an employer, you can kick in another 20% of your net self-employment income, up to a combined maximum of $49,000 in 2010. Plus, if you are 50 or older, you can contribute an extra $5,500 in catch-up contributions. (SEP IRAs do not allow catch-up contributions.) See the solo 401(k) calculator (opens in new tab) at the 401khelpcenter to calculate how much you can contribute.

If you’re interested in a solo 401(k), however, you need to act quickly. Although you have until April 18, 2011 (or October 17, 2011, if you file an extension), to contribute to a solo 401(k) for 2010, you need to establish the account by December 31, 2010 -- and that means finding a plan administrator right away. Solo 401(k)s are available at some brokerage firms, mutual fund companies and banks, but you won’t have as many choices as you have with SEPs, and some firms charge much higher fees than others (see the 401khelpcenter’s list of companies offering solo 401(k)s (opens in new tab)).

One good choice is Fidelity’s Self-Employed 401(k). It charges no set-up or annual fees (just the standard brokerage fees for your investments) and lets you invest in anything you can buy with a Fidelity brokerage account. To set up the account, you need to complete an application and an adoption agreement. Fidelity has a fax line set up that will be in operation to receive your forms until 4 p.m. eastern time on December 31.

For more moves self-employed people can make to lower their taxes before the end of the year, see Last-Minute Tax Breaks for the Self-Employed and Moonlighters (opens in new tab).

Kimberly Lankford
Contributing Editor, Kiplinger's Personal Finance

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.